State of the economy: Pulling back from the abyss

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State of the economy: Pulling back from the abyss

I: Are we edging towards the abyss?

ARTICLE (June 28 2010): Pakistan today presents a picture of stark contrasts. Take one day, for example, the 19th of April 2010. This day witnessed the historic signing of the 18th Amendment to the Constitution by the President of Pakistan at an impressive ceremony.

At the same time, less than 300 miles away, there were two major terrorist attacks in Peshawar, killing 25 people, including a bomb explosion in a procession of people protesting against power loadshedding. On this particular day, we saw major positive political developments coupled with evidence of increasing cracks in the economic and social fabric and a breakdown of law and order.

Therefore, we need to identify the positives and the negatives relating to the contemporary situation of Pakistan in the areas of security, economy, society, politics and institutions. This will enable an assessment of where we are going as a nation and as a people.

Security

The major negative development on the security front is the retaliation in the form of terrorist attacks throughout the country to the military operations in the North and drone attacks. The frequency and intensity of these attacks has increased greatly over the last few years. Beyond terrorism, the level of human security has been adversely affected by the virtual breakdown of law and order in the country. Some of the root causes of the increase in crime are rising levels of unemployment and poverty which have alienated a larger section of society.

Perhaps, one of the more disturbing and negative developments is the loss of trust and faith of a large section of the population in the ability of the government to address the problems they face in their day-to-day lives. This has resulted in mass protests against problems like loadshedding and rising prices.

On the positive side, military operations in Swat and North Waziristan have apparently gone well and large tracts of land have been cleared. Intelligence agencies have been successful in apprehending various important militant leaders and their accomplices. This will contribute to weakening the terrorist networks and reducing their ability to undertake suicide and other attacks.

Economy

The economy today is replete with a large number of negatives. Of prime concern is the near total breakdown in the delivery of basic public services like power, gas and water. As highlighted above, this has already led to a large-scale public agitation and violence on the streets. The next factor, impacting severely on the living standards of the people is the high cumulative inflation in prices of essential items, since 2006. Coupled with this, the low rate of economic growth since 2007-08 has implied stagnation of real incomes and rising levels of unemployment, which may have doubled in the last three years. The combination of high prices and high unemployment in the presence of constant or declining household real incomes has inevitably led to a big increase in the incidence of poverty in Pakistan.

Along with the faltering rate of growth of the national economy, there is evidence that regional disparities are widening further fuelling agitation by various ethnic and nationalist groups. The largest province, Punjab, has shown some dynamism, but incomes have fallen in Balochistan and in rural Sindh, fanning nationalist tendencies. This reflects a failure of the federal government in investing relatively more in infrastructural development in the lagging regions of the country. Prospects for economic revival and renewed dynamism of the economy have been dampened by a big fall in private investment, both domestic and foreign, which has fallen by 7 percent in 2008-09 and is likely to show a further decline in 2009-10.

The financial sector has remained largely insulated from the global financial crisis due to the absence of strong international links of Pakistani banks. But domestic factors, primarily linked to the on-going recession in the real sector, have contributed to a big increase in the volume of nonperforming loans which have reached 13 percent of outstanding advances. Smaller banks, in particular, have been exposed to the risk of default by borrowers, especially the SMEs, farmers and households.

The financial sector is also suffering from liquidity problems, even though credit demand by the private sector is slack. This is due primarily to large-scale borrowing by the public sector. The pressure on the banking system could increase further in the coming weeks as the financial year comes to an end, and the government has to finance a larger than anticipated fiscal deficit.

The large and rising levels of government borrowing can also be attributed to the substantially lower than anticipated aid inflows. The budget for 2009-10 was framed on very optimistic assumptions about the level of support from the international community. For example, Friends of Democratic Pakistan were expected to contribute over $2 billion during the year, whereas only $174 million has come in to date. US bilateral assistance has not commenced yet and there is lack of clarity as to the extent to which this will finance the government's development programme.

The budget deficit for 2009-10 is expected to be significantly larger than originally anticipated depending upon the magnitude of shortfall in the achievement of the FBR's target of revenues and the extent of reimbursement of military expenditures in the North from the CSF. If the borrowings from the market to reduce the circular debt in the power sector are included, then the size of the fiscal deficit could approach Rs 1000 billion (almost 7 percent of the GDP). This is despite a large cutback in the PSDP of almost 40 percent to a critically low level of less than 3 percent of the GDP at a time when infrastructural bottlenecks are crippling the economy.

There are also apprehensions that the level of public debt is once again approaching unsustainable levels close to 65 percent of the GDP. The large ongoing SBA from the IMF will require repayment within the next five years and Pakistan could find itself back in a 'debt trap'.

