Role of the State in Pakistan's Economy: Assessing the Past and Exploring Future Challenges

Author(s): Parvez Hasan

Source: Economic and Political Weekly, Vol. 42, No. 18 (May 5-11, 2007), pp. 1623-1630
Published by: Economic and Political Weekly
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 Role of the State in Pakistan's Economy
Assessing the Past and Exploring Future Challenges
This article draws on examplesfrom east Asia to point out that political will,
well-conceived vision and clear strategic directions have been critical ingredients in the most
successful stories of development. With this perspective, it examines the role of the
state in guiding, stimulating and hindering growth and distribution in Pakistan over the last
60 years. It reviews Pakistan's economic progress with reference to commitmentto
marketsand the private sector, strategic directions provided by the state, the burden of
defence on national resources, the quality of governance, effectiveness of delivery of
basic public services, attention to matters of distributionand domestic resource mobilisation
efforts. It assesses progress under president Musharrafon macroeconomic, governance
and structuraleconomic issues. It then lays out the key economic
and non-economic challenges that remain.
PARVEZHASAN

lowly but surely Pakistan has undergone a sea change in
its policies towards a liberal economic framework,
privatisationand private sector development since the early
1990s. Since 2000, the restoration of strong macroeconomic
fundamentals, a determined push towards privatisation and
promotion of foreign investment and a recovery in essential
public investments have greatly stimulated private sector activity.
There is some debate over whether privatisation has been pushed
too far. But by and large there appears to be a consensus that
private sector development including privatisation has yet a long
way to go in Pakistan.1
The private sector cannot prosper on a sustained basis and an
equitable high growth rate cannot be achieved, without a strong
and stable state, an effective government role in policymaking,
essential public investments and delivery of basic public services.
This overview paper examines factors that have shaped state
interventions and policy in Pakistan over its history, reviews
recent improvements, current directions, and challenges and
attempts to identify priorities for the near and longer term.
StateandEconomicDevelopment:
of Vision
Importance
Accepting the paradigm that reliance on markets is greatly
desirable and should be encouraged as a matter of public policy,
the role of the state can, nonetheless, be pivotal in economic
development. The role of the state is normally put in the context
of addressing market failures (defence, law and order, public
health, macroeconomic management) addressing externalities
(basic education, environment), regulating monopoly, and im-
proving equity, especially protecting the poor. These definitions
of the role of the st:ite do not capture some of the dynamic
elements of the state's contribution to economic development
nor do they deal with issues of an effective government. The
issues of resources available to the state and the basic choice
between guns and butter as constraints are also not addressed.
In my view, even with a strong commitment to the markets,
four areas of state intervention can significantly influence the
growth path of an economy: First, a vision or a lack thereof for
the future of the country and its strategic directions by the state,
as embodied in the political leadership and the elites. Second,
the burden of defence on national resources and the balance
between development and defence. Third, quality of governance
and effectiveness of delivery of basic public services such as law
and order, property rights, education and health and infrastruc-
ture. Fourth, resource mobilisation through taxation, borrowing,
and foreign assistance. The last three points are rather obvious
but the first one needs some elaboration.
The spectacularfailure of communism to deliver on its promise
of material advancement and social justice in the Soviet Union
and eastern Europe is the most extreme example of unsuccessful
state interventions and philosophy. The sad experience of the
former Soviet Union suggests that even a combination of high
rates of investment and high level of human resource develop-
ment can fail to deliver sustained growth if the economic signals
are distorted, competition is absent, and incentives for efficiency,
productivity improvements and technological change do not
exist. Soviet Union experience also points to the danger of
excessive preoccupation with defence spending.
However, in sharp contrast to the Soviet model, vision, philo-
sophy and strategicdirections set by the state have, in combination
with reliance on marketforces, played a very positive role in some
of the most successful cases of development during the last
quartercentury.South Korea,Singapore,Taiwan, China, Thailand,
Malaysia, andmore recently Indiahave all strongly benefited from
positive directions provided by a reformed or reforming state.
In Korea, manufacturedexports were almost negligible in the
early 1960s and saving and investment and balance of payments
gaps were huge. ParkChung He who assumed leadershipin 1961,
put his trustin export development and export-led growth became
almost a religion in Korea during the 1960s and 1970s. The
Korean export drive would not have been quite so successful,
if, in the early 1970s the Korean planning board had not, again
under the direction of president Park,drawn up an ambitious plan
to diversify and deepen the export and industrial structures. Till
that time, Korean exports were heavily concentrated in labour-
intensive manufacturedgoods such as textiles, clothing, footwear

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and wigs accounted for nearly 70 per cent of manufacturedgoods
exports in 1970.
Recognising that relatively low skill intensive manufactured
exports will be losing their comparative advantage as real wages
had started to rise sharply, the political leadership launched a
long termplan in 1973 to develop more skill and capital intensive
heavy industries including steel and shipbuilding as well as
electronics - the new growth pole in international trade. Appar-
ently, the impulse for shipbuilding came directly from president
Park who wanted to emulate and ultimately challenge Japan's
dominant place in world shipbuilding at the time.
In the same way, as south Korea's development strategy drew
its inspiration from examples of Japan, Taiwan and Singapore,
China in its historic opening to the outside world under Deng
Xiaoping, drew on the example of Hong Kong, starting as late
as 1979. A couple of decades ago, few could have imagined that
a continental economy like China could make exports expansion
its growth engine by turning large parts of its eastern coast into
essentially free trade zones. In a generation, exports of goods
and services from China have risen to $ 800 billion or well over
35 per cent of GDP. China is the most export-oriented large
country in the world, its ratio of exports of goods and services
compares very favourably with the ratios of 15 and 11 per cent
for India and US respectively.
