Pakistan and the World Economy
Paper presented at the annual conference of the Pakistan Society of Development Economists
© Peterson Institute for International Economics
This paper was written while Mr. Williamson was the Chief Economist for the South Asia Region at the World Bank.
Pakistan survived the experience of the sanctions imposed on it in 1998 surprisingly well. Economic growth remained positive, in a year when many other Asian countries were recording negative growth. Inflation did not accelerate significantly, as was anticipated by most external forecasters. The current account deficit declined further, so that Pakistan's short-run balance of payments position remained viable once lending by the IMF and World Bank was resumed and debt had been rescheduled by the London and Paris Clubs (something that was about to happen at the time of the conference where this paper was presented).
Complacency would nonetheless be out of place. Exports have been declining throughout the fiscal year 1998-99, normal capital inflows have almost dried up, and the country's weak credibility and policy uncertainties have discouraged foreign direct investment in particular and productive investment in general. Pakistan is the only country in South Asia that has recorded a lower rate of growth in the 1990s than in the preceding decades. Suspension of the convertibility of the foreign currency deposits, and the London and Paris Club reschedulings, were essential in the short run, but they will tend nevertheless to compromise Pakistan's ability to borrow internationally for years to come. The social indicators - literacy, mortality, fertility, and poverty - remain poor, even for a country with Pakistan's per capita income, and the squeeze on the budgets of the provincial governments suggests that this is unlikely to improve much in the short run. The country clearly faces a difficult challenge in reviving its economy and in achieving a level of social standards in which it can begin to take pride.
The present paper aims to explore what options exist, and which of them look to have more potential, in this difficult situation. The focus is on Pakistan's relations with the rest of the world, in the tradition of a series of studies on Country X in the World Economy that have been produced during recent years by the Institute for International Economics, where I worked for many years before joining the World Bank. These studies have sought to identify the strategic options and principal issues confronting various countries, and where their national interests lie, in relating to the world economy.
This focus on external issues should not be construed as casting doubt on the proposition that profound domestic reforms are essential if Pakistan is to restore the economic progress that it recorded in the first decades after independence, and begin to realize the social gains that have so far eluded it, let alone if it is to realize its potential of becoming a miracle economy. That is conceivable only if universal education is at last achieved, if population growth is rapidly brought down, if the rural oligarchy can be persuaded to forego its privilege of not paying taxes, if the encouraging reports of less corruption are confirmed and prove to be the first step in a thoroughgoing transformation of the standards of public life ; in short, if the agenda of my late and much lamented friend Mahbub ul Haq at last becomes a reality instead of just a personal dream.
During the Cold War Pakistan occupied a key strategic position near the frontier with the Soviet Union, a geopolitical fact which gave the country an ability to rely on Western support, or at least acquiescence, in a crisis. That advantage has now ended, as was graphically illustrated by the hostile G-7 reaction following the nuclear tests of last May, which led to the imposition of sanctions that would have crippled the economy had they remained in place any longer. If it remains without strong regional partners, Pakistan will need to cultivate a self-reliance that has not so far been necessary.2
Recent years have seen a strengthening of regional groupings in many parts of the world, alongside the development of globalization. While some economists (e.g. Bhagwati and Krueger, 1995, Srinivasan 1998) see these two processes as competing with one another, I am among those who instead view the two processes as complementary. That is, rather than regarding regional groupings as a threat to the global system, I believe they provide natural opportunities for a deeper level of integration than is practical at the global level, and offer the chance of experimenting with new forms of integration that would be unlikely to emerge from global negotiations without the prior development of regional models among groups of states with particularly close relations.
It is therefore natural to ask whether Pakistan's geopolitical situation offers it the potential to participate in any such grouping. To its north, Pakistan has as neighbours a group of weak commodity producing states. The potential of links with these countries would appear to be limited. If and when the conflict in Afghanistan ends, the provision of transit routes for the export from the region of oil and gas, and the opportunities for exchanging a number of Pakistani industrial and agricultural products for energy supplies, would surely be worthwhile, but these hardly offer a basis for changing Pakistan's economic destiny.
Many of Pakistan's western neighbours are relatively rich, and there are important cultural and religious links with the region. On the other hand, with the possible exception of Iran, it is a region of very limited industrial potential, which therefore offers no possibilities for the development of the sort of trade in intermediate industrial products that has been the mainstay of other successful regional arrangements. And even Iran is much more distant from Pakistan's industrial heartland in Punjab than are some of India's industrial regions.