On the positive side, there has been a substantial improvement in the balance of payments position of the country. During the first nine months of 2009-10, the deficit on the current account has declined by as much as 68 percent as compared to the corresponding period of last year. The primary reason for the improvement is the fall in the import bill due not only to the lower cost of POL imports, but also the saving in food imports due to the bumper wheat crop, along with some decline in machinery imports due to the depressed private investment.

Remittances are up by 16 percent. More recently, exports are beginning to show some dynamism as the world economy recovers. Exports grew by 38 percent in March 2010 with textiles exports rising by 30 percent. There is also evidence of an incipient recovery in the manufacturing sector. The stock market has shown a rising trend.

Overall, the economy exhibits a mixed picture. There is slow growth, high persistent inflation and the fiscal situation has deteriorated significantly, while unemployment and poverty continue to rise. As opposed to this, there has been a spectacular improvement in the balance of payments, the agricultural sector has performed relatively well and there are some signs of recovery in the manufacturing sector.

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Politics and institutions

Perhaps, one of the areas of greatest concern is the perceived large-scale breakdown in the quality of governance in the country. This is acutely reflected in the burgeoning losses (approaching Rs 200 billion) of state enterprises and public utilities. There are also frequent media reports of 'grand corruption', some of which has been taken notice of, on a suo motu basis, by the Supreme Court.

The bureaucracy is demoralised and ineffective, with limited implementation capacity. Reports by the Transparency International indicate that Pakistan is beginning to approach once again the peak levels of corruption attained in the mid-90s. There exists no independent and impartial accountability mechanism to apprehend people in high places for acts of corruption. The consequence is a decline in the writ of the state and a breakdown in the rule of law. The delivery of services by public agencies is abysmal. Overall, since delivery of services is the prime interface between the government and the people, it is not surprising that there is a general disillusionment with the quality of governance in the country.

While there are serious problems at the local level, there are some positive developments on the political and constitutional fronts, which highlight that the functioning of democracy, howsoever imperfect, can still achieve major results. Historical signing of the 18th Amendment, incorporating fundamental changes in the Constitution has been achieved by a consensus of the political parties, seen for the first time after 1973. The Balochistan Package announced by the government is also a major attempt at removing the longstanding grievances of the province.

The generous dispensation to the provinces in the Seventh National Finance Commission (NFC) award along with transfer of the Concurrent List of functions should go a long way in strengthening the process of provincial autonomy.

Other major developments, which auger well for the future of democracy, are a strong, independent and assertive superior judiciary and a vibrant media. On the social side, the democratically elected government has shown more concern about the plight of poor people. A more comprehensive social protection programme has been developed through targeted income transfers under the BISP.

The contrasting developments highlighted above with many serious concerns on the one hand and some promising and positive developments on the other, raise the fundamental question: Is Pakistan on the edge of the abyss?

In subsequent chapters we discuss issues related to the future stance of macroeconomic policies for promoting economic revival, costs of infrastructural shortages and solutions thereof, implications of decline in the quality of governance and key areas where improvements are required, and prospects for greater provincial autonomy and resulting benefits to the people arising from the eighteenth amendment and the NFC award. If we are to pull back from the abyss actions on all these fronts are required.

(To be continued)

Business Recorder [Pakistan's First Financial Daily]

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State of the economy: Pulling back from the abyss - II

ARTICLE (June 29 2010): The Federal government faces some hard choices. It would have to be particularly prudent in expenditure allocations because the NFC award has reduced its fiscal space. How should it proceed? Here are a number of suggestions. First, be honest with the public on the nature of the challenges that the country faces that are the cumulative result of policy neglect or failures for decades.

Second, try to appeal to the enlightened self-interest of the elite that sacrifices and tax compliance are absolutely necessary to avoid economic disaster or worse. This, however, can work only if political leaders can restore trust and confidence in the government by showing high standards of integrity, avoid parochialism and favouritism and set a real example of austerity, which a situation of war demands. At the same time, issues of deteriorating governance have to be addressed frontally.

Working more closely with the provinces in co-ordination of economic policy actions is now a necessity. In view of the devolution of authority and resources to the provinces, the co-ordinating role of the National Economic Council has become even more important. It must meet frequently and should be supported in its staff functions, both by the Planning Commission, the NFC Secretariat and the planning departments of the provinces.

In the immediate future, the macroeconomic imbalances, especially the large and persistent fiscal deficit and the relationship with the Fund are going to be a central challenge for the government. While strong tax mobilisation efforts, both at the central and provincial levels, are necessary and there is need for a close scrutiny of all public expenditures to achieve savings, a rapid fiscal adjustment on the scale envisaged by the original IMF medium-term framework of a reduction of deficit to less than 3 percent of GDP by 2012-13 may be neither feasible nor desirable. This could fundamentally jeopardise prospects for revival of the economy.

