Earthquake may accelerate rate of inflation

Nov 14 - 20, 2005

The country's economic growth may slip by half a percentage point and the inflation to accelerate faster than expected in the fiscal year to June 30 because of last month's earthquake that devastated northern parts of the country.

"The pressure on the economy will be felt mainly on the government's budget, trade balance, GDP and inflation,'' said Dr Ishrat Husain, Governor of the State Bank of Pakistan, in an interview.

"Initially, there would be more pressure on the government's budget, especially in the wake of slow response of the international community for the relief work.''

The 7.6 magnitude earthquake killed more than 80,000 people, injured many more thousands and left 3.3 million people homeless in 25,000 square kilometers (9,653 square miles) area in Kashmir and the North West Frontier Province. Pakistan said it will need $5 billion over the next five to 10 years to rebuild cities and rehabilitate quake-affected people. The country's fiscal deficit may widen this year as the country steps up spending on rebuilding areas damaged by the Oct. 8 earthquake, the central bank said.

"The fiscal space will be sorely tested in the aftermath of the recent earthquake that severely damaged infrastructure in the affected areas,'' said the 2004-05 annual report.

PAGE: At present it appears that the aid is coming slowly whereas huge funds are required for reconstruction and rehabilitation, which means it will create pressure on our economy.

DR ISHRAT: Yes, it is true that aid is flowing in slowly. The response of the international community has not been very encouraging despite calls from the UN. The commitments/donations made so far are about US$ 1.8 billion, which is obviously quite less than the requirement. Initial assessment of future needs has been estimated at US$5 billion by the government, but some other private estimates are hovering around US$ 10 - 12 billion. A more realistic assessment being done by the government, WB and the ADB would be available by mid November.

The pressure on the economy will be felt mainly on government's budget, trade balance, GDP and inflation. The intensity of the pressure, however, will vary over the time and would be related with the three stages to combat the earthquake effect i.e. relief, rehabilitation and reconstruction. Initially, there would be more pressure on the government's budget especially in the wake of slow response of the international community for the relief work. Inflation is also likely to increase as the supply from those areas has vanished and their demand needs to be met from other areas. Trade balance and GDP will be more affected once the phase of reconstruction begins which may take some time but the financing sources of imports and new investment will determine the magnitude of changes in these variables. During FY06, GDP growth is likely to slow down by half a percent due to the loss in contribution by the affected areas of NWFP.

The current pressure on the economy is due to the on-going relief efforts and partly the rehabilitation work that has now been initiated in the form of some financial support to the relatives of the victims or the injured or the reopening of schools for children. In this stage, the pressure will be more on government's budget, trade balance and inflation. Though the foreign aid and domestically generated resources are helping the government, most of funds are likely to be diverted for the reconstruction phase and therefore the government would bear most of the expenses in this relief phase that may raise the budget deficit for this year significantly. The trade deficit will widen due to the import of tents, blankets and medicines. Inflation is likely to rise as the supply of food items like vegetables, meat, poultry and milk that was produced within the affected areas is no more available and will now be procured from the adjoining areas.

The major pressure of rehabilitation and reconstruction would come late in the current fiscal year and onwards and would be on all the areas identified earlier.

The rehabilitation activities, such as (i) provision of school or hospital services; (ii) welfare services to the permanently disabled, destitute women and the orphans; and (iii) financial support for the poor to begin their own businesses will put relatively more pressure on the government budget.

During the reconstruction phase, the major impact will be on GDP, trade balance and inflation. Its impact on budget would depend on the extent of resources generated through foreign aid and the external borrowings. Given the funds generation pace so far, government is more likely to depend on external borrowings. Though external borrowing will not increase budget deficit on one-to-one basis but it would create debt servicing burden in the coming years. The extent of such burden would depend on the terms and conditions associated with such loans.

The reconstruction activities' major impact would be on GDP growth as the construction activity is likely to boost the construction sector itself, its allied industries and the services sector. These activities would trigger import of raw material and machinery thereby widening the trade deficit. Imports may also rise if the government decides to import pre-fabricated houses from abroad. The impact may be diluted given the recent increase in cement manufacturing capacity by almost 1/3rd of the existing production and the recent decision by the government to allow import of cement.