Malaysia represents a success story of a different sort but again
one in which state vision and a well articulated strategy played
a key role. While GDP, investment and export growth from
Malaysia have all been very impressive, Malaysia's most sig-
nificant achievement has been the creation of a more equitable
society in a multiracial setting. In 1970, Malays constituted about
53 per cent of the peninsular Malaysian population. However.
the share of Malay entities in corporate sector assets was only
2 per cent. The incidence of poverty in Malaysia was the highest
among Malays (nearly two-thirds)comparedto 39 percent among
Indians and 26 per cent among Chinese. This was largely because
Malays were concentrated in rural areas where the incidence of
poverty was twice as high as in urban areas. The average Malay
household income in 1970 was half that of a Chinese household.
The point of the above examples is that political will, well
conceived vision, and clear strategic directions can help stimulate
and support the private sector as a part of an overall effort to
accelerate growth and ensure equitable distribution. At the same
time, as the Korean example in early 1980s and less than suc-
cessful Malaysian public industrial projects show, state attempts
to manage precise directions of the economy are likely to fail
as the economy becomes more complex and sophisticated. Still,
an enlightened state can help push economic growth as well as
poverty alleviation,particularlyin the early stages of development.
II
State and Economyin Pakistan1950-2000
The previous section outlines some of the ways in which the
state can help or hinder economic development. What has been
the Pakistan experience? What state directions and policies have
promoted economic development? What state notions or priori-
ties have hurt growth and social change?
Vision, Strategy and Priorities
Pakistan has never had a very strong, coherent and clear
economic vision about its futurea la Korea, China, and Malaysia.

Table 1: State and the Economy - A Profile by Political Periods

KeyAspects EarlyYears AyubKhan'sEra Z A Bhutto's Zia-ul-Haq Returnto MusharrafYears
of State's Role Rule Period Democracy
Vision,strategy Rapidindustrialisation, Foreignaid Publiccontrolof Largelystatus quo Economic Debtburden,reduction,
and priorities reducingdependence mobilisation, modernsector, withvery few really liberalisationand revivalof high
on tradewithIndia, acceleratinggrowth, nationalisationof importantpolicy promotionof private economicgrowthand
and seeking large longtermwaterand education,and initiatives sector, relative accelerated
scale US militaryand powerinvestments, weakeningof neglect of induction
privatisation,
economic assistance and speedy spread bureaucracy macroeconomic of foreignprivate
of green revolution imbalances investment
Defence spending High Moderatetill1965, High Veryhigh Moderate Moderate
Highafterwards
Domesticresource Moderate Moderate Moderatebutwith Moderatebutwith Lowbutwith Lowbutwith
mobilisation heavy relianceon heavy relianceon improvingtax improvingtax
foreigntrade foreigntrade structure structure
taxation taxation
Degree of economic
liberalisation Low Moderate Low Moderate High High
Priorityto private
sector Moderate Moderateto high Verylow Moderate High Veryhigh
Levelof public Moderate High Veryhigh Moderatebut Lowand declining Lowbut rising
economic, social declining
and development
spending
Effectivenessof Moderate High Low Moderate Low Moderate
policycoordination
Qualityofgovernance/ Moderate Moderate Declining Declining Declining Lowbut improving
publicservices
delivery/
effectiveness of
spending
Concernwithsocial Low Low Highbutineffective Low Low Lowbutimproving
justice/poverty
reduction

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But fairly distinct national agendas and notions of economic
development have guided economic policies and priorities in
almost all political periods. Economic strategies have evolved
over time influenced not only by the personal views of the
leadership, most notably Ayub Khan and Zulfiqar Ali Bhutto but
also by the contemporarycurrentsof internationalthinking about
planningandeconomic development. Majorpoints aresummarised
in Table 1 and discussed below. The categorisation of state
performance is, in the final analysis, subjective and not scientific
and I realise that it could be challenged.
Policy thinking and development in early years were primarily
focused above four things: building defence capability, rapid
industrialisation, reducing dependence on trade with India, and
seeking large scale US military and economic assistance.
With a firm grip on power and relative political stability, Ayub
Khan, Pakistan's first military ruler, put economic and social
development high on his agenda. His commitment to economic
development was strong and clear and his approach to economic
issues was essentially pragmatic.
The basic model of development under Khan relied
heavily on the key relationship with the US for military and
economic assistance, a strong push for public sector investments
especially in water and power facilitated by the Indus basin treaty
with India, relaxation of foreign exchange and investment con-
trols, and improved availability of long term industrial credit for
the private sector through Pakistan Industrial Credit and Invest-
ment Corporation and International Development Bank.
The essential parametersof his vision, however, fell apartafter
the 1965 war with India which led to a very sharp increase in
defence spending from Pakistan's own resources as US assis-
tance, both military and economic, decreased sharply.
Bhuttocame to power in December 1971. His PakistanPeople's
Party (PPP) had captured the imagination of the general public
with the slogan of 'roti, kapara, makan'. Though Bhutto had no
clear notions about socialism, he felt he had the public mandate
to bring aboutfundamentalchanges in public ownership of means
of production. Bhutto undertook large-scale nationalisation of
industry, insurance, and banking, extending the state control of
the modem sector significantly. The Bhutto government also took
full control of country's educational system by nationalising
privateeducationalestablishments.This experimentwith socialism
had far-reaching and long-term consequences. Though succes-
sive governments in the next two decades attemptedprivatisation,
large segments of banking, insurance, and industryremainedwith
the state till the late 1990s.
