Mis-Managed Growth

Of the myriad of problems faced by developing countries, one is the mismanagement of international capital inflows. Pakistan is a case in point. In the five year period, 2002-2006, Pakistan experienced substantial capital inflows, both for geopolitical reasons and opening of investment opportunities after a series of market reforms. Stock market indices multiplied ten fold, real estate prices tripled, and retail markets were filled with high value consumption goods. However, the period of 'prosperity' was followed by a painful bust of the economy. The global rise in commodity prices and domestic political instability triggered a fall in domestic and international investment in Pakistan, causing a rise in inflation, widespread unemployment, and shortages of primary commodities. Pakistan was on the verge of default in late 2008. I will discuss the policy options to handle these capital inflows both as exercised by Pakistan and as prescribed by International Financial Institutions (IFIs).

The impact of international capital flows critically depends on the policy environment in recipient country, and a number of factors determine it. Firstly, consider the sequencing of market reforms, which includes achievement of macroeconomic stability first, followed by the liberalization of current and financial accounts. The liberalized sector must be regulated and protected by governing institutions. In Pakistan, the order was reverse. In 2002, government budget deficit was high and inflation was unsteady. However, significant reductions in trade barriers for luxury goods, and financial sector regulation were carried out, followed by wide privatization of national assets- ranging from banks, telecommunication, power and manufacturing. The attraction of attracting foreign capital was so high that no attention was paid to the establishment of institutional framework. Secondly, financial sector in Pakistan was rudimentary, and financial assessments for investment opportunities were nonexistent. In the absence of institutions, no means exist to ensure efficient investments. The funds from outside were often invested either in non-productive and risky investments like real estate or were used for speculation in stock markets. I was often amazed by reading the international economic statistics at the last page of The Economist; while the growth rate of Pakistan was 7%, the industrial output was declining at 1.5% annually. Now I know were these funds were going. Thirdly, most of the growth was consumption spurred. Sustaining growth requires continued investments in national capital stocks. However, government used international capital as a substitute rather then compliment to domestic savings. Low and almost negative real interest rates coupled with lower taxes on luxury goods, spurred consumer spending. This ensured that Pakistan would continually depend on foreign investment and lending to sustain its growth. Even during the growth years, a collapse was in the waiting. In the face of domestic inflation, consumer spending stopped and international capital flew, and there was no institutional cushion for the impending crises.

IFIs argue for the achievement of macroeconomic stability and fiscal discipline as a foundation for economic reforms. However, there are problems with the implementation of this approach as well. Fiscal deficits are lowered by cutting government expenditure on vital development programs. Majority of government subsidies are directed towards primary food items and on health and education spending. These are the programs that get most adversely affected. Removal of subsidies increases food and energy prices which lead a spiral of inflation. At one end, inflation destabilizes the economy and on the other, it substantially decreases the purchasing power and living standards of the poor. In such a scenario, multilateral lending is often met with widespread domestic criticism because they mean more for the rich and less for the poor. In economies like Pakistan, where majority of the peoples income is spent on basic food, housing and clothing, and tax evasion is rampant, taxation on luxury items can be an effective channel of indirect taxation. On the other hand, easing the burden on primary commodities by investing in infrastructural programs for the wider populace can be seen as a possible mean of justifying long term borrowing. Thus, the IFI approach of maintaining fiscal discipline may be correct in theory; in application it often gives wrong incentives to the recipient governments.

To conclude, it is apparent that there is no scientific methodology of providing the most suitable environment for international capital flows. Although the theoretical link between Foreign Investment and its impact on growth is deterministic; international development policies have opportunities for improvement. There can be no uniform formulae applied to all countries in all financial crises; a tailor made approach is imperative. Lessons from Pakistan acknowledge the need for higher degree of investment management, more supervision of government policies, and a deeper understanding of local economic situations.