As discussed later, a somewhat slower fiscal adjustment path, say a reduction in overall public sector deficit from an estimated 6.5-7.0 percent of GDP ratio in 2009-10 (including borrowings for circular debt reduction and public enterprise losses) to 5 percent by 2012-13 would have credibility. But only if the tax-to-GDP ratio can be raised by about 2 percent over the next three years, the quality of public spending can be improved, and losses of public enterprises largely eliminated.

A successful introduction of the value added tax in the coming months would be a test for the government's will to collect additional taxes. In the medium run, the VAT would help to raise tax revenues by 1.5- 2 percent of GDP. Other reforms like a restructuring and broad-basing of the income tax regime also appear urgent. Exemptions of agricultural income and capital gains need to be reviewed. The present tax collections, particularly from non-salary individuals and private companies, are small and must be enhanced. The Revenue Advisory Council should be entrusted with the task to develop a comprehensive resource mobilisation strategy, with the objective of not only enhancing the tax-to-GDP ratio, but also to rationalise the tax structure, strengthen tax administration and make the tax incidence more progressive.

Should Pakistan go for another IMF programme?

Pakistan has had a long history of going on and off IMF programmes since 1988. During the decade of the 90s, Pakistan sought IMF assistance at different times when foreign exchange reserves were depleted and had fallen to critically low levels. From 1999 to 2003, this programme was successful in bringing down sharply the current account deficit from over 4 percent of the GDP in 1998-99 to a virtual surplus in 2001-02. The inflation rate also remained low, at below 4 percent, while the fiscal deficit was contained at about 4.5 percent of the GDP. But the process of severe contraction of aggregate demand in the economy implied a very low growth rate of the GDP of only 3 percent. Consequently, there is evidence that unemployment and poverty rose sharply during this period. In December 2004, the then government announced that Pakistan would never go once again with a 'begging bowl' to the IMF.

But history has a nasty tendency of repeating itself. The large oil price shock in 2008 along with the rise in commodity prices, especially of food items like wheat and edible oil, led to a severe haemorrhaging of the foreign exchange reserves in the first ten months of 2008. The newly elected government had hoped initially to mobilise large-scale support on a bilateral basis from "Friends of Pakistan" following the return to democracy and the on-going War on Terror, but it soon became clear that this would be forthcoming only under the umbrella of a comprehensive Fund programme. Fortunately, the Fund largely accepted the 'home-grown' programme prepared by the government with the help of the Advisory Panel of Economists to the Planning Commission. The programme, relatively speaking, was soft and initially Pakistan has performed relatively well in meeting the macroeconomic targets.

Once again, however, of great concern is the impact of the Fund programme on the rate of growth of the economy. There was a quantum decline in the growth rate of the economy from an average of 6.8 percent from 2002-03 to 2006-07 to 2 percent in 2008-09, with the likely outcome of just over 3 percent growth in GDP in 2009-10.

Though it is difficult to disentangle the impact of various factors on the loss of dynamism of the Pakistan economy, like the global financial crisis, and the emergence of major infrastructural bottlenecks, there are elements in the Fund programme, which may have contributed to the slowing down of the rate of growth. The steep reduction in the fiscal deficit, which meant curtailment of the PSDP, and the rise in interest rates, which may have dampened private investment, are examples.

What should be the optimal fiscal framework for 2010-11 and how should the medium term macroeconomic framework be modified in light of the experience in 2008-09 and 2009-10? We develop in this report a 'home-grown' macroeconomic and fiscal framework, which is consistent with the ground realities of Pakistan at this time. The government may use this framework in its forthcoming discussions with the IMF on the coming budget and for any extension of the tenure of the Fund programme beyond December 2010 when the current SBA comes to an end. The basic conclusion is that if Pakistan is to remain on the original fiscal framework agreed with the IMF then there is very little 'fiscal space' left for executing the development programme, which will have to fall to about 2-3 percent of the GDP and show a drop in real terms of over 19 percent in relation to the already depressed level in 2009-10. This is despite a significant increase expected in the tax-to-GDP ratio of 0.6 percent of the GDP.

As mentioned earlier, we are of the view that a smaller adjustment in the fiscal deficit is warranted for 2010-11. As such, the fiscal deficit may be brought down to 5.0 percent of the GDP, rather than 4 percent or so, and the additional fiscal space be used to raise the size of the development programme by one percent of the GDP (equivalent to about Rs 170 billion), for high priority projects and programmes in the Federal PSDP, focusing on removing the infrastructural bottlenecks. Such a move is justified on a number of grounds: the need to preserve the 'human face' of the structural adjustment process, and creation of more jobs as unemployed youth could be driven to crime and militancy in the absence of their productive absorption in the economy. A fiscal stimulus to facilitate recovery has already been implemented in a much bigger way by other countries like India and China with some success. Given the slump in private investment, the only option for a counter-cyclical policy is to push up public investment to revive the economy. Of course, this must be accompanied by sharper prioritisation of the PSDP and better implementation of projects.