Pakistan's existing regional arrangement is indeed focused on South Asia, a region with which it has had acute political problems, but which certainly seems the most natural economic partner. I conclude that there are really only two strategic options for Pakistan. One is to seek to develop SAARC, and the other is to go it alone as a member of the multilateral system.
Table 1 shows the direction of Pakistani trade. It can be seen that the principal trade partners are the OECD countries, with the oil-importing countries also being an important source of imports. Trade with Pakistan's partners in SAARC is miniscule; the ASEAN countries are of a similar order of importance as an export market, and are a much more important source of imports. Table 2 shows that, among the SAARC countries, little Sri Lanka and distant Bangladesh are more important export markets than giant, nearby India. Of course, everyone believes that much trade with India takes place through Dubai, or is smuggled over the border, so that the statistics do not give a true reflection of India's importance as a trade partner; but even if one accepts the common estimate that half the trade is missed by the official statistics, bilateral trade with India still seems very modest, given the size and geographical proximity of the Indian market. Indo-Pakistani trade is only some 1% of Pakistan's total trade, which is a fraction of the level that would be predicted by a gravity model even in the absence of common membership of a trading arrangement. This is presumably one reason why in 1998 Pakistan's exports amounted to only 13.2% of GDP and its imports to 16.1% of GDP, which are fairly low figures by international standards, although one should allow for the fact that Pakistan is a relatively large country.
It is not just the level of trade that is repressed: there is a whole type of trade, namely intra-industrial trade in manufactures, that is largely missing from Pakistan's export bundle (see Table 3). Such semi-manufactures as Pakistan does export tend to be cotton goods rather than engineering products, which is the type of trade that has traditionally been nurtured by regional trade agreements. While it may well be possible to trans-ship consumer goods through Dubai without adding so much to costs as to eliminate the incentive to trade, it is quite implausible that carburetors could be made in Lahore and shipped to Haryana that way and still compete in the era of just-in-time inventory management. This is what I conjecture Pakistan is missing by virtue of its membership in a regional arrangement that is dysfunctional.
Up to now SAARC has established preferential trade arrangements among its members, on the basis of a positive list of products on which concessions have been negotiated one at a time. The impact of these preferences on actual trade appears to have been minimal, and is in any event still offset by a number of active impediments to intra-regional trade, including India's maintenance of quantitative restrictions on imports of consumer goods and Pakistan's failure to extend most-favoured nation treatment to India, as well as some notable absences of essential transport links. SAARC has tried to shift to a more effective way of liberalizing trade, and at one stage did succeed in getting the SAARC leaders to commit themselves to free trade by 2001. But at the last SAARC summit it was acknowledged that this timetable was unrealistic, and the leaders committed themselves instead to the objective of achieving agreement by 2001 on how and when to achieve regional free trade.
It is obvious that SAARC will never achieve the sort of deep economic integration that has been achieved in Europe, or is in process of being achieved in Mercosur, without a transformation of Pakistan's political relations with India. I do not believe that this necessarily implies that a strategy of seeking to build up SAARC as a regional trade arrangement is doomed to failure. On the contrary, it is worth remembering that when the European Common Market3 was first formed, in the 1950s, the inspiration was very much that of using commerce as a means to build functional cooperation that would ensure permanent peace between France and Germany, which had been at least as hostile to each other for the preceding century as India and Pakistan have been for the past half-century. Although relations with India have long been difficult, one should not rule out the possibility of a breakthrough because of the current political situation in India; just as it took a Nixon to declare peace with China, so a BJP government would be politically well-placed to initiate cooperation with Pakistan if it chose to take that path. The agreement-in-principle already reached between Pakistan and India for the former to sell electric power to the latter is an encouraging indication that functional cooperation is possible between the current regimes.4 Of course, functional cooperation needs to be complemented by a mutual political desire to improve relations if it is to lead on to permanent reconciliation and deep economic integration of the sort that France and Germany have now achieved.
