Balance of Payments Constrained Growth in Pakistan - Implications for Development Policy

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1. SBP Working Paper Series No . 107 February, 2021 Balance of Payments Constrained Growth in Pakistan - Implications for Development Policy Bilal Raza STATE BANK OF PAKISTAN
2. SBP Working Paper Series Editor : Farooq Pasha The objective of the SBP Working Paper Series is to stimulate and generate discussions on different aspects of macroeconomic issues among the staff members of the State Bank of Pakistan. Papers published in this series are subject to intense internal review process. The views expressed in these papers are those of the author(s) not State Bank of Pakistan. © State Bank of Pakistan. Price per Working Paper (print form) Pakistan: Rs 50 (inclusive of postage) Foreign: US$ 20 (inclusive of postage) Purchase orders, accompanied with cheques/drafts drawn in favor of State Bank of Pakistan, should be sent to: Chief Spokesperson, External Relations Department, State Bank of Pakistan, I.I. Chundrigar Road, P.O. Box No. 4456, Karachi 74000. Pakistan. Soft copy is downloadable for free from SBP website: http://www.sbp.org.pk For all other correspondence: Postal: Editor, SBP Working Paper Series, Research Department, State Bank of Pakistan, I.I. Chundrigar Road, P.O. Box No. 4456, Karachi 74000. Pakistan. Email: wps@sbp.org.pk ISSN 1997-3802 (Print) ISSN 1997-3810 (Online) Published by State Bank of Pakistan, Karachi, Pakistan. Printed at the SBP BSC (Bank) – Printing Press, Karachi, Pakistan
3. Balance of Payments Constrained Growth in Pakistan - Implications for Development Policy Bilal Raza1 Abstract This study examines relevance of Thirlwall ’s Law (1979) for Pakistan which states that in the long run no country can grow faster than the rate consistent with balance of current account, unless it can finance ever-growing deficits. Descriptive analysis shows that worsening of external sector balances leads to slowdown in growth rate. Different estimations of growth rate using ARDL regression analyses also suggest that Pakistan’s long run growth is at least partly BOP constrained. Major factors for this constraint are stagnant primary structure of exports, relatively inelastic demand for imports and deteriorating terms of trade. Relaxing external constraint requires structural transformation; however, political economy of stabilization process results in stability without reforms and thus leads to vicious cycle of crises. It is argued that dynamic manufacturing sector is key to long-term development; and Pakistan should pursue dynamic comparative advantage as it is in consonance with historical global experiences of successful developments. JEL Classification: E12, F43, E63 Key Words: Growth Rate, Balance of Payments Constraint, Post-Keynesian, Stabilization Acknowledgments Authors would like to thank Sajawal Khan, Farooq Arby, Farooq Pasha and anonymous reviewer for the thoughtful comments on an earlier version of this paper. Contact for correspondence: Bilal Raza Assistant Director, Research Department State Bank of Pakistan I.I. Chundrigar Road Karachi 74000. Email: Bilal.Raza2@sbp.org.pk 1 Assistant Director, Research Department, State Bank of Pakistan, Karachi (Bilal.Raza2@sbp.org.pk )
4. Non-technical Summary Economic literature suggests that Pakistan needs to grow at least 7 % per annum to provide jobs to newly entering youth in the labor market. However, Pakistan‟s actual growth rate since 2008 is only 3.9%. This markedly less than desired growth rate can convert potential demographic dividend into demographic disaster. Thirlwall's law (1979) says that in the long run no country can grow faster than the rate consistent with the balance on current account, unless it can finance ever growing deficits. Following this post-Keynesian approach, this paper argues that Pakistan can‟t sustain high growth rate because of balance of payments constraint on effective demand. Declining exports to GDP ratio as well as repeated episodes of slowdown in economic growth following a balance of payments crisis show relevance of this approach in the case of Pakistan. For empirical evaluation, this study takes annual data over the period 1980-2017. Using Autoregressive Distributive Lag (ARDL) regression analysis, it finds that balance of payments constrained growth rate is 4.2%. In other words, external account will become unsustainable as growth rate will start moving above this level, ceteris-paribus. Results show that declining terms of trade also put significant downward pressure on economic growth. This study postulates that because of the way economic and political forces interact in Pakistan, repeated IMF programs do achieve stability but reforms remain incomplete. It gives rise to a myopic outlook and results in lower R&D and long run investment expenditures. This makes future crisis a self-fulfilling prophecy by further reducing exports and growth potential. This vicious cycle of crisis is put forward as an explanation for Pakistan‟s deteriorating terms of trade as well as declining exports and growth potential. Within the framework of this study, if sufficiently high growth to accomodate increasing labour force is to be achieved then Pakistan needs to relax external constraint on growth by improving terms of trade, increasing income elasticity of export demand and/or decreasing income elasticity of import demand. Based on the understanding of historical episodes of economic development, this study suggests that Pakistan should pursue dynamic comparative advantage wherein successful import substitution precedes export oriented strategy for economic growth. Page 4 of 26