From the economic point of view, Zial-ul-Haq's rule (1977-
88) was the least ideological and the least innovative. Fortunately
for Haq, the economy showed a high and sustained growth rate
helped mainly by a number of special factors both domestic and
external. The completion of the long-gestation period Tarbela
dam project in 1977 added considerably to irrigation water
availability and hydel power capacity. A tremendous boost to
economic activity was also provided by increasing worker
remittances and large external assistance for Afghan Mujahedin,
channeled through Pakistan.
Lulled by a comfortable growth rate and a balance of payments
situation greatly helped by remittances and other external factors
mentioned above, the Haq regime did little to deal with the serious
structuralproblems inherited from the 1960s and 1970s: the over-
extension of government, the poor climate for private sector
investment, heavy dependence of exports on cotton based ex-
ports, andthe inelasticity of the tax system. Indeed some structural
problems were intensified. Relentless growth in public spending,
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a major shift in public expenditure priorities from development
to defence, and consequent rise in fiscal deficits increased debt
burden sharply.
There is no doubt that macroeconomic imbalances were
worsening and growth was slowing down after the mid-1980s.
Had Haq lived, he would have had to face the consequences of
his neglect of some basic economic issues. As it turned out, the
responsibility of sorting out the difficulties fell to a succession
of weak political democratic governments which followed Haq.
Notwithstanding substantial macroeconomic mismanagement
over decades (less visible in the 1980s than in the 1970s and
1990s), there was a gradual process of liberalisation of the
economy starting in the late 1980s - notably the reduction of
interventions in agricultural prices, relaxation of import and
investment controls and financial sector reforms. Major agree-
ments with the International Monetary Fund and World Bank
financially supported the structural reform process which was
further accelerated by the removal of foreign exchange controls
and stepping up of the pace of privatisation under the first Nawaz
Sharif government in 1991-92.
The policy shift towards the private sector and greater reliance
on market signals ratherthan administered prices was influenced
largely by pragmatic considerations. Policy decisions to involve
the private sector in energy and infrastructure development
reflected a realisation going back to 1987 that the public sector
funds hadbecome a serious constrainton development. Similarly,
the draincaused by losses of public sector enterpriseswas a major
factor in the decision to hasten privatisation of industrial assets.
Efficiency considerations were also behind the drive to privatise
government banks and telecommunications corporations.
Defence Spending
Because relations with India deteriorated early on and the
Kashmir dispute has continued to simmer between the two
countries, a high level of defence spending has remained a key
feature of state policy and strong competition between defence
and development has been unavoidable. The only periods in
Pakistan's history when defence spending grew less rapidly than
GDP were the first half of the 1960s and the second half of the
1990s. In the formerperiod, it was the large US military assistance
which made putting a lid on military expenditures possible. In
the latter period, growing financial and fiscal crises led to an
actual decline in defence outlays for a few years.
Between 1965 and 1990 there was an almost relentless growth
in defence and related spending. Real defence expenditure almost
doubled between 1960-65 and 1965-70 in the wake of the 1965
war. Under Bhutto defence outlays increased by a further33 per
cent even though the size of the country and the economy
had shrunk substantially. Under Haq, real defence spending
increased by 9 per cent per annum on an average during
1977-88 while development spending rose 3 per cent per
annum; by 1987-88, defence spending had overtaken develop-
ment spending. For the 1980s as a whole, defence spending
averaged 6.5 per cent of GDP. Not only was this a peak but it
also contributed strongly to large fiscal deficits and a rapid build
up of public debt.
Public versus Private Sector
The notion that the state must be the leading agent in economic
development was also embedded deeply in early economic
thinking. An importantachievement of the 1950s was the increase
1625
in the rate of domestic capital formation, in absolute terms fixed
investment in then west Pakistan increased nearly fourfold in
the 1950s. But there was a clear public sector bias. The result
was an almost sevenfold increase in the real level of public
investment in the 1950s and the share of public investment in
total investment increased from less than 40 per cent to two-thirds
over the decade.
The Khan era was an exceptionally successful period of eco-
nomic management because it used planning institutions and
processes effectively for economic policy coordination. The pace
of economic decision-making was speeded up, implementation
processes strengthened and sectoral planning substantially
decentralised. But the public sector bias of the development
policy of the 1950s continued and was compounded by the large
availability of foreign assistance, which mainly financed public
sector development.
Bhutto's economic policies virtually halted the growth of the
modern private industrial sector and reinforced the anti-export
bias of the industrial strategy. Large public investments in
industry focused on import substitution and the reform of the
exchange rate system failed to remove the large wedge between
the average effective exchange rates for imports and exports.
Even though the attitude towards the private sector improved
during the Haq period and some privatised units were returned
to the private sector, there was no attempt to tackle the overhang
of major nationalisation of the Bhutto period. Even though major
inefficiencies had already emerged in public sector enterprises,
especially the nationalised commercial banks, not much thought
was given to systemic solutions.
The early 1990s saw the emergence of liberal economic policies
and a fuller realisation that the private sector should be allowed
to play a greater role in the economy. But structural reforms
including financial sector liberalisation and privatisation did not
go far enough or remained in early stages. Only limited progress
was made in privatisation in the financial, telecommunication
and energy sectors. The delay in privatising large state-owned
banks was particularlycostly because credit allocation decisions
became more susceptible to political pressures under democrati-
cally elected governments.
Paradoxical though it may seem, some of the liberalisation
measures, though sound in themselves, had the impact of diluting
the urgency of macroeconomic adjustment. First, the ease of
financing the foreign exchange gap through foreign currency
deposits and portfolio investments became an excuse for not
facing the unsustainability of large balance of payments deficits.
Second, large receipts from privatisation were used to bolster
public spending rather than to retire debt.