What are the principal differences between our 'home-grown' medium term macroeconomic framework and the proposed IMF framework? First, there is the difference in choice of policy instruments over the next five years. As highlighted above, the 'home-grown' framework envisages a bigger build up in public investment. Second, the current account deficit is significantly smaller in the 'home-grown' framework when debt repayments peak after 2011-12. The strategy of import compression and promotion of exports is critical to the achievement of greater self-reliance. This is proposed to be achieved by imposition of regulatory duties on imports (excluding essential imports) and a somewhat faster depreciation of the exchange rate.

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Third, the inflation rate is somewhat higher in the 'home-grown' scenario, at about 7 percent by 2014-15, due primarily to the more aggressive use of the exchange rate instrument. Fourth, the 'home-grown' framework envisages a significantly faster growth of the economy, from 4.4 percent to 6 percent by 2014-15. In the IMF framework, the GDP growth rate will remain below 5 percent up to 2013-14. Finally, with a higher GDP growth, the prospects for employment and thereby lower poverty are unambiguously better in the 'home-grown' strategy. Estimates show that there are likely to be about 2.5 million less poor people in Pakistan in 2014-15 if the 'home grown' strategy is resorted to.

Therefore, should Pakistan stay in or exit out of the IMF programme? This will hinge crucially on discussions with the Fund over the next few weeks on the forthcoming budget and updating of the medium-term macroeconomic and fiscal framework in light of the expected outcome in 2009-10. If the Fund accepts the need to push for higher public investment next year as a means of reviving the economy and thereby relaxes the fiscal deficit target then Pakistan should continue the relationship with the Fund up to the end of the present SBA in December 2010 hopefully under better terms of repayment (SAF or ESAF). As far as getting on to new programme thereafter is concerned this must hinge on acceptance of a medium-term macroeconomic and fiscal framework like the 'home-grown' framework presented in the report, which enables a process of sustained recovery of the economy. The costs of continued breakdown in the provision of public services and of rising unemployment and poverty are becoming too high to be contemplated.

Removal of infrastructural constraints

The year 2009 has witnessed an escalation in power outages and water shortages as well as an emergence of gas shortages to further compound the supply-side constraints on all sectors, including industry, agriculture and services. These shortages not only constrain growth in terms of the GDP foregone, but have impact on employment, exports and development in general.

Despite a commitment by the government, the incidence of power loadshedding increased by over 30 percent during the course of the year. As highlighted earlier, the problem has aggravated to the extent that people in various cities have resorted to street protest against loadshedding.

Recent analysis based on a survey of industrial units, shows that the cost to the economy of power outages in the industrial sector in 2008-09 was Rs 230 billion. This is equivalent to 11 percent of industrial value added. The reduction in industrial value added has led to a loss of industrial employment of about 535,000 workers. This magnitude of retrenchment can have significant consequences on the level of poverty in the country, where poverty is already on the rise due to escalating prices and lower growth. Allowing for the multiplier effects, the total cost to the economy of power loadshedding in the industrial sector is estimated to be Rs 315 billion. This is equivalent to two-and-a-half percent of the GDP. The loss of exports is estimated at about US $1.3 billion in 2008-09. Compared to 2008, the costs to the economy of power outages in 2009 are probably 40 percent higher.

Policy actions taken more recently by the government include the following: establishment of Debt Co (PHCL) and transfer of debt stock of over Rs 30 billion from power utilities; financing of debt servicing (Rs 40 billion) through tariff increases; 48 percent increase in power tariff from March 2008 and institution of performance contracts with Discos aimed at efficiency improvement, loss reductions and improved recoveries. The government has also held last month a high-level energy summit, which agreed on a number of steps for energy conservation and short and long-term proposals to improve energy security in the country.

Ensuring energy security will, however, require a more structural solution to the circular debt problem; upgradation of existing power plants; expansion in capacity through the implementation of a comprehensive programme to reduce technical losses and improve the reliability of the distribution system and formulation of load management strategy. It is also important that alternative sources of energy, in particular solar and wind energy, be explored.

After electricity, there is an incipient crisis in gas supplies, which is likely to strike the country with equally far reaching impact in the coming years if corrective policy actions are not taken with some urgency. It is projected that the demand for gas in Pakistan, over the next five years, will increase at about 5.5-6 percent per annum. The gap in demand and supply is likely to increase to between 342 and 405 bmcft by 2014-15, depending on the supply position of gas. The annual cost to the economy of this shortfall could be as high as Rs 110 billion by 2014-15.

Overall, Pakistan needs to develop and implement a comprehensive energy strategy with the objectives to: (a) enhance the exploration and production activities of oil, gas and coal resources, (b) encourage the utilisation of the country's hydel potential and other indigenous resources to reduce dependence on imported fuel: (c) create an environment conducive to the participation of the private sector and (d) develop the local energy scenario in the context of a regional perspective.