5. 1 . Introduction Pakistan‟s economy needs to grow at a minimum 7 percent per annum, that is also long run growth target set by the government, to provide jobs to newly entering youth in labor market (Framework for Economic Growth, 2011; Pakistan Economic Survey, 2015-16). However, Pakistan‟s growth rate since 1980 has averaged 4.91 percent and stood at merely 3.90 percent from 2008-18. In a country of 212 million with about 64 percent population under the age of 30 (UN Population Statistics), this markedly lower GDP growth rate means supposed demographic dividend may end up in a demographic disaster. Therefore, it is pertinent to explore why Pakistan has failed to achieve long run growth target to identify structural bottlenecks and design optimal policy. Pakistan had experienced periods of high economic growth, sometimes exceeding current long run target of seven percent. From 1961-70, average GDP growth rate was 7.24 percent and it had better economic prospects than most Asian Tigers. Economic performance was relatively better in 1980s as average growth rate stood at 7.08 percent from 1980-88. Similarly, in mid 2000s, at one point it was only second to China in growth rate and average growth rate from 2003-07 was 6.18 percent. During the latest spurt in economic growth, it peaked at 5.8 percent in 2017-18 before taking a nosedive. All these episodes show two things. First, peak as well as average growth rate for successive boom periods has declined that suggests steady erosion of long run growth potential. Second, Pakistan can certainly achieve higher growth rate but fails to sustain it for a longer period, and that is what differentiates it from Asian Tigers. Hence, problem is with both trend and cyclical components of growth. This leads to next question: Why Pakistan has failed to sustain high growth rate? There is a multitude of factors, with possibility to frame within different theories and models, that can help explain Pakistan‟s inconsistent economic performance. However, one of the most convincing and plausible explanations comes from Balance of Payments Constraint Growth (BPCG) model. BPCG model states that in the long run no country can grow higher than the rate that is consistent with balance of current account, unless it can finance ever-growing deficits (Thirlwall, 1979). A balance of payments (BOP) constraint emerges when higher growth rate is achieved through domestic demand management policies that increases imports but does not affect exports. Assuming net capital flows are negligible, the resulting trade deficit cannot be sustained in the long run. External financing can only provide short run relief because rising level of external debt increases country risk and makes borrowing costly. One effective way to address this deficit in the short run is to slowdown economic activity, ceteris paribus. Hence, BOP constraint impedes sustainability of higher economic growth rate. Stylized Facts Pakistan has never run a trade surplus from 1980-2018. Although most of the times net inflows of capital and remittances compensated negative impact of trade deficit on current account, there are recurrent episodes when it led to BOP crisis. After liberalization of the economy in early 1990s, foreign reserves averaged for 1.76 months of import bill from 1993-2000, well below satisfactory level of three months, and average growth rate plummeted to 3.35 percent. Table.1 presents five episodes when growth rate declined below 4.8 percent that is also approximately equal to actual average growth rate. Each time, average current account deficit (CAD) as percentage of total foreign earnings (TFE) for period „t‟ and „t1‟ jumped significantly above the historical average while foreign reserves (Res) fell markedly short of Page 5 of 26