IIIll
Pakistanat Thresholdof 21st Century
As I have argued elsewhere, Pakistan, as it approachedthe 21st
century was faced with not only a financial crisis but also an
economic growth crisis because the per capita GDP growth had
slowed down to 1 per cent per annum during the 1990s from
an average of around3 per cent per annumduring 1960-85 [Hasan
1998].
It is too simplistic to lay the blame for Pakistan's economic
and financial problems at the end of the 20th century mainly on
the governance and economic policy failures of the 1990s. The
fundamental governance and growth problems had long roots
and had their origins in: (a) a level of defence spending that the
country could ill afford; (b) inability of the government after the
mid-1980s to collect enough revenues to cover current expen-
ditures leading to borrowing partly for current outlays including
defence and thus, a sharp build up of public debt; (c) a major
neglect of human development outlays and quality of public
education in face of rapid growth of population and rising needs
for skills; (d) a weak industrial and export structure,dominated
by cotton based exports resulting from both insufficient progress
in education and trade policies which discouraged backward
linkages, exports based on imported inputs and diversification;
(e) personalised rule, over-centralised decision-making, weak-
ening public institutions and rule of law, increasing
public corruption, and lack of accountability; and (f) a pattern
of development which resulted in sharply increasing
inequalities and only slow reduction in poverty because it re-
warded rent seeking, discouraged genuine entrepreneurship,did
not promote labour-intensive exports, and did not sufficiently
tax the rich.
By the end of the 1990s, growth and governance problems had
become intertwined. Because growth benefits were not widely
shared, the quality of public services (especially education) was
deterioratingand the pace of poverty reduction was slowing, the
tensions in the society had begun to erupt with increasing fre-
quency in ethnic, sectarian and random violence. The deterio-
rating law and order situation in turn had become a constraint
on investment and growth.
Taking the second half of the 20th century as a whole, however,
it is the governance failures in Pakistan that stand out much more
than growth disappointments. Pakistan no doubt missed major
economic opportunities, especially in exports of manufactured
goods but its average GDP per capita growth rate of 2 per cent
per annum over 1950-2000 was about the average for developing
countries and about the same as India's.2 Furthermore,Pakistan

Table 2: Key Fiscal Aggregates, Public and Private Investment

(as percentage of GDP)
Years PublicFixed PrivateFixed ConsolidatedPublic Defence Non-Interest,Non-Defence Fiscal Tax
Investment Investment Spending Spending PublicSpending Deficits Revenue
1960s 8.2 8.8 NA 2.8 (1960-65) 4.0(1965-70) NA 2.1 NA
1970s 10.3 5.6 21.5 5.6a 14.0 5.3 13.8
1980s 9.2 7.8 24.9 6.5 14.5 7.1 13.4
1990s 7.5 9.1 24.1 5.6 11.7 6.9 14.0
1999-2000 6.0 8.4 23.6 4.9 10.5 6.6 12.9
New Revised National Account Series
1999-2000 5.6 10.4 18.7 4.0b 7.8 5.4 10.7
2000-01 5.7 10.2 17.2 3.2 8.0 4.3 10.6
2001-02 4.2 11.3 18.8 3.4 8.0 4.3 10.9
2002-03 4.0 11.3 18.6 3.3 9.2 3.7 11.5
2003-04 4.0 10.9 16.7 3.2 10.0 2.4 11.0
2004-05 4.4 12.1 18.2 3.2 11.8 3.3 10.0
2005-06 4.8 13.6 17.7 3.2 11.3 4.2 10.4
Notes:(a) Refersto theaveragein1975-76and1976-77,lasttwoyearsof Bhuttorule.(b)Including
defencepensionswhichwereexcludedfromdefencebudget2000-01.

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had to cope with a much higher growth rate of population of
nearly 3 per cent per annum over 50 years. If governance had
not deteriorated so much and the strength of public institutions
not eroded over time, the resources mobilised through taxation
would have been more adequate and the quality of public services
(especially education) would not have declined so precipitously.
Poor governance hurtthe poor and low income groups especially
as they depend relatively more on public services. The failure
of the well-intentioned Social Action Programme in the 1990s,
which aimed at the provision of basic education and health
services and narrow the gaps in human development must ba-
sically be attributed to poor governance.
Why did governance decline so sharply over time? This is a
big question, the answer to which is essentially beyond the scope
of this paper. But one can point to some basic factors. I believe
the very high population growth rate complicated, both finan-
cially and managerially, the delivery of basic public services. The
responsibility for the weakening of the rule of law must be borne
by the political leadership, both military and civilian. Some argue
that extra-judicial interventions by the military and disregard of
the constitution is a root cause of this problem. But in some
respects Pakistan's military regimes were less arbitrarythan some
democratically elected leaders starting with Bhutto. The weak-
ening of bureaucracy, a decline in its competence, and increase
in corruption are as much due to its steadily declining relative
compensation as to the frequent political interventions in vio-
lation of rules and regulations.
But purely from an economic policy viewpoint, the picture at
the end of the 1990s had some bright spots. By the sheer pressure
on public resources, defence spending did not increase much in
real terms in the 1990s. The gradual liberalisation of imports and
reduction of tariffs had by reducing foreign trade taxation sub-
stantially, reduced the anti-export bias in policies, agricultural
price distortions had become minimal, and the environment for
the private sector had become much friendlier. There was a clear
recognition in the privatisation efforts and seeking of private
investments in power generation thatthe government had become
overextended, financially as well as administratively.
