Pakistan’s economy witnessed an episode of high inflation between 2008 and 2011, after a period of exciting economic growth. What is interesting is that this boom-bust is not new, and high inflation after high growth is a phenomenon the economy has been witnessing for the past two decades.
Interestingly, what we consider as primary reasons behind inflation spikes, such as international commodity price hikes or supply-side rent seeking, are all secondary causes. The heart of the problem lies in our consumption-based growth model, which lacks the required level of investment necessary to improve the economy’s productive capacity. Where this investment deficit comes from and how it relates to inflation is not too difficult to comprehend.
What we save is what is invested. Historically, low savings ultimately means lower resources that are to be injected into the production capacity of an economy, where population is growing at an average 2.5% per annum.
The inter-linkage between savings (investments), inflation and economic growth is very strong. Cross-country analyses suggest that in all of the regions where the savings-to-GDP ratio declined over time, it also led to decline in real GDP growth. Moreover, out of the 30 countries that faced high (above 10%) inflation during 2008 and 2011, 23 were those where savings-GDP ratio was below 25%.
Savings has never been Pakistan’s forte, and, in fact, the trend has seen a significant decline over time. After remaining around 16% in the mid-70s to 80s, Pakistan’s savings-to-GDP ratio fell to 14% in the 90s. The early 2000s saw a brief spike in this ratio to average 19%, but then it kept falling from 18% in 2005 to 13% in 2010 and further to 10.7% in 2012. It also remained abysmally low compared to the rest of the world. While in developing Asia, emerging economies and Brazil, Russia, India and China were able to report an average savings-to-GDP ratio of above 30% between 1990 and 2011, that of Pakistan has remained around 16% – lower than even 17% in Sub-Saharan Africa.
Conversely, our consumption habits have remained relatively much stronger. Pakistan’s private consumption-to-GDP ratio saw a sharp rise from 68% in 1991 to 75% in early-2000s, and further to 86% in the ongoing decade. As highlighted, this consumption boom was not backed by corresponding investments in the domestic productive capacity. Even adjusted for inflation, private consumption grew at an average compound growth rate of 4.7% in the 90s and 2000s, as compared to 1.6% average compound growth in investments in the same periods.
Over the years, this deficit between consumption and production has been madly financed through imports, which have been growing at an average rate of 14% since 2001, compared to just 5% in the 80s, and 4% in the 90s. In layman’s terms, we are demanding more than we produce, and the result is an economy with an immense potential to overheat. This overheating has been the single largest factor in fuelling inflationary spirals in our recent history.
Such a growth model is inherently weak and structurally flawed. And such a model implies that the episodes of high economic growth (call them bubbles) are bound to be followed by stagflation. Or look at it this way: to avoid triggering high inflation, we would have to keep our real GDP growth continuously below its long term potential (5% in Pakistan’s case). How about such a choice?
Of course, business cycles are a historic reality, and every peak is eventually followed by a trough. But in Pakistan, lack of investment-led growth is one of the key reasons why our business cycles are abrupt, short-lived and somewhat unpredictable compared to the rest of the world.
One of the major tasks of the State Bank of Pakistan is “to strike a balance between growth and inflation”. Unfortunately, this is a balance that cannot be struck in the presence of a consumption-led growth model, because it means that every episode of high growth will also accompany a tighter monetary policy to tame demand-pull inflation. At the end, down goes not just inflation, but also growth.
What our economy needs is investment in industries that produce capital goods and raw material, so as to hold back the pass through of international raw material prices. And investment does not mean only foreign investment: local investment also needs to be geared up, which is only possible if the supply of loan-able/investable funds is adequate, and these funds come from domestic savings.
Aggressive campaigning is needed to improve the savings culture. Households, especially upper-middle income classes and higher, are needed to be educated as to why the decision to save should come before consumption. We now have a number of avenues where households can easily invest. These small household investments can then be channelled towards investment in the country’s fixed capital formation.
Unless we shift from a purely consumption-based growth model to an investment/savings led growth model, our growth bubbles will continue to burst and continue to trigger inflation. Of course, this is not a feat to be achieved in the short term, and policymakers need time to make this structural change. But it is inevitable. Either we should do this or be accustomed to choose between low inflation and high growth after every few years. We just cannot sustain both!
The writer is an investment analyst working with a Karachi-based Development Finance Institution
Published in The Express Tribune, March 25th, 2013.
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