Turning next to the water sector, Pakistan is now one of the world's most arid countries with an annual rainfall of less than 240mm and virtually total reliance on a single river system with no additional injections into the system.

According to the UN Report (2009), total water renewable resources in Pakistan have decreased from 2,961 cubic meters in 2000 to 1,420 cubic meters per capita in 2005. It is estimated that by 2025, not more than 1,000 cubic meters will be available per person in Pakistan making it a water-scarce country.

Over 80 percent of the cropland is irrigated in Pakistan. The country receives an inflow of 104 million acre feet (MAF) from the Indus Basin out of which 64 MAF are consumed by crops and the remaining is lost to the Arabian Sea and seepage. The flows in the three rivers is declining at the rate of 6.6 percent per year. The other main source is ground water, which accounts for 40 percent of irrigation. There is evidence of over exploitation as ground water pumping has increased from 3.34 MAF in 1959 to 55 MAF by 2009.

An important issue in recent years has been under-investment in water. Recent analysis has demonstrated that, if water availability had grown at the trend rate, of about 1.3 percent, the agricultural value-added would have been higher. The loss of GDP in 2008-09 due to underinvestment in water in the current decade has been as much as Rs 125 billion, equivalent to 4.8 percent of the agricultural value-added.

Quick actions are required in order to avoid a drought situation in the country, which will severely impact the lives of millions of people in Pakistan. An ecologically sound and sustainable strategy would include: construction of dams; improvement in operation and maintenance of the irrigation system; private sector involvement to improve performance and efficiency in the water supply and other infrastructure; implementation of strict laws for industries with respect to water contamination and pollution; introduction of water efficient cropping system; new technologies such as drip and sprinkler irrigation; proper water pricing and improvement in cost recovery to both reduce stress in financial position of water providing agencies and wastage; introduction of a water credit system with the involvement of the private sector and based on the principles of microfinance and lastly introduction of measures to reduce water theft in the irrigation network.

Overall, the analysis in the report demonstrates that the country is paying a heavy price for the delay in the effective resolution of the enormous infrastructural challenges facing it. Potentially, the GDP could have been higher by almost Rs 450 billion, or about 3 percent, if the shortages of power and water shortage alone were not adversely impacting on the economy. The concomitant repercussions for exports, employment and poverty are also sizable. Any further inaction or inadequate/inappropriate policy action can severely frustrate the country's growth potential.

(To be continued)

Business Recorder [Pakistan's First Financial Daily]

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State of the economy: Pulling back from the abyss - III

ARTICLE (June 30 2010): Governance is a very broad concept that encompasses the form of political regime, the process by which authority is exercised in the management of economic and social resources of a country and the capacity of governments to design, formulate, and implement policies and discharge functions.

It includes formal institutions and regimes empowered to enforce compliance as well as informal arrangements that people and institutions either have agreed to or perceive to be in their interests. The current governance problems in Pakistan, of worsening security and law and order situation, widespread corruption and declining public authority and institutions, threaten future investments and growth as well as political and social stability.

However, to a considerable extent, the present governance problems have also their roots in the pattern of economic development over the last fifty years. The uneven distribution of growth benefits and the increasing dualism in the society are reflected in the sharp contrast between the growing numbers of poor and illiterate, on the one hand, and increasing sophistication and wealth of the elite and upper middle classes, on the other.

However, in contrast with the familiar litany of governance problems noted above, there have been some positive recent developments that hold at least the potential of improving the quality and the effectiveness of governance structures. These major developments have greatly enhanced the prospects of a free, stable, and decentralised democratic order.

First, the passage of the 18th Amendment to the Constitution as already noted transfers greater powers and authority to the provinces and lays the basis of healthy competition as well as direct negotiations among provinces and the Centre on matters of common interest. Second, the Seventh NFC award provides the financial underpinnings of greater provincial autonomy and equity by not only significantly increasing the share of the provinces in the divisible pool of revenues, but also considerably expands the share of smaller provinces. Third, the restored and reinvigorated higher judiciary has shown great independence in asserting the rule of law and has been fearless in pursuing wrong doing thus increasing public confidence in this important third pillar of the state.

How does Pakistan fare in international rankings of governance? Numerous international sources, which follow different methodologies in constructing indicators and cover different dimensions of governance, have been analysed in this report to determine Pakistan's ranking in governance indicators. It turns out that Pakistan is in the lowest quintile (bottom 20 percent) in two-thirds of the rankings.

The conclusion follows that Pakistan performs poorly in governance in relation to most countries, and has the lowest ranking among South Asian countries. There are only 11 rankings in which Pakistan is in higher (first and second) quintiles, which relate to economic governance like business regulatory environment and quality, debt policy, structural policies and size of government. There is no other indicator of governance in any international assessment in which Pakistan performs relatively well.