IV
StateandEconomyunderMusharraf:
ProgressandProblems
So what has changed and by how much during the last seven
years? Unfortunately the views on what has happened tend to
be rather polarised. The government claims broad success in
putting national finances on a sound footing, reviving strong
growth, improving social indicators and beginning the difficult
processes of improving governance and sharing of growth
benefits more widely. The sceptics point to the continuance of
serious issues in governance and quality of public services,
narrow base of the prosperity, only modest progress in poverty
reduction, and reemergence of heavy reliance on external
flows.
As often, the reality is more complex. There have been some
fundamental changes in macroeconomic policies, attitudes to-
wards the private sector and the size and use of public resources
which have revived strong growth and improved growth pros-
pects enhanced the priority of social sectors including higher
education, and accelerated pro-poor spending. But it also remains
a very much open question whether reforms have so far put the
economy on a sustainable, high growth path and improved the
economic model and governance structuressufficiently to ensure
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more equitable growth. This section and the next explore both
the progress and challenges that remain.
Macroeconomic Management:
Reduction of Deficits and Debt Burden
The sharp turnaroundin the public and external finances of
Pakistan has been the singular economic policy success of recent
years.
No doubt the improvement in external and domestic finances
and the large build-up of foreign exchange reserves has been
greatly helped by developments following 9/11 and realignment
of Pakistan's relationship with the US and other western coun-
tries. External grants, substantial concessionary assistance, Paris
club rescheduling, payments for logistical supportto the US, and
somewhatbetteraccess to externalmarkets,all contributedstrongly
to the remarkablebuild-up of external reserves over the last few
years. But tough stabilisation policies aimed at restoring financial
discipline, shrinking fiscal deficits, great restraint on non-con-
cessionary external borrowing, and measures to promote exports
laid the basic ground work for the much increased confidence
in the stability and strength of the Pakistan rupee, which in turn
resulted in the reversal of capital flight, large increase in worker
remittances, and growing interest by foreign investors.
The external and public debt levels have come down very
sharply since 2000. External debt, as a percentage of exports of
goods, services, and transfers has dropped from around 250 per
cent to 115 per cent over the period 2000-06.
The public debt to GDP ratio has declined from over 90 per
cent (on new GDP numbers) in mid-2000 to 55 per cent in mid-
2006. As a proportionof government revenues, Pakistan's public
debt has also declined from nearly 600 per cent in mid-2000 to
less than400 per cent in 2005-06. Interestpaymentsas a percentage
of government revenue have come down from 33 per cent of
public expenditure in the late 1990s to 17.5 per cent in 2005-06.
The sharpdecline in interest payments in the budget from nearly
7 per cent of GDP inihe financial year (FY) 2000 to 3.1 per cent
(as well as containing defence spending as a percentage of GDP)
has opened up fiscal space, defined as non-interest and non-
defence spending, while at the same time making possible a
reduction in fiscal deficits. Non-interest and non-defence spend-
ing has doubled over the last six years in real terms providing a
strong momentum to both growth and social development.
The macroeconomic management in Pakistan is being chal-
lenged once again partly because of external shocks - the almost
doubling of the international oil price between 2003-05 and in
2005-06, the devastating earthquakewhich will cost the economy
$ 6 billion over five years and too accommodative a monetary
policy in FYs 2005-06.
Notwithstanding major economic shocks, Pakistan has been
able to avoid disruption to economic growth because of adequate
level of foreign exchange reserves and large foreign investment
flows partly related to rapid privatisation. However, the current
account balance of payments deficits, after official transfers,was
at $ 5 billion in 2005-06 and, as the July-October 2006 data
suggest, could grow to $ 6.0 billion or over 4 per cent of GDP
in 2006-07, if the recent decline in international oil price is not
sustained. Meanwhile, inflation though stable at around 7-7.5
per cent is stubbornly high.
Maintaining macro stability would require furtherstrengthen-
ing the structuralposition of both external and internal finances
not only through fiscal and monetary policy adjustmentsbut also
through export push in non-traditional exports. Having said that
1627
Pakistanhasmuchgreaterfreedomof financialoptionsthanever
before as typifiedby its successful long term bond placement
in the internationalmarket,the continuingstronginterestfrom
foreigninvestorsespeciallyfromwestAsia,andcontinuedstrong
supportfrom internationalorganisationsespecially the World
Bank and the Asian DevelopmentBank.
Defence Spending
The analysisof defence spendingsince 2000 is complicated
by two facts.First,as is the customin manycountriesincluding
India,the defencepensions were moved to the civilian budget
from2000-01.Second,the nationalincomefigureswererevised
substantiallyupwardsand a new series was introducedstarting
with 1999-2000.This makeshistoricalcomparisonssomewhat
difficult.Since 2000-01, defence spending,excludingpensions,
has risenin realtermsroughlyin line with the growthin GDP.
Itactuallyfell in thestabilisationyears2000-02buthasincreased
by 23 per cent duringthe last three years (2003-06).
Currentlydefencespendingis around3.2 percentof GDPand
appearsto be lowerthanthe level in the 1990seven aftermaking
roughadjustmentsfor comparabilityof data.Two points need
to be noted,however.Firstthe defence budgetis still absorbing
nearlyone-thirdof governmentrevenue.Secondly,the current
militaryoutlaysarebeingsupportedpartlyby paymentsfromthe
US governmentfor the fight againstterrorism.The issue of an
appropriatelevel of defence spending,i e, the choice between
guns and butterremainsvery much alive.
Private Sector Development and Privatisation
Anotherimportant successof theMusharraf regime,notunrelated
to the strengtheningof the financial position and increased
confidencein the currency,has been the furtherenergisingof
theprivatesectorthroughacceleratedprivatisationandimprove-
mentof the investmentclimate.Inductionof foreigninvestment
has becominga promisingsource of futuregrowth.