In economic terms, one benefit that I would anticipate Pakistan could hope for from effective regional integration would be the chance to develop a serious engineering industry. This is the part of the industrial sector that is critically dependent on the existence of a large network of suppliers, where economies of scale and scope really count. Pakistan's economy alone will be too small to support much of this until development has proceeded a lot further, whereas the chance to fill niches in the Indian market would offer it an opportunity of rapid growth relatively soon. There may also be prospects of Pakistan exporting cotton textiles, processed foods, and raw agricultural products, prospects enhanced by the country's ability to import world-class machinery and engineering goods to produce downstream products with a higher quality and technology content than India can aspire to so long as its downstream industries are constrained to buy Indian inputs.
One problem with the regional strategy is that it takes two to tango; either partner can certainly torpedo the chances of cooperation succeeding, but it cannot unilaterally will the strategy to succeed. Hence, even if one were convinced of the superiority of the regional strategy, it would be necessary to consider also the alternative strategy of go-it-alone.
Many economists, including me, would argue that the best go-it-alone strategy would be something fairly close to a policy of unilateral free trade, involving a moderate uniform tariff of no more than 10% (motivated partly by revenue considerations and partly by a belief that there is a legitimate social interest in some pressure to expand the industrial base) and no other trade restrictions. Many economists would also rate this option preferable to the regional strategy, but here I part company with them. To explain that, I should clarify that I would regard the first-best as unilateral free trade by both India and Pakistan, but I make the judgment that the chance of India adopting unilateral free trade is near-zero. Since I see a very strong Pakistani interest in duty-free and guaranteed access to the Indian market, my preferred policy is one of regional cooperation (provided this can take place within a context of relatively free trade with the rest of the world, so that the costs of trade diversion are modest).
What sort of industrial future would I see for Pakistan under such a policy? In the near term, I would expect it to remain predominantly an exporter of low-tech consumer goods like cotton clothing and sports goods, perhaps branching out into non-cotton textiles if and when the process of importing intermediate goods needed to produce exports is eased. In the longer term future, I would hope that Pakistan would be ready to take advantage of whatever the next generation of labour-intensive activities demanded by the world economy proves to be. (The last generation involved assembly of electronic products, but there is already excess capacity in that business, which is part of East Asia's current problem. The current generation happens not to involve manufacturing at all, but rather to consist of electronic services, including software, transcription, and data entry, activities where India is at last making a mark on the world economy. Given the weakness of Pakistan's education system, one fears that it is unlikely that it will be in a position to emulate India here.) This will be the case only if Pakistan undertakes important policy reforms to eliminate the systemic anti-export bias that grew up in the decades following independence (Khan 1999). The simplest way of doing this would be to adopt a policy close to free trade, so that there is no need for a system of import duty drawbacks such as is indispensable if export industries that use imported intermediates are to have a chance under a regime of protection.5
There is at least one way in which the world is now an easier place in which to pursue a policy of export-led growth than it used to be, and that is a result of the long series of international initiatives to liberalize trade, which have culminated in the creation of the World Trade Organization. The agreement in the Uruguay Round to phase out the Multi-Fibre Arrangement (MFA) is of particular interest to Pakistan in view of the leading place of cotton textiles among its exports. Our assessment in the Bank (World Bank 1997) is that this will offer a major opportunity to increase its exports to Pakistan, although one needs also to recognize that the elimination of restrictions will also expose countries like Pakistan to the risk of bigger and quicker losses of market share if they stumble in maintaining a supportive environment.
Under either of these scenarios, the re-establishment of a dynamic industrial sector will be dependent on macroeconomic policies, and specifically on exchange-rate policy. It is no good imagining that rapid export expansion can be achieved on the basis of a policy of a strong exchange rate, or an exchange rate policy that is dedicated to countering inflation that would otherwise result from loose fiscal or monetary policies, or a reluctance to allow the exchange rate to depreciate when this is necessary to maintain competitiveness. No sensible person would deny that many other factors besides the exchange rate influence export competitiveness, but unwillingness to use the exchange rate as the residual factor to maintain an adequate degree of export competitiveness means that policymakers have one hand tied behind their back in seeking export-led growth. My own view, which I have propagated in a long series of writings going back to long before I joined the World Bank, and which was most recently expressed in Williamson (1998), is that the maintenance of a competitive exchange rate is not always well-served by a policy of floating. Periods of strong capital inflows occur, when a floating exchange rate can float up to a level that threatens the incentive to continue investing in export industries. In such circumstances I believe the maintenance of export competitiveness is better served by a policy of substantial but nonetheless circumscribed flexibility, involving a wide band with a crawling central parity. But of course an excessive capital inflow is not a threat that Pakistan faces in the foreseeable future: rather, the immediate need is to ensure that the exchange rate is indeed used as the residual factor in maintaining enough export competitiveness to ensure rapid export growth.