Cross-country regressions indicate that if governance in Pakistan had approached the average for the countries of South Asia, then the GDP growth rate during the period, 1996 to 2008, could have been higher by 0.66 percentage points annually (that is, at 5.3 percent per annum instead of the observed 4.6 percent). In other words, the GDP today could have been 8.3 percent higher, equivalent to about Rs 820 billion. These results also demonstrate the impact of the quality of governance on progress on the Millennium Development Goals (MDGs) and human development. Clearly, Pakistan has sacrificed growth and human development due to poor governance.

There is no doubt that Pakistan can make a major headway with improved governance, for example, by learning from international experience. Some key lessons on successful implementation of governance reforms are as follows: national ownership - by governments and communities - is key; continued political will and support throughout all phases of reform is vital; creating broad coalition of support for reform is important; change agents or reform champions are needed to anchor the reforms; support and engagement of multiple stakeholders is essential; change management is an integral part of any reform process; there is no one-size-fits-all programme design; strategic incrementalism may be a more pragmatic and feasible option; setting realistic and well-defined targets can be useful; ensuring financial and institutional sustainability of reforms is crucial; projection of "good results" and provision of incentives for continued progress are useful.

The report presents a ten-point governance reforms agenda. A pre-requisite is for the political leadership at both the federal and provincial levels to try to regain the trust and confidence of the public. Several steps can help to alleviate the present mistrust. Among them are: less arbitrariness and greater transparency in decision-making, a clear respect for the rule of law, adoption of austerity measures to curb wasteful and low priority public spending, and finally strong accountability mechanisms that reward good performance and punish wrong doing. At the same time, the capacity for governance must be improved by the appointment of highly capable and honest individuals.

Specific areas of governance reform in Pakistan must include the following: better policy framework, civil service reform, improved delivery of services, emphasis on curbing corruption by enhanced transparency and accountability, strengthening the rule of law and the role of civil society institutions.

Enhancement of provincial rights and responsibilities The passage of the 18th Amendment to the Constitution is a momentous development in the direction of enhanced provincial autonomy. Decentralisation of policy-making as well as the implementation of the policies made would be some of the important outcomes of this amendment.

Most of the press coverage of the 18th Amendment has been concerned with the division of powers between the president and the prime minister. What has escaped notice by most analysts and commentators is another part of the amendment, a significant increase in the powers of the federating provinces. Granting provincial autonomy was also the intention of the original constitution. The constitution had two lists, one for federal subjects and the other that were to be the joint responsibility of the federal government and the provinces. The concurrent list included matters - 47 in number - such as civil and criminal law, population planning, electricity, tourism, trade unions, and other matters of common interest. The concurrent list was to be removed from the constitution ten years after its promulgation. That, of course, did not happen and the country continued to be run from the centre at Islamabad. Under the 18th Amendment, there is once again a promise that decentralisation will be achieved not just on paper but also in practice.

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The country has also attempted to bring government closer to the citizenry by constituting local bodies, directly elected by the people. A number of different systems have been tried since independence, but did not survive long enough to provide services effectively. Had one system been allowed to remain in place with changes introduced from time to time, Pakistan would possibly have developed an effective system of local governance. This has not happened.

There cannot be any doubt that the 18th Amendment will have a profound impact on the way Pakistan's economy is managed. If the federating units receive additional powers as a result of the abolition of the concurrent list put into the 1973 Constitution by its framers, it will mean transferring large amounts of economic authority to the provinces. They will, for instance, have the right to manage labour laws, environmental impact of development in both the public and the private sectors of the economy, generation of much larger amounts of electricity than currently permitted, development of infrastructure, movement of goods and commodities within their own boundaries, improving the level of education and providing for the acquisition of usable skills by the populace. This will happen only if the provinces find a way of financing these activities. If they remain dependent on the central government for funds, the autonomy promised by the amendment will remain illusory.

The Council of Common Interests (CCI) has also been greatly strengthened. Some of the subjects which will now be under the purview of the CCI include major ports; electricity, presumably all aspects of it including generation, transmission and distribution; all regulatory authorities; national planning; public debt; census; legal, medical and other professions; higher education standards; and inter-provincial matters and co-ordination.

The 18th Amendment has also removed the sixth schedule to the Constitution that had given protection to 35 laws. Included in these was the Devolution Plan of 2001.This leaves open the question whether the provinces would continue the systems that were in place as a result of the 2001 Ordinance. It is essential that the process of decentralisation is further deepened and local governments are strengthened.

There are a number of provisions pertaining to strengthening the finances of the provinces. They will have the right to raise domestic or foreign loans with the approval of the National Economic Council, a body chaired by the Prime Minister with a secretariat in the Ministry of Finance. Future NFCs cannot issue awards that reduce the combined share of the provinces in the central "divisible pool".