During the last five years, 2001-06, direct foreign private
investmenthas totalled$ 7.3 billion, risingfrom $ 500 million
in 2001-02 to $ 3.5 billion in 2005-06. Privatisationreceiptsat
$ 2.4 billionhave accountedfor over one-thirdof directforeign
investment.The privatisationsales to the foreignerhave been
concentrated in banking,telecommunications andthermalpower
while otherimportantforeigninvestmentflows havebeen in oil
and gas and telecommunications.
Theopeningupof thefinancialandtelecommunications sectors
partly with the help of foreign sectors is transformingand
modernisingthe economyin a fundamentalfashion.Thegrowth
in cellularphonesin Pakistanhas been nothingshortof pheno-
menalandthecompetitionin thetelecommunications sectorshas
pusheddown pricesvery sharply,essentiallyreducingthe cost
of informationand doing business.
The liberalisation,privatisationand reformsof the financial
system, a processthatwas startedin the 1990s, is providinga
strongbase for healthyprivatesectordevelopment.The largely
publiclyowned bankingsystem was greatlymisusedby vested
interestsbothto earneconomicrentsand thwartgenuineentre-
preneurialactivity.Ina veryshorttime,thecontrolof thebanking
systemhasmovedintoprivatehands.Regulatorycapacityof the
centralbankhasbeengreatlyenhancedanditsautonomyincreased.3
Financialreformshaveimprovedresourceallocationbymaking
lendingfollow soundeconomicandfinancialcriteria.It has also
improvedgovernanceby closing avenuesfor corruptpractices
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and political influence paddling. There is also evidence of
financial deepening as the ratio of monetary assets to GDP has
risen from 40 to 44 per cent over the last five years after having
been stagnant for a long period. The increased financial inter-
mediation also generally augurs well for economic efficiency.
There is also broad evidence that the investment climate for
the private sector is improving and the cost of doing business
is decreasing. According to the World Bank, Pakistan was one
of the top reformersin terms of doing business in 2004.4 It ranked
60th out of 154 countries in 2006 (India was 116th) and 74th
out of 175 countries in 2007. According to World Economic
Forum global competitiveness reports, Pakistan's ranking im-
proved from 75th out of 102 in 2003 to 66th out of 116 in 2005.
However, Malaysia, Thailand, India, China, and Turkey were
substantially ahead of Pakistan in these rankings.
The growing importance of the private sector in Pakistan is
also evident from its share in fixed investment. The share of
privateinvestment which exceeded 50 per cent of total investment
in the 1990s is now approaching 75 per cent.
Still, there are three major problem areas. First, in the power
sector which is largely in public hands, the inefficiencies and
frequent breakdowns in supplies not only increase the costs for
the private sector by requiringalternative generating capacity but
also result in large losses for public entities which are a significant
drainon public resources.It is not clear thatlargescale privatisation
of the Water and Power Development Authority's energy corpo-
rationsis a quick and fully feasible answer, at least in the short run.
Second, though much progress has been made the private sector
still looks too much to the government for solving its competi-
tiveness problems by seeking tax, credit and other concessions.
A Rs 50 billion package demanded recently by the textile industry
to cope with competitive pressures in the post multi-fibre agree-
ment era is a case in point. The government on its part has not
been able to resist the urge to control prices as inflationary
pressures reemerged and the consumers complained. Rent seek-
ing behaviour has not entirely disappeared and genuine entre-
preneurship is still hampered, though medium and small indus-
tries are faring better than before.
Third, while large foreign investment flows are providing a
more balanced source of external finance, the bulk of foreign
investments are taking place in areas like energy, telecommu-
nications, financial and other services which do not contribute
directly to export development. Since, as discussed below, export
growth remains critical for Pakistan's development, a lop-sided
patternof foreign investment could prove costly in the long run.
In other areas where state interventions requiredimprovement,
resource mobilisation, distribution of growth benefits, human
development, and last but not least governance, progress has been
more mixed.
Taxation
The structureof taxation has improved, the burden of several
taxes has been reduced, the move away from reliance on foreign
trade taxation has continued, and serious efforts are under way
to improve tax administration. It is too early to say, however,
whether improvements undertaken or proposed would result in
an elastic system of taxation which will automatically capture
a reasonable share of GDP growth as government revenues. Also,
the tax system is regressive because the rich and the well-to-do
do not pay sufficient taxes and the individual income tax receipts
remain very small. Finally, the present tax to GDP ratio at 10.4
percent remainsvery low both in relationto needs andinternational
Economic and Political Weekly May 5, 2007
norms.It shouldbe stressed,however,thatthe stagnationin the
tax to GDP ratio,indeeda small decline comparedto 1990s, is
entirelydue to the liberalisationmeasureswhich have reduced
importduties.It has beenestimatedthatif the importtax reduc-
tions had not occurredand if sales tax had not been increased
in partialcompensation,the governmentrevenueswould have
been about 11 per cent higher than otherwisein FY 2005.5
Income Distribution, Poverty, and Employment
The revival of strong growth, and doubling of real public
spendingoverthelastsixyears,afterthestagnating foradecade,has
expandedemployment,resultedin some increasein realwages,
andreducedpovertyincidence.Theextentof reductionin poverty
incidenceover 2001-05 is a matterof some debate6but there
is little disagreementthatpovertyhas declinedin recentyears.
Still, ruralpovertyand growingdifferencesin incomebetween
ruralandurbanareasarea matterof growingconcern.According
to governmentnumbers,the ruralpovertyincidencein 2004-05
was at28 percent,almostdoubletherateof urbanpoverty.Surely
the highincidenceof ruralpovertyin a bumpercropyearcannot
be the basis of much satisfaction.
