STRUCTURAL RIGIDITIES AND INFLATION IN PAKISTAN

LUBNA NAZ
Jan 29 - Feb 04, 2007

An acceptable rate of inflation is known to one that fosters the profits of private producers to an extent which guarantees increase in output, employment, incomes and decline in the real value of money borrowed by deficit units of the society. At present, inflation is a major issue in Pakistan and inflation controlling policies are being sought to fight this mounting problem.

This recent shift in the focus of macroeconomic policy is taking place due to the possibility of facing running inflation by the economy as the current inflation rate seems to have touched almost double digits from the last two years. Food inflation is already turned in double digits and has caused the prices of many essential items to go beyond the reach of the common people. Hence it can be regarded as an alarming situation at a time when Pakistan has heralded in an era of high growth with some signs of sustainability. For the first time in a decade, total gross investment to GDP ratio has reached to 20% from 18.1 in 2005(SBP report FY2006), per capita income has increased to $590, export have reached to $16bn in 2006 from $12bn in 2004, debt to GDP ration has declined to 57.8% in 2006 from 63.7% in 2005, manufacturing sector picked up growth touched 14.0 growth rate in 2004 but declined to 8.6 in 2006. Despite all such progress on the economic front, inflation has turned out to be the biggest challenge for the present government which is why the SBP seems keener to tackle this problem on priority basis.

The rising cost of living leads to increase in cost of production which deteriorates the competitiveness in our exports in a free trade regime in which survival of our exporters has already being questioned due to their inability to produce value added and cost competitive products in comparison with their Chinese and Indian competitors. In addition to this, the real value of the profits of producers will be threatened and will provide sufficient pretext to them to shift their businesses elsewhere which in turn will cause decline in employment. Declines in the purchasing power will lead to cut down in aggregate expenditure coupled with a decline in private savings due to further decrease in real returns and hence a major barrier in achieving a projected 7% growth rate or perhaps even sustain a growth rate above 6%.

Looking in to the causes or addressing the real factors behind rising prices is a rather hard nut to crack as inflation in our economy seems to have been attributed by a myriad of factors including the much debated demand pull and supply side factors as well as much more importantly but the less discussed structural rigidities in the existing economic system, as reported in recently issued SBP annual report (2006).

In the first place, focusing on the problem of structural rigidities and their role in aggravating the problem of inflation, calls for investigating the decline in agriculture incomes or increase in non agriculture incomes and the equally important inelastic nature of the agriculture output. In the case of Pakistan, the contribution of the services sector in GDP is reported to have increased to 53.3% in 2006 , manufacturing sector output contributed 25.1% in 2006, agriculture output 21.6% showing a decline after having maintained a 6.7% growth rate in 2005 is sufficient to support the argument that the increase in non agriculture sector or increase in urban sector incomes caused increase in the demand for agriculture output in the recent past . Wherein the agriculture sector output supply remains always vulnerable to vagaries of nature like recent hike in the prices of onions, garlic and tomatoes widely reported to have resulted from the damage to onion crop by the heavy and unexpected rains in Sindh and decline in output of other vegetables occurred due to changes in the water courses in the earthquake affected areas.

Poor marketing, delayed sowing of wheat are also known to have brought a decrease in the cotton crop particularly in the year gone by and the delayed crushing of sugar ignited pressure on the government to use valuable foreign exchange for sugar imports. This all led to the increase in the miseries of common people who had to succumb to purchases of onion, tomatoes and sugar at unaffordable prices. These were actually the routine demand and supply imbalances that resulted in double digit food inflation but these demand and supply gaps can be attributed to structural rigidity inherent in our agriculture sector.

Another factor that highlights the persistence of inflation arising out of the structural frame work is the sluggish growth of exports which is reflected in terms of constantly declining export/GDP ratio from 13.06 in 2005 to 12.81 in 2006 despite the $6bn package offered by the government for restructuring, modernizing and balancing of textile industry in the economy. The import to GDP ratio has increased from 17.13 in 2005 to 19.36 in 2006, which is taking place due to the heavy reliance on the exports of goods which are not value added and less competitive in the world market. A host of other factors can not be ignored as well like rising cost of utilities, frequent power breakdown in industry, rising oil prices and above all decline in the growth rates world over after having seen robust growth in the last decade. Thus stagnation or further decline in the exports is likely if a good mix of monetary and fiscal incentives is not granted to prospective foreign buyers of national assets in order to attract them in producing exportable instead of importing raw material by reducing valuable foreign exchange to produce import substitutes.