Will the 18th Amendment deliver decentralisation? For this to happen, the military will have to come under the control of the civilian authority. The country may also be moving towards the creation of a federal system in which there is sharing of power between governments at different levels - between the federal and provincial governments and between provincial and local governments. Also, it is essential that the lower levels of government have the capacity and wherewithal to effectively perform their functions. This involves allocation of resources, including financial resources. Currently the distribution of fiscal powers is highly skewed in favour of the federal government.

All in all, while the 18th Amendment to the Constitution has taken a major step forward in moving Pakistan towards a federal system, the real test of the efficiency will come once the envisaged system begins to take shape. The passage of the amendment and its signing into law has not resolved the controversy that surrounds many aspects of governance in Pakistan. Another test will come in terms of providing services for which the provinces will have the responsibility with the abolition of the concurrent list by the 18th Amendment. There is general agreement that decentralisation of the government's authority should help in addressing the problem the country faces as the number of people living in absolute poverty increases. But will the provinces have the capacity and the resources to carry out this mandate? We turn in this context to the implications of the recent NFC Award.

(To be continued)

Business Recorder [Pakistan's First Financial Daily]

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State of the economy: Pulling back from the abyss - IV

ARTICLE (July 01 2010): Fiscal decentralisation: Inter-governmental revenue transfers are the lifeline of provincial governments in Pakistan. These transfers account for over 80 percent of sub-national revenues. This dependence is a consequence of the imbalance in the allocation of functional responsibilities and fiscal powers between the federal and provincial governments in Pakistan, whereby the federal government collects as much as 92 percent of tax revenues and the provinces, only 8 percent.

Since partition, eight revenue sharing awards have been announced in Pakistan for determining transfers, which have historically taken three forms, "divisible pool" transfers, straight transfers and grants/subventions.

Overall, it appears that, inter-governmental transfers between the federation and federating units have evolved within the broad philosophy of promoting a degree of fiscal decentralisation and by strengthening the resource base of the provinces making them more dynamic as service delivery agents. There has been a rise in federal transfers as a proportion of federal tax revenues.

However, the change in the nature of fiscal transfers has accrued to the advantage of natural resource rich provinces. The share of Sindh has increased significantly in the late 90s and in the earlier part of the current decade. Khyber-Pakhtoonkhwa's share peaked following the 1990 NFC award and transfer of hydel profits and has declined thereafter. Both NFCs of 1990 and 1996 enhanced the share of Balochistan in federal transfers, but this trend was not maintained by the 2006 Presidential Order. Punjab shows a steady decline in its share of the transfers.

Factors which justify a further increase in the provincial share in the divisible pool include: the security conditions prevailing in the country which have increased the 'fiscal needs' of the provinces in the war against militancy. Provinces also need more resources for skill development and employment creation to reduce the propensity of youth towards extremism; for achieving the Millennium Development Goals (MDGs), which are the principal responsibility of the provincial governments; and for financing transfer of Concurrent List functions and vertical programmes by the Federal government.

The 7th NFC award has, in fact, made a major headway in transferring more resources to provinces. It has enlarged the size of the divisible pool through a reduction in collection charges from an average of 5.2 percent to 1 percent. It has provincialized sales tax on services and has increased provincial share in vertical transfers from 46.25 percent to 56 percent in the first year of NFC and 57.5 percent in the subsequent years.

It has also diversified the bases of distribution of revenues among provinces. Punjab showed accommodation to the longstanding demand of other provinces to have multiple indicators for horizontal distribution. Provincial shares are now derived on the basis of poverty, inverse population density (IPD) and revenue contribution (both proxy collection and generation) and, of course, population.

The seventh NFC award is also unique as it takes into account special considerations, which impact on the fiscal requirements of the provinces. First, the Federal government and provinces recognized the role of Khyber-Pakhtoonkhwa as a frontline province against the 'war on terror'. As a gesture of support, all provinces joined the Federal government to allocate 1 percent of the divisible pool to the province. Second, the federation and all the provinces accepted the special development needs of Balochistan and agreed to raise its share in the divisible pool to over 9 percent. Also, the award enhanced straight transfers by accepting the provincial demand of payment of arrears from profits of hydel power electricity and gas development surcharge.

All in all, the 7th NFC award is unique in its design and its sensitivity to the needs of the federating units. It is also an award, which has made big changes in the status quo and, therefore, has substantial and varying implications both on the Federal government and four provincial governments.

Total divisible pool transfers to the provinces in 2010-11 are projected at Rs 883 billion, Rs 58 billion higher than the transfers if the current revenue-sharing arrangements had continued. Other transfers will also be higher at Rs 244 billion, due to, first, transfer of the entire proceeds of the sales tax on services to the provinces, and second, payment of arrears of hydel electricity profits and GDS to the smaller provinces. There will, however, be some reduction in grants. Overall, transfers to provinces are estimated to be Rs 1077 billion in 2010-11, higher by Rs 283 billion as compared to the present distribution formula. The larger transfer to provincial governments implies that the federal budget deficit could approach 6 percent of the GDP.

