A simple solution to Pakistan’s economic conundrum

All our efforts should push for policies that help realise our growth potential.

During the 2008 global supply shocks, concerns over the dollar to rupee exchange rate depreciation and inflationary pressures were pushed to centre stage in Pakistan. These became a source of fear to policy makers, who clung to the general mantra of curbing inflation. The prescribed antidote was monetary tightening, which has since been complemented by calls from the IMF to withdraw subsidies.

The prescription was more ad hoc than well thought out, since it fundamentally failed to achieve what it set out to do – ie, attract more foreign exchange so that foreign exchange reserves were adequately replenished to support the value of the rupee and restrain the second bout of inflation that would have been caused by its depreciation.

This is an apt example of how inert economic theory can be in achieving economic targets, when implemented in true word and spirit. Even at a discount rate of 15%, real interest rates in Pakistan remained negative. In addition to that, unusual increases in interest rates can also have the signalling effect of economic distress; something far from helpful for any economy.

Let’s walk through a simple example of a hypothetical company with high financial leverage to see what can be presumed to have happened. The company records sales of Rs10 billion; assets of Rs12.5 billion (based on an asset turnover of 0.8, which is usual for a manufacturing concern); interest rate (pre-monetary tightening) 10%; interest rate (post-monetary tightening) 15%; debt to assets ratio of 50% (within State bank’s limit of up to 80%); an earnings before interest and taxes (EBIT) margin of 12%; and a tax rate of 35%. The result is given in Table One above.

The interest rate hike substantially decreases net profitability and the interest coverage ratio, making the company less palatable not only for an equity investor but also for debt providers. Given this, it is not surprising that not only did FDI, but private sector credit growth also has gradually dried up since the central bank took a hawkish monetary policy stand.

Now complement this with another policy: that of withdrawing energy subsidies. Withdrawal would have the effect of reducing gross and EBIT margins, pushing companies even more out of profitability. Any adjustments in prices charged to consumers would result in inflationary pressure. Perhaps these are some of the reasons why core inflation in Pakistan has been stubborn and remained in double digits.

A very simple solution to Pakistan’s economic revitalisation is that of combined monetary and fiscal stimulus. Obviously, the delicate balance between the much-needed stimulus and extravagance will need to be managed with extreme caution, finesse and responsibility.

Having lower interest rates seems to be a good means to breaking the pervasive economic stupor. The solution, however, seems too obvious to be believable. Let us see how it would work: the results are summed up in the flow-chart above.

A simple hypothetical example in Table Two illustrates the type of relationship between M2, productivity and inflation that is being proposed here. Velocity of money is assumed to be 1, so M2 is equal to Nominal GDP.

M2 is a category within the money supply that includes all physical money such as coins and currency demand deposits, in addition to all time-related deposits, savings deposits, and non-institutional money-market funds.

The calculations in Table Two are under a scenario where the home currency is not appreciating as a result of increased economic growth and FDI; in which case the real GDP growth would sustain at a higher level and inflation would tend to fall earlier. The GDP per capita would grow five times by the end of the fifth year, bringing Pakistan into the mid-level per capita income bracket.

This seems to be quite an achievable feat. A feat that is going to transform the entire perception of Pakistan on the global economic landscape, and which may catapult Pakistan into a vibrant growth story.

Caveats

Policy to focus on value addition ie  import of raw material, value addition in Pakistan, and export of value added finished products. In order for economic growth to be sustainable, such an economic transition is extremely important.

Extremely strong regulatory framework to keep speculative activity in check, especially in assets whose supply is naturally limited; eg real estate.

Pakistan should not choke gas supply to industries. The estimated recoverable gas reserves are 27 trillion cubic feet. The annual consumption is 1.2 trillion cubic feet, at which rate the reserves can last for almost two decades. Isn’t that enough to plan and arrange supply of alternate fuels?

THE WRITER IS A CORPORATE FINANCE AND ADVISORY MANAGER IN THE INVESTMENT BANKING GROUP OF SAMBA BANK LIMITED

Published in The Express Tribune, June 18^th, 2012.