Colin Miranda - Investment Analyst, UBL Fund Managers Ltd.
Feb 8 - 14, 2010

The maintenance of law and order is a prerequisite for economic growth and societal development, and a breakdown of the same can have adverse impact on various facets of an otherwise thriving economy.

In FY09, plagued by rampant inflation, runaway twin-deficits, tight monetary policy and bleak law and order situation, the Pakistan's economy grew at a mere 2%. In contrast, in the post 9/11 era, this economy witnessed robust growth of 7% during FY03-07 on the back of record FDI inflows, modest inflation, manageable fiscal and current account deficits, loose monetary policy and peace in the northern areas.

The impact of a poor law and order situation manifests itself most evidently in the flows of foreign investment (FDI and portfolio). With a population of about 170 million, out of which over 50% are under the age of 25, and a growing middle-class with a high propensity to consume, Pakistan has potential for foreign investments.

In addition, given the huge excess demand situation in certain sectors e.g. electric power generation, and the attractive guaranteed returns offered to foreign investors, one would expect overseas investors to flock to Pakistan but this is clearly not the case as seen in the steep decline in FDI.

Foreign direct investment in the country witnessed 52% contraction YoY in first five months of FY10. The FDI inflows during July-Dec 2009 came in at US$774 mn versus US$1.62 bn in the corresponding period last year and US$1.73 bn in July-Dec 2007.

Unfortunately, it is the uncertain security situation that stops foreign investors from bringing large amounts of capital into the country in the form of FDI and contributing to the economic growth.

The KSE 100 is currently one of the cheapest stock markets to invest with a P/E ratio of 8.1x compared to 9.14x for Dubai, 15.1x for India, and 10x for Thailand, yet during CY09, the KSE100 index's performance was significantly below its regional peers.

Amongst the myriad of reasons for the underperformance, is the initiation of the military operation in the northern areas in April 2009. The security situation in the country has continued to deteriorate since then. Foreign capital has not yet returned to the stock market in a big way.

The law and order situation plays a pivotal role in determining fiscal policy. The current government's drive to eradicate militant elements in the north has taken its toll on essential PSDP expenditure and on its budget deficit. According to some estimates, the cost of the military operations in the Swat valley alone is about $2.5 billion (PkR 210 billion); not to mention the additional cost of the reconstruction of the war-torn zones and of rehabilitating the IDPs.

To add to the GoP's woes, FATA's payables to PEPCO have surged to an estimated PkR80 bn, an amount, which given the region's shattered economy is most likely to remain outstanding for quite some time.

In its report on the third review meeting, the IMF acknowledged the fact that Pakistan met most of its quantitative performance criteria in the 1QFY10 except its fiscal deficit targets, citing higher security spending as one of the primary reasons for fiscal slippage of 0.3% compared to the 1Q target. Whether or not Pakistan is able to achieve its fiscal deficit-to-GDP ratio of 4.9% for FY10, will remain contingent upon its ability to curtail non-essential spending, widening the tax base and/or increase tax rates, and the inflow of funds from foreign entities such as the FoDP.

The reduction of PSDP allocation from the initial allocation of PkR 646 billion to PkR 300 billion (as of January 2010), will help the GoP bring its fiscal deficit in line with the IMF-prescribed targets, although it may have a negative implications for sustainable economic growth over the long-term due to the GoP's inability to develop human capital and infrastructure. If defense expenditure were to be curbed, it would allow for more expenditure on much-needed PSDP projects.

The volatile law & order situation also plays a significant role in tainting the country's image abroad, which impedes growth in export revenues. As a result, the country has come to rely heavily on a lower import bill and higher foreign remittances to keep its current account deficit under control, and external inflows in the form of loans/grants to keep its overall balance of payments in check, which is not representative of organic economic growth that can be sustained in the long-run. Putting an end to the lawlessness would keep the airwaves free of negative newsbytes about Pakistan, and pave the way for rejuvenation of the country's image.

The Pakistan's economy is currently faced with numerous challenges that differ in magnitude and the time period over which they can be resolved. If the law and order situation is effectively resolved, and the essential structural reforms are implemented in letter and spirit, it may well usher in the dawn of a new era of prosperity for the country, provided that the concerned authorities have the prerequisite tenacity to further the interests of the country.