Foreign Direct Investment
Much of East Asia's export success was based on inward direct investment, particularly in Singapore, Malaysia, China, and Thailand. The Chinese experience is particularly interesting, because much of the inward investment there came from the Chinese expatriate community. Pakistan is also a country with a relatively large and affluent expatriate community, and so it is worth asking why there has (so far as I am aware) been virtually no inward investment by expatriate Pakistanis. I would hypothesize that the main explanation goes back to the issue that has just been discussed, namely Pakistan's failure to convert its economy into an attractive export platform, because the investment by the overseas Chinese was predominantly in relatively low-tech industries directed toward exporting. So a part of the answer as to what needs to be done to attract FDI is to improve the exporting climate. A possible additional explanation is that Pakistan has created such an array of attractive, convenient financial instruments for investments by expatriate Pakistanis as to have diverted some capital inflows that would otherwise have come in the form of FDI.
The other critical factor is to improve the rule of law. The extra-legal attempt to renegotiate IPP tariffs by threatening prosecution over corruption, and related events in mid-1998, created a great deal of resentment among the existing stock of foreign investors. They are unlikely to forget easily, and one cannot expect that potential new investors will be ignorant of their complaints. By far the most hopeful way of overcoming these complaints is to make Pakistan a country of laws and not of discretion. Of course, this would have additional benefits in improving the climate for Pakistani business too.
I have taken it for granted that more FDI is better than less, which is not a position that is universally accepted. One attraction of FDI is that it is unlikely to suffer massive withdrawal during an economic crisis: in fact, FDI was essentially unchanged in East Asia last year, in contrast to the massive reversal in other components of the capital account, just as it has continued to come into Pakistan on a modest scale since last May (although this probably reflects the completion of existing projects and cannot be taken as assurance that future FDI will be unaffected by the events of last summer). Another is that it brings with it ancillary benefits in the form of access to technology, know-how, management, and markets. The countervailing disadvantage in the eyes of some is that it involves a measure of foreign control over the economy. But, unless one takes a very nationalistic position on that issue, FDI is in most circumstances a good thing.
Two exceptions may be noted. One is the case of immiserizing growth analyzed by Carlos Diaz Alejandro and Richard Brecher in the 1970s, when the foreign investment is directed to an import-substituting industry (ISI) that is so heavily protected that the social value of the firm's net output is less than the profits it is able to earn and remit abroad. Given the ubiquity of ISI in Pakistan in the past, it is entirely possible that some of the FDI that did come fell in this category. The other would arise if a foreign investor were able to get such favourable contract terms (e.g. such a high power tariff) as to outweigh the efficiency gains that it brings. While I acknowledge that this is a possibility, and I understand that there are claims that this case also arose in Pakistan, it is a case that one would expect to arise only if the contracting process is corrupted. Even if either or both of those unfortunate cases did occur in the past, it would be foolish to rule out future FDI because of past errors, instead of making sure that in future contract negotiation will be undertaken within a secure legal framework and a less distorted policy environment.
Openness to financial investment raises very different issues. We are all familiar with the benefits that flows of financial capital can in principle bring, notably the possibility of increasing investment above the level that could be financed from domestic savings (for a country where the rate of return on investment equal to domestic savings exceeds the world rate of interest plus the country risk premium), and the opportunity of diversifying the risk of savers by holding an international rather than a national portfolio.
Unfortunately there is now also pretty conclusive evidence that exposure to the international capital market can bring with it very significant risks. In particular, the evidence suggests that the crisis that originated in Thailand in July 1997 became a general East Asian crisis because the countries involved had built up a level and structure of liabilities that made them extremely vulnerable to adverse shocks.