1. The higher demand of food and other raw materials would result into increase in prices, thereby raising inflation rate.

The overall demand for food is not going to increase other than annual increase in population. The supply of food items, however, is definitely affected since items produced within the area and the stocks of other items have been destroyed and may take some time to resume. This demand-supply gap would have a regional impact since the demand for food by the affected would be met from the nearby areas especially of items like vegetables, fruits, meat, milk, poultry etc. Impact on other items like wheat and rice is unlikely to be very significant as these items are mostly procured from various of the country and the extra pressure would only be to the extent of lost stocks.

The pressure due to the raw material demand would raise once the reconstruction phase begins and it will definitely affect inflation.

PAGE: If our local industries failed to meet the demand, import bill would go up leading to the widening of trade deficit?

DR ISHRAT: "As I said earlier, the trade deficit would be affected both at the relief stage and following the reconstruction phase. The relief stage effects would be temporary but could be significant. The reconstruction stage effects would be spreading over a number of years and depend on the nature of demand and the readiness of the domestic industry to meet the demand, which would decide about how much this is going to impact trade balance.

PAGE: There is a remote possibility that the economy will go unscathed and GDP rate may fall?

DR ISHRAT: "Our economy is unlikely to go through a major dislocation due to the great tragedy. As I mentioned earlier, the loss in contribution by the people in affected areas of NWFP and the impact on economic activities of other areas due to temporary migration of people related to the affected areas will weigh on the economy but only marginally. At the same time, however, production of items like tents, medicines or other required items may increase offsetting this decline to some extent. Based on our estimates the loss in GDP growth could be to the tune of 0.5 percent for FY06.

PAGE: The government has to utilize public sector development fund which means development works on other major projects will halt such as construction of roads, dams and airports.

DR ISHRAT: The infrastructure and the government building losses due to the earthquake are massive and the resource requirement to repair or rebuild these is enormous. This process of rebuilding/repair would be spread over a number of years and would be financed in collaboration with UN and international donor agencies, domestic private sector, NGOs, etc. To the extent these sources of financing fall short of the actual requirements and there will be a need for some reallocation from low priority development projects, containment of non-essential non-development expenditure and mobilization of tax and non-tax revenues. If the government remains unable to generate enough resources through foreign aid, domestic revenues and external borrowings then this would squeeze the existing development budget for other areas/projects. Initially the government will have to re-prioritize the projects giving top priority to the affected areas' projects. All this may entail postponing some of the projects for the time being. The government may also begin a drive to save on account of current expenditures, which would be a welcome step. One of the encouraging steps by the government is to postpone the buying of F-16 planes.

PAGE: What the government should do or avoid in this national disaster to sustain economic growth in this fiscal year and coming years because the rehabilitation work will take as much as five years?

DR ISHRAT: "This is a tough time not only for the economic managers of the country but the whole nation. To sustain economic growth during the coming years, there is a number of things the government needs to do such as:

i. An optimal utilization of the scarce resources - optimal utilization of resources entails prioritizing projects and an efficient usage of resources. Setting up of priorities for reconstruction and their timing must be done very cautiously to avoid a skewed distribution of resource requirement over the time and geography. For efficient usage of resources, appropriate planning of activities and coordination among the various implementing bodies must be ensured. Redundancies must be eliminated and the government must ensure that the resources are not spent lavishly or more on the operations than the affected people for whom these resources are meant for.

ii. Accountability and transparency must be ensured in all operations. Government must keep a vigilant eye on the utilization of available resources and must not sacrifice accountability and transparency in its operations. Due to the massive scale of operations, there would be a tendency of leniency tempting to misappropriation of resources or neglect. To win the confidence of the foreign as well as the domestic donors various processes of resource utilization must be transparent and the authorities having control on these must be accountable to the nation.

I would like to add here further that this difficult time is for the whole nation and the public must not leave the government alone in this time of need as without the help of the nation, it will be difficult for the government to accomplish this gigantic task.