6. standard benchmark of three months import bill . Fig.1 shows that CAD as percentage of GDP in time „t‟ is almost mirror image of GDP growth It supports our claim that build-up of CAD translates into BOP constraint and leads to decline on GDP growth. Table.1 BOP Components as percentage of TFE when Growth Rate fell below 4.8 Period CAD TAD* FAD* Res ΔY 1989-90 16.0 34.7 17.8 1.1 -0.5 1992-93 21.3 33.3 20.8 1.8 -5.9 1996-97 22.6 31.1 22.2 1.4 -3.8 2007-08 32.6 52.2 32.2 2.0 -3.1 2018-19 34.8 68.4 35.4 1.9 -3.9 1980-19 12.4 36.5 11.2 3.0 *TAD=Trade Account Deficit; CAD=Current Account Deficit. Similarly, last two consumption-led booms (2003-07 & 2014-18) ended after reserves depleted to 2.02 and 1.92 months of import bill and current account deficit reached at 8.4 and 6.3 percent of GDP, respectively. Each time Pakistan entered in an IMF program for structural adjustment and focus of government policy shifted from growth to macroeconomic stability. For example, Pakistan Economic Survey (2007-08) states that „top priority of government is correction of imbalances through shaving off aggregate demand by appropriate policies‟. Similarly, Pakistan Economic Survey (2018-19) states that „foremost challenge to the economy is the rising aggregate demand without corresponding resources to support it, leading to rising fiscal and external account deficits‟ and to address it „government has introduced a comprehensive set of economic and structural reform measures‟. This analysis can help us draw two conclusions: i) successive IMF programs have succeeded in bringing stability without reforms; ii) Current account deficit is the perennial underbelly that does not allow sustaining high growth rate once achieved. Within current account, Pakistan has three major components i.e. imports, exports and remittances. Since 2000, remittances have grown from 1.13 percent to 7.3 percent of GDP. Imports have stayed on average around 19 percent of GDP with occasional big jumps acting as prelude to external crisis. However, exports as percentage of GDP have steadily declined from 14.4 percent in 2003 to 8.9 percent in 2018. It means Pakistan‟s Achilles‟ heel is poor performance in exports, so any long run solution to relax BOP constraint must contain measures to increase exports growth. Literature on Pakistan‟s economic growth is predominantly focused on supply constraints. This paper builds on Felipe et al. (2009) to appreciate role of aggregate demand in determining Pakistan‟s long run Page 6 of 26
7. GDP growth . Apart from estimating standard model for latest data, this study modifies BPCG model to allow capital flows to finance CAD so that estimates are more realistic and reliable. The rest of the paper progresses as follows. Section two describes BPCG model. Section three discusses literature review. Section four is data and methodology while section five presents estimation and results. Section six analyzes reasons for Pakistan‟s BOP constraint and discusses policy implications. Section seven provides conclusions. 2. Balance of Payments Constraint Growth Model In a simple closed economy Keynesian model, full employment equilibrium requires that planned savings (leakages) are equal to planned investment (expenditures). However, in an open economy framework, another important constraint arises when exports earnings fall short of financing full employment imports. Harrod (1933) states that if terms of trade are constant and exports are less than imports (X<M), then, like Keynesian models, output (Y) will adjust to restore BOP equilibrium. In Harrod‟s static economy model, Y=X/μ where μ is propensity to import and 1/μ is foreign trade multiplier. Thirlwall (1979) revived Harrod‟s analysis and developed Dynamic Harrod foreign trade multiplier, also known as BPCG model. Following is a beautiful articulation of this idea: “At any given time there is a certain level of domestic spending at which . . . the balance of payments on current account would be in balance. We may call this the level of spending „warranted‟ by the country‟s performance in foreign trade . . . While swings of fiscal and monetary policy . . . have influenced the level of spending from year to year, in the longer run the main determinant was the spending level „warranted‟ by the economy‟s performance in foreign trade.” (Cambridge Economic Policy Group, 1981, pp.10-11). BPCG model presumes underutilization of capacity and claims that effective demand “drives” economic system, to which supply, within limits, adjusts. If actual growth rate is higher than BOP consistent growth rate (yA > yBP), then output will contract to adjust BOP imbalances. To put it simply, growth rate will be BOP constrained if YA is consistent with YBP but lower than the potential rate of economic growth (yP). Fig.3 below presents graphical illustration of BOP constraint growth. Fig.3: Balance of Payments Constraint Growth Growth rate 7 6 Yp 5 Ybp 4 Ya 3 2 1 0 0 2 4 6 8 10 12 Time Page 7 of 26
8. Harrod‟s static foreign trade multiplier and Thirlwall‟s dynamic foreign trade multiplier are based on similar assumptions (Thirlwall and Hussein, 1982). BPCG models has following three equations: Where PxX, PmM, R and F are values of exports, imports and net remittances & capital flows, respectively. Z and Y are world and national income respectively. REER is real effective exchange rate. Similarly, ε and π are world income elasticity of demand for national exports and national income elasticity of demand for imports whereas Ψ and η are price elasticity of export and import demand, respectively. A & B are constants. Writing Equation (1 – 3) in growth rate form and solving Equation (1), after substituting Equation (2&3), yields following equation (See Appendix-A): Here