Government pro-poorspending,thoughstill low, hasincreased
in recentyearsto 4.5 percentof GDPas fiscal spacehas opened
up and progresson some ruralprogrammessuch as ruralelec-
trificationandgirls' educationis impressive.Increasedpace of
socialspendinghasimprovedgrossenrolmentratiosandreduced
genderdifferences.Butnetprimaryenrolmentrateof 60 percent
in 2004-05 meansthat40 per cent of the primaryschool cohort
werenotin school.The overalleducationspendingis only about
2 per cent of GDP andqualityand governanceissues in public
educationremainhuge. At the same time, the governmentmust
be givencreditforturningits urgentattentionto highereducation
and skills gap and developingcogent plans.
Reducingpovertyincidenceand increasingthe access of the
poorto basicpublicservicesin theruralareasis, however,only one
dimensionof Pakistan'sdistributionproblemswhich are re-
flectedin growingincomeinequalitiesandregionaldifferences.
Containingincome and consumptiondisparitiesas well as
steadyreductionin povertyespeciallyruralpoverty,needsto be
built in more explicitly as an integralpartof futureeconomic
strategybecauseclearly,the issue of the distributionof growth
benefitshasassumedmoreurgencywitheconomicliberalisation
anda greaterrolefortheprivatesector.Thedistributionproblems
have distinctdimensionsin ruraland urbanareas,with poverty
beingmuchmoreof a problemin ruralareasandgrowingincome
disparitiesmuchmoreof a problemin urbanareas.In ruralareas
the shareof consumptionof the highest quintileto the lowest
quintilewas only 2.2 in 2004-05 and had changedlittle since
2000-01.7 But as mentionedabove,ruralpovertyis widespread
andnearly80 per cent of Pakistan'spoor live in ruralareas.In
contrast,urbanareasaccountfor little over 20 per cent of the
poor. But in urbanareasconsumptiondisparitiesare huge and
growing. In 2004-05 the share of consumptionof the highest
quintileto the lowest quintilein urbanareaswas over 12 times
and had grownfrom 10.4 in a short period of four years.8
Governance
Governance is averybroadareawhichencompassesthedelivery
and effectivenessof all public services. Here again the record
of thelastseveralyearsis verymixed.Theopeningof fiscalspace
has certainlymade possible a very sharpexpansionin public
Economic and Political Weekly May 5, 2007
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spendingon economicand social developmentincludingmore
adequatepay for civil servants.But the qualityof manyservices
includinglaw and orderandjustice includingenforcementof
property rightsremainsextremelyproblematic. Thelackof definite
progresson governanceissues shows,the intractability of issues
of institutionbuilding and lags in obtainingvisible results as
shown by the tax administration reform.
The biggest achievementof the Musharrafgovernmenthas
beenthe creationof a politicalstructureconsistingof 6,400 new
indirectly-electedgovernmentswith significantparticipationof
women.The devolutionto Nazim as an electedhead of district
governmentcould proveto be a revolutionarychangeprovided
otherpoliticalinterestsdo notundercutthereforms,theinitiative
is properlyfundedandis fully supportedby measuresto enhance
local governments'capacities.
The biggestdisappointment is the stallingof the civil service
reform.While meritnow plays a greaterrole in recruitmentand
promotion,andthereis an importantinitiativeto upgradeskills
of civil servantsthroughforeign training,the restructuring of
processesand incentivesto attractthe best and the brightestto
the top layers of governmentsat all levels of governmentare
lacking.Civilservicereformmustgo hand-in-hand witheffective
devolutionandshouldincludeimprovedcompensationat higher
levels as well more competitionfor these positions including
hiringfrom the privatesector.
V
LookingAhead
Pakistan'sdevelopmentand modernisationhave sufferedin
the past eitherbecausetherewas not a very clear vision of the
futureortherewereconflictingviews aboutnationalidentityand
priorities.One hopes that that main political parties and the
militaryleadershiphave learnttheir lesson from history and
would strive to unite the country arounda broad emerging
consensusaboutfuturedirections.Thisconsensusmusthaveboth
economic and non-economicdimensionsbecause social and
political shocks can easily derailthe economy.
Some of the elements of the non-economicconsensus that
appearto be falling in place are: (i) need for an enlightened
moderationin which narrowinterpretationsof Islam are not
allowedto drivethe societaland stateagenda;(ii) resolutionof
conflictswith India,containmentof militaryestablishmentand
a gradualreductionof defencespendingas a percentageof GDP
and public spending;and (iii) a determinedattemptto reduce
the centralisationof decision-makingby empoweringthe prov-
inces in the spiritof the federation.
Decisive progresson the non-economicissues is a necessary
but perhapsnot a sufficientconditionfor releasingthe creative
energiesof thecountryto meetits aspirationof highgrowthrates
to matchthose thatarebeing achievedby ChinaandIndia.For
that,abetterarticulationof aneconomicvisionis necessarywhich
encompassesconcernwith growthas well as broadeningof the
growthbenefits,reducingincome,regional,genderdisparities,
and modernisationof attitudestowardswork and thrift.
Export Development
Despiteearlypromise,exportgrowthhas lagged in Pakistan.