Consider the various hypotheses that have been advanced to explain the contagion in East Asia. Many observers have focused on inadequacies of the system of financial supervision, which permitted banks to take on a dangerous level of short-term and/or foreign currency debt. It has also been argued that transparency was inadequate, resulting in foreign lenders failing to appreciate the extent to which the countries had already borrowed abroad and accumulated short-term foreign exchange debts. And Paul Krugman (1998) has emphasized the role of explicit and implicit guarantees in creating moral hazard and generating asset price bubbles. All of these factors may well have contributed to the problem. Nevertheless, a consideration of which countries succumbed to the crisis, and which succeeded in riding it out, makes it difficult to believe that any of these was the critical factor. Consider the 13 economies listed below (the 13 major Asian developing economies between Pakistan and Korea), which are divided between those that fell victim to the crisis and those that did not according to whether GDP growth is believed to have been negative or positive in 1998.
Negative growth in 1998:6
Marginally negative growth in 1998:
Positive growth in 1998:
Now ask what the countries within each group have in common but that distinguishes between the first and last groups. It is surely not the quality of bank supervision, which is notoriously bad in several of the non-crisis (positive growth) countries, is probably somewhat better on average in the crisis countries, and is famous for its excellence in one of them, namely Hong Kong. Nor is it transparency, which is, once again, somewhat less of a problem in the crisis countries. Nor is it the extent to which banks enjoy implicit guarantees, which is at least as strong in South Asia as elsewhere. And it is certainly not the strength of the macroeconomic fundamentals. Neither, for that matter, is it the exchange-rate regime, which involved a loose form of dollar pegging in most of the countries. The one feature that discriminates correctly between the two groups is whether or not they had liberalized the capital account of the balance of payments. (Malaysia had made some effort to limit short-term capital inflows in the past, but its regime was still more liberal than that which prevailed in any of the non-crisis countries prior to its imposition of comprehensive capital controls in August 1998.)
It is well known that the abolition of capital controls has often been followed by a large inflow of capital. Moreover, this inflow has typically been disproportionately in the form of short-term capital, which is the form that foreign lenders often seem most willing to supply, presumably believing that it gives them the opportunity of liquidating their position if things begin to go wrong (a belief that cannot be simultaneously right for the majority of them, at least without a bailout from the international community). Hence it seems all too easy to believe that the observed association between the absence of capital controls and the occurrence of financial crisis was causal and not merely coincidental. This conclusion is reinforced by the reflection that an abrupt reversal of capital flows usually involves an outflow of capital owned by residents ("capital flight") as well as that owned by foreigners, a flow that is facilitated by an absence of capital controls.
Moreover, attempts at empirical measurement of the growth benefit of capital account convertibility have, at least so far, failed (Alesina, Grilli, and Milesi Ferretti 1994; Rodrik 1998). Of course, it is important to understand that rejection of capital account convertibility does not imply rejecting opportunities to borrow abroad; it is perfectly possible to free long-term capital flows even while maintaining restrictions on inflows of short-term loans of the sort that have wrought devastation elsewhere. My view is that such limitations are best achieved via the sort of reserve requirements on foreign capital inflows that have been imposed by Chile and Colombia, and that countries will be well-advised to maintain such restrictions unless and until the negotiations on a new international financial architecture succeed in persuading Northern investors to adopt practices that threaten less instability than resulted from past investment practices.
Current Account Targets
However, Pakistan's short-run problem is unlikely to be one of discouraging excessive capital inflows in any form; indeed, I doubt if this will figure among its problems even in the medium run. It is surely necessary for Pakistan to escape from its dependence on inflows of short-term capital (formerly in the form of foreign currency deposits) that were being used to finance the current account deficit prior to the imposition of sanctions. This is not just because the need to freeze the foreign currency deposits is likely to limit future access to that particular source of foreign exchange, but also because short-term borrowing is inherently a fragile way of financing a deficit. In the Pakistani case, it also seems to have been an expensive way. Since the outlook for secure inflows, of FDI or long-term capital, seems pretty bleak for some time to come, I would argue that Pakistan needs to be targeting a major and sustained improvement in its current account balance over the next several years. Achieving this will require the restoration of export dynamism, as was discussed earlier; doing so while allowing a much-needed increase in domestic investment will require also a major improvement in savings performance if investment is to increase rather than be cut back even further.
