IPP’s Third Annual Report 2010 State of The Economy: Pulling Back From the Abyss Institute of Public Policy Beaconhouse National University Copyright© by Institute of Public Policy Beaconhouse National University No part of this report is to published without permission Published by Institute of Public Policy Beaconhouse National University Printed by Cross Media [email protected] | www.crossmedia9.com +92 (42) 661 0240 | +92 (333) 450 1684 III Institute of Public Policy Beaconhouse National University nstitutional Institutional backing is absolutely essential to policy makers of today, to guide their Iactions in promoting development and peace. These are times of change and challenge. There is a need for policy makers to base the policies on sound analytical work. Therefore, The Beaconhouse National University established the Institute of Public Policy as an independent, private sector think tank for research on economic, social, political and foreign policy issues. IPP's mission is to; "work in the areas of importance for improving the welfare of the citizenry. Its work will focus in particular on public policies in areas of economics, social and political development, as well as on foreign policy". Key activities of the Institution include: independent and objective analysis of the economy; strategic analysis of the concepts and doctrines in selected areas of public policy; research in the areas that are important for regional cooperation; conduct seminars and workshops to bring together policy makers, experts and other members; undertake funded research projects and disseminate research findings with the view to enhance public awareness and contribute to debate on issues of public policy. The IPP Executive Council consists of eminent personalities devoted to improvement of public policy in Pakistan. The members are: Mr. Shahid Javed Burki Chairman Dr. Hafiz Pasha Vice-Chairman Dr. Parvez Hasan Executive Member General(R) Jahangir Karamat Member Mr. Shahid Hamid Member Mr. Shahid Kardar Member Dr. Akmal Hussain Member Mr. Ziad Alahdad Member Mrs. Nasreen Kasuri Ex-officio Member, Chairperson, BNUF Mr. Sartaj Aziz Ex-officio Member, Vice Chancellor, BNU Dr. Aisha Ghaus-Pasha is the Director of the Institute. State of the Economy: Pulling Back From the Abyss V PREFACE his is the third Annual Report of BNU's Institute of Public Policy on the State Tof the Economy. The first Annual Report was released in May 2008, only two months after the new democratic government took over in the midst of a serious economic crisis marked by record trade deficit, high fiscal imbalances and double digit inflation for the third year in a row. The focus of the Report was therefore on short term macro economic adjustments to bring down inflation and to reduce the fiscal and current account deficits. It also addressed the issue of making the growth process more sustainable and more inclusive. The second Annual report released in May 2009, was strongly influenced by the deteriorating security situation and its impact on the economy. Chapter 4 of the Report presented a detailed overview of "the economic cost of the War on Terror". The Report also presented, in the wake of the serious energy crisis, estimates of the "Economic Cost of Power Outages in the Industrial Sector of Pakistan". Another important component of this Report was its analysis of the global economic and financial crisis of 2008-09, and its impact on the Pakistan economy along with suggested policies for "Managing External Vulnerability and Risks". These recommendations were supplemented by policies for industrial revival emphasizing the need for exploring a different model of economic growth. This Third Annual Report is built on some very positive political developments: the passage of the 18th Constitutional Amendment which will strengthen the Parliament and the federal structure, the unanimous 7th NFC Award, which will significantly increase the financial resources of the Provinces to carry out the additional functions being transferred to them under the 18th Amendment, and the successful military operations against extremism in Swat and South Waziristan. But the economic picture presented in this Report is not equally hopeful. Despite improvements in the balance of payments and the buildup of foreign exchange resources, largely through short term IMF loans, the fiscal situation has worsened further, the energy crisis has deepened and continuing high inflation, in the wake of virtual stagnation in per capita incomes, has further increased poverty and unemployment in the country. The Report presents a summary of the negative and positive facets of the current security, economic, institutional, social, and political situation in the country to State of the Economy: Pulling Back From the Abyss VI explore if the country is about to fall into an abyss or will it muddle through. It then outlines the strategy for the transition to a better future provided we can correct three major fault-lines: (i) closing the fiscal hole through better governance, (ii) defusing the poverty bombshell through a different homegrown strategy of economic revival and (iii) reducing ethnic and provincial polarization through democratic decentralization. I hope, like the previous two Reports, this Report will also be useful for the policy makers and other stakeholders, inside and outside the government, as they grapple with these momentous issues. Sartaj Aziz Vice Chancellor Beaconhouse National University The Institute of Public Policy is grateful to the Asia Foundation for its financial support for the preparation, publication and dissemination of this Report. State of the Economy: Pulling Back From the Abyss VII FOREWORD he third annual report is the continuation of the program launched by the Institute of Public TPolicy to prepare and publish an annual assessment on the state of the Pakistani economy. The reports have been prepared with two intents in mind: to use the tools of economic and other social sciences to read the Pakistani situation at the time the work is done. This way with each report we have advanced the state of our knowledge about the structure and the character of the Pakistani economy and society. Since the effort was begun three years ago we have, we believe, broken a number of new grounds. Four of these are important and hence worth noting. We have made attempts first to estimate the sustainable levels of fiscal and current account deficits for a country in Pakistan's situation. This analysis and the conclusions it has reached has been useful to the policymakers as they engage in dialogue with the I.M.F. and the two development banks, the World Bank and the Asian Development Bank. As targets are established for public policy to pursue, it is important to have a reasonably accurate idea of the absorptive capacity of an economy for adjustment. Making serious mistakes on either side can be very costly as several members of the European Union are discovering in the summer of 2010 and as several East Asian countries came to understand in 1996-97. Squeezing too hard in the process of adjustment to reduce the twin deficits can stall the economy and hurt the poor. This was the East Asian experience. Being too accommodating can throw the economies and the markets that support them completely out of balance. This is what the Europeans are finding now at a great cost to some of their weaker economies. The second area of analysis that has developed new analytical insights and provided some ideas about how the economy is being hurt by a number of exogenous factors is to estimate the cost of three shortages - of electricity, gas and water - as well as terrorism. We began this exercise with the second report and advance it further in this one. These costs have many dimensions, not just economic. They are also producing social tensions and grievances that a still-developing political system may find hard to absorb. Understanding the scale of these problems should help to focus the attention of the authorities. The third area of focus which is not customary in country economic analysis is to explain what is meant by the loosely used term "provision of good governance". In most accounts - in particular those produced by multilateral and bilateral aid agencies - the term is a euphemism for widespread corruption. Our understanding of the term goes beyond that notion. We have emphasized also institutional support that must be available to the policymakers to provide them with the wherewithal to serve people. This needs to be done from several different levels - the national, the provincial, the local. This also means bringing in the civil society into the decision- making process. For us decentralization of decision-making and devolution of authority have become important instruments for promoting both development and social change. State of the Economy: Pulling Back From the Abyss VIII The fourth and final part of the development process we have emphasized in our reports is to understand Pakistan's problems and its prospects in the context of the region in which it is placed as well as the perspective of the extraordinary changes occurring in the global economy and the political structure that supports it. For a country that remains so dependent on external flows, the incident involving a person of Pakistani origin in an attempt to set off a bomb in Times Square, the busiest area in Manhattan, is not just one episode in the war against terrorism. For Pakistan it is much more than that: it strengthens the negative image of the country that reduces foreign interest in it and makes it even more isolated from the world at large. One of the important reasons for producing these reports is to generate informed debate in the country on a number of policy issues critical for Pakistan's future. There is not enough of it at this time; some of which is taking place is based on strong biases or poor knowledge of our economic and social circumstances.