Evenafterthe substantialexportexpansionof the lastfew years,
the ratioof exportsto GDP remainsat 13 per cent, very much
below the range of 30-50 per cent of GDP in successfuleast
Asianeconomies.The failureof Pakistanto developa largeand
1629
diversifiedbaseof exportsis one of the fundamentalreasonsfor First, the rather obvious but sometimes overlooked point, the
why it has not matchedthe growthand povertyreductionper- trend in population growth would remain a major determinant
formanceof not only the first generationof Asian tigers,South of poverty. Since fertility rates are much higher in rural areas,
Korea,Hong Kong and Singaporebut also relativelate comers present efforts to increase the levels of female education must
to the field, Thailand,Malaysiaand above all China. be combined with making family planning services available
Futuredevelopmentstrategyneeds to emphasiseexportssuf- widely and cheaply.
ficientlyandhelpremovethetradepolicydistortionsthatremain. Unlike earlierperiods ruralpoverty is now more deeply grounded
Specialpolicy supportmightbe neededto diversifythe export among the landless poor and non-farm households: 60 per cent
base and to develop informationtechnology exports. Recent of the rural poor are landless agricultural labourers and non-
weaknessin exportsis particularlyworrisome. agriculturalhouseholds. For them public infrastructureand other
spending are critical.
Revenue Mobilisation and Size of Government A healthy agricultural growth rate of say 4-4.5 per cent per
annumremains essential for the high growth rate of the economy.
Improvementsin governanceand furthereconomic reforms The expansion of agricultural productivity can help bring real
will depend critically on the managementof public service prices of wheat, which is so important for poor households.
personnel.ButI doubtthatimprovedgovernance,betterdelivery Agricultural diversification to higher value crops can assist in
of public services,and a vibrantcivil service can be delivered export development as well as job creation. Unfortunately, the
withoutexpandingthe base of governmentrevenues. trend growth rate of agriculture since 1999-2000 has fallen to
The over-extensionof governmentin terms of its functions less than 3 per cent per annum compared to a rate of 4.5 per
should not obscure the woeful inadequacy of its financial cent in the previous two decades. Unless this trend is reversed,
capacity.In Pakistan,non-interestnon-defencepublicspending, growth and equity problems will intensify.
a key indicatorof the size of governmentis only a little over Fiscal policy must play a role in not only in supporting public
11 per cent of GDP, much lower than almost all developing interventions to reduce poverty but also to moderate income
countries(Table 3). disparities.
Raisingtaxrevenueis botha moralanda practicalimperative. Last but not least, the issue of urban income disparities must
Onecannotrunaneffectivegovernment,howevercircumscribed be addressed by examining the access of land for the middle
its functions,on a shoestring.Butthe expansionin realspending classes which are in growing danger of being locked out of the
in supportof social and economic developmentmust focus on housing and real estate boom.
decentralisedprogrammessupportingthe importantdevolution
initiativewhichremainsseriouslyunderfunded.Taxationeffort VI
and authorityalso need to be devolved in parallel. Conclusion
Distribution of Growth Benefits Notwithstanding the strong revival of the private sector, the
agenda for the role of the state in the Pakistan economy remains
Sustainedgrowth and political stability do requirea better both large and challenging. No agenda can be implemented
distributionof growthbenefitsthan in the past. Incomedistri- without a vision, a national consensus, and a government struc-
butionissues arenot peculiarto Pakistan.Evenrapidlygrowing ture that can deliver public services on a priority basis. There
economies like China have major income distributionissues has been a great deal of talk about second generation reforms
notably growing ruraland urbanincome gaps and widening but in Pakistan a lot of the basics of governance have yet to be
regionaldisparities. put fully in place. [X
Some of these issues arisefromstructuralfactorslike concen-
trationof labourforce in agricultureand ruralareaswhile the Email: Phasan@aol.com
non-ruraleconomy grows much faster. In the long-runonly
increasededucation and out-migrationfrom rural areas can Notes
providea durablesolutionto ruralpovertyin Pakistan.Butmuch 1 For reservationabout
morecanandshouldbe donein themediumtermto alleviateboth the policy of privatisation,see, Kaiser 'Bengali
Politics of Privatisation',Dawn, July 11, 2005.
ruraland urbanpoverty and to contain income disparities. 2 India's growth per capita was, however, much higher than Pakistan's
Table 3: Non-Interest and Non-Defence Expenditurefor during 1985-2000 thus, offsetting its very slow growth till the 1980s
Selected Countries compared with Pakistan.
(Per cent of GDP) 3 See IshratHussain, 'BankingSystem Reform In Pakistan',The Business
People's Magazine, January 2005.
1990 1995 2000 4 World Bank, 'Doing Business in 2006', Tablel.l page 2, World Bank,
Argentina 9.0 13.2 12.7 Doing Business Report: Pakistan Highlights.
Bangladesh 15.1 12.6 11.8 5 Social Policy DevelopmentCentre, AnnualReport2006, Chapter2, p 62.
Chile 16.2 17.4 21.1 6 The governmentestimates that poverty incidence reducedfrom 34.5 per
Egypt 20.4 24.3 19.4 cent in 2000-01 to 23.9 per cent in 2004-05 - a more than 10 percentage
India 21.0 17.8 19.8
Indonesia 14.7 12.1 13.0 point drop.The World Bank estimates the reductionin incidence at only
20.5 15.9 17.5 5 percentage points.
Malaysia
Nepal NA 14.3 13.8 7 Economic Survey 2005-06, p 58.
Pakistan 14.5 11.7 10.3 8 Op cit, p 58.
Philippines 11.2 12.9 14.3
Sri Lanka 20.9 19.3 15.9
Thailand 9.8 13.2 15.5 Reference
Turkey 12.2 17.3 22.2
Hasan, P (1998): Pakistan's Economyat the Crossroads:Past Policies and
Source:WorldBank,PakistanPublicExpenditureManagement,2004. Present Imperatives, Oxford University Press, Karachi.

1630 Economic and Political Weekly May 5, 2007

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