While Pakistan's current economic position is undoubtedly difficult, it is not obviously worse than that of other countries (for example, Taiwan in the late 1950s, or Korea in the early 1960s, or Indonesia or Singapore in the late 1960s) at the time when they succeeded in engineering major policy changes that laid the basis for their future prosperity. One of the dimensions in which a clear policy stance will be needed is with regard to Pakistan's international economic relations. I have argued that there would be great economic benefits from a policy of deep regional integration, if that proves politically possible, and that such an economic initiative could in turn improve the prospects for political cooperation in the way that happened in Europe. The second-best trade policy, if regional cooperation proves impractical, would be close to free trade, which would eliminate the anti-export bias from which Pakistan has suffered in the past. Either option would help to make Pakistan an attractive export platform, which might help to attract FDI, specially from expatriate Pakistanis. Reestablishing Pakistan's credentials in the eyes of potential foreign investors also needs a determined effort to establish the rule of law. Finally, I argued that Pakistan needs to achieve a major and sustained improvement in its current account so as to relieve itself from dependence on inflows of short-term capital, and that subsequently, when foreign capital wants to come in, it will be important to make sure that the form of capital inflow is a relatively stable one so that the danger of a future crisis is minimized.
If such an international agenda were complemented by an effort to increase savings, by a resumption of progress in privatization and liberalization of the domestic economy, and by a serious attempt to address what I earlier characterized as "Mahbub ul Haq's Agenda", I see no reason why Pakistan's progress in the next half-century should not be a lot more impressive than that during its first 50 years.
|Total Imports||(Rs |
|of which share of|
|Total Exports ||(Rs |
|of which share of|
|Source: Economic survey- Statistical Supplement, 1997/98|
|Note: OIC is the Organization of Islamic Countries|
|Total Exports |
|Source: Economic survey- Statistical Supplement, 1997/98|
|Total Imports||(Rs |
|of which share of|
|Raw materials for|
|Total Exports ||(Rs |
|of which share of|
|Source: Economic survey- Statistical Supplement, 1997/98|
Alesina, Alberto, Vittorio Grilli, and Gian Maria Milesi-Ferretti (1994), "The Political Economy of Capital Controls" in L. Leiderman and A. Razin, eds., Capital Mobility: The Impact on Consumption and Growth (Cambridge: Cambridge University Press).
Bhagwati, Jagdish, and Anne Krueger (1995), The Dangerous Drift to Preferential Trade Agreements (Washington: AEI Press).
Khan, Ashfaque (1999), "The Experience of Trade Liberalization in Pakistan", paper presented to the PSDE Conference, Islamabad, January.
Krugman, Paul (1999), "What Happened to Asia?", http://web.mit.edu/ krugman/www/DINTER.html.
Rodrik, Dani (1998), "Who Needs Capital-Account Convertibility?", in S. Fischer et al, Should the IMF Pursue Capital-Account Convertibility? (Princeton: Essays in International Finance no. 207).
Srinivasan, T.N. (1998), "Regionalism and the WTO: Is Nondiscrimination Passe?", in A. Krueger, ed., The WTO as an International Organization" (Chicago: University of Chicago Press).
Williamson, John (1998), "Crawling Bands or Monitoring Bands: How to Manage Exchange Rates in a World of Capital Mobility", International Finance, Oct. 1998.
World Bank (1997), South Asia's Integration into the World Economy (Washington).
____ (1998), East Asia: The Road to Recovery (Washington).
1. The author is indebted to participants in the Annual Conference of the Pakistan Society of Development Economists where this paper was presented for comments and criticisms that are reflected in the present version, as well as to colleagues who commented on an earlier draft and to Forhad Shilpi who provided research assistance. Views are those of the author and not necessarily of the World Bank or its Executive Board.
2. Self-reliance is not the same as self-sufficiency, which would be impossibly costly in this age of globalization. By self-reliance I understand rather the ability to cope purely on the basis of commercial relationships, without relying on the goodwill of any foreign power.
5. Note that a system of duty drawbacks, even if operated without the hurdles that so diminish its usefulness in Pakistan, is not a full substitute for free trade in terms of providing a hospitable environment for exporters. One reason is that tariffs cause the real exchange rate to appreciate, which makes exporting less cost competitive. Another is that import tariffs raise the price of imported goods above world prices, and these price effects spill over into the overall cost structure. So even if exporters can buy inputs at world prices (after negotiating the administrative hurdles) they still face a higher local cost structure than do competitors in countries with lower effective protection, which constitutes a hidden tax on exporters.