The major proportion of the foreign direct investment received in the last four years in particular has been found in the services sector and particularly in telecommunication and energy which will not only invoke further disparities in incomes between the agriculture sector and services sector but also accelerate the current account deficit. The rise in imports is justified on part of the government on almost unchanged grounds in which increase in oil prices, increase in foreign direct investment promoted to fill the saving investment gap seems to have delivered the economy rising import bill. The alarming frequent import of food items due to demand and supply imbalances by the government is rarely discussed within government circles. The government has been unable to do justice with the agriculture sector by taking much needed steps to resolve long standing issues like land reforms, credit availability, timely announcement of support prices, establishment of centers for encouraging use of biochemical technology that has given promising results in the neighboring country in terms of increase crop intensity, increase in the pace of double cropping and above all increase in the productivity of labor at the constant capital labor ratio.

Another noticeable factor contributing to structural inflation in Pakistan is the increase in consumer durables purchases that comprise the major proportion of imports directly or indirectly. The increase in electric and electronic gadgets imports, as well as the electronic engineering industry growth, indicates that the promotion to 'consumerism' through the perception of "buy now and pay later" in order to reflect wide spread benefits of growth has added more to costs rather than benefits as well as adding greatly to banking profitability.

In this situation, the SBP seems over ambitious about controlling inflation through the tightening of monetary policy which can control inflation to a certain extent through the decline in money supply or indirectly resulting in lower aggregate demand. The upward pressure on interest rates will hamper investment in the long run thereby enlarging gap between saving and investment. To encourage private savings a lot seems to have been done and still a lot is underway by the SBP. For the first time, private banks have been warned of strict action if returns on saving are not rationalized. In the present situation, prospects to achieve projected growth rate by the end of fiscal year 2006-07 will turn into a far-reaching reality.

The taxation system of Pakistan can also be held responsible for the worsening economic stability. Our economy is known to have a tax system that has low inflation elasticities which means when prices rise the real value of taxes falls as often taxes are fixed in money terms. Moreover, it often takes time to collect taxes with the result that by the time they are paid by the assessee their real value is less to the exchequer. While planned expenditure on projects are not undertaken on scheduled time due to various supply bottlenecks resulting in price rises which then causes the money value of expenditure to increase proportionally. The Asian development bank in 2004 prepared a report titled as "Guideline for monitoring and evaluation of ADB assisted projects in Pakistan" to bring to light some interesting facts about the total delays in the undertaking of development expenditure. According to this report, the estimated time taken for loan signing on average is six months. After signing, further delays are encountered in the loan effectiveness and start up of actual implementation, the total time estimated which a project financed through ADB loan takes in Pakistan are twenty four months or two yeas. Thus the decline in the real value of the tax collections and the rise in the money value of expenditure lead the government to adopt to large fiscal deficits which further accentuate inflationary pressure as well as increasing the revenue expenditure gap. The government then has to resort to domestic or external borrowing which causes damage to economic stability as the funding needed by the private sector to maintain investment deemed inevitable for achieving stable growth is diverted to fill the increasing fiscal deficit. On top of this, government borrowing which is undertaken against future promise leaves less fiscal space to be available in the future.

In view of the above analysis, merely further tightening of monetary policy can no more be justified as a single available measure for controlling inflation in Pakistan where some inherent and some uncorrected rigidities in the economic structure are contributing noticeably in the sustained rise of price levels. Thus there is a need to look into the causes of inflation in a more realistic way so that the solution set to be put forward must have more to offer, especially to the poorer members of our society.

Sources

* State Ban of Pakistan (Annual Report FY2006)
* Asian Development Bank
The author is a Lecturer on Economics at University of Karachi.