As opposed to the Federal government, the provincial governments will witness a substantial improvement in their fiscal position. Assuming that the provincial governments maintain the level of fiscal effort and expenditure growth envisaged in the IMF agreed fiscal framework, the provinces of Sindh, Khyber-Pakhtoonkhwa and Balochistan will carry surpluses ranging from Rs 22 to 35 billion. Overall, these estimates indicate that the provinces combined could initially generate a budget surplus of Rs 115 billion, of about 0.7 percent of the GDP, due to limitation of absorption capacity, especially in the smaller provinces.

Perhaps for the first time, there will a shift of development focus from the Federal government to the provinces. The provinces combined could carry out development programmes approaching Rs 370 billion in 2010-11, thereby exceeding the federal PSDP. The fast growth in development spending will require enhancement in provincial capacity to design, execute and manage a larger portfolio of projects.

Of course, since the provincial governments are primarily responsible for the social sectors, prospects for 'investing in the people' have improved. For the medium-term consequences to be favourable provinces must not slacken their own fiscal effort, so that additional transfers essentially supplement and not substitute for provincial own revenues and avoid profligacy in current expenditures. Additional resources should be used for development and largely routed towards backward regions and pro-poor sectors. It is recommended that the provinces may prepare their own Medium Term Development Frameworks (MTDF) to help strategize and prioritise their development priorities and facilitate proper planning and management of spending.

As highlighted above, the award has reduced the fiscal space for the Federal government. Sharper prioritisation and pruning of federal PSDP has become indispensable. Also, the linchpin in the strategy to keep the federal fiscal position from becoming unsustainable is to enhance the level of resource mobilisation of the type described earlier.

In conclusion, the 7th NFC award has major implications for both the federal and provincial governments in Pakistan which will require well thought out, coherent policy responses by the two levels of government. Its real accomplishment is that in one of the most difficult times in the history of the country, it has rekindled the spirit of national solidarity, consensus building, cohesion and unity.

This is the fourth part of the executive summary of third annual report prepared by the Institute of Public Policy Beaconhouse National University. The title of the report is: "State of Economy: Pulling back from the abyss". The key contributors of the report include Shahid Javed Burki, Sartaj Aziz, Dr Hafiz Pasha, Dr Parvez Hassan, General Jahangir Karamat (Retd), Shahid Hamid, Shahid Kardar, Dr Akmal Hussain, Ziad Alahdad, Nasreen Kasuri and Dr Aisha Ghaus-Pasha.

(To be continued)

Business Recorder [Pakistan's First Financial Daily]

[Neo]

State of the economy: Pulling back from the abyss - V

ARTICLE (July 02 2010): Strengthening of local governance: The argument in favour of local governments is based on a simple proposition: that the allocation of public resources at the local level is more likely to conform to public welfare priorities, and the delivery of basic services is likely to be more efficient, in a situation where these administrative functions are being performed by elected government officials, close to and in full view of the electorate. Thus, proximity to the electorate and accountability to them, are more likely to impel local government officials to seek the public good.

The most recent experiment with devolution in Pakistan is the introduction of the ambitious Devolution Plan in 2001. This was based on a template developed by the National Bureau of Reconstruction, which meant the adoption of a "one size fits all" approach to creating governmental units at the local level. Working under the direction and control of elected councils and Nazims, the local government system attempted to create institutions and mechanisms for public participation in design, management, monitoring and control of social service delivery and development activities. There were 31 decentralised departments with management control and functional responsibility transferred from provincial government under Part A of the First Schedule to LGOs, 2001.

Devolution reforms, also envisaged large-scale fiscal decentralisation to follow the administrative and political decentralisation. This, however, did not happen. While a fiscal relationship was forged between the provinces and the districts, an extensive reorganisation of resources did not take place and the vertical financial imbalance stayed in place with the major financial collections being made at the federal, and to a lesser extent, at the provincial level, and transferred to the local tiers under semi-institutionalised arrangements.

Many studies have been conducted on the decentralisation experience in Pakistan. Some have emphasised the gains to be made from a decentralised system, particularly in terms of allocative efficiency and participation of the people at the grassroots, while others cast doubt on some of these gains, and raise concerns about possible negative consequences, particularly related to local elite capture and poor quality of service delivery.

Admittedly, there is a strong case for strengthening the local government system through deepening of reform. These reforms are warranted in political, institutional, legal, fiscal and administrative areas. The report presents a number of structural reforms related to province/district/tehsil relations; local institutional capacity; transparency and accountability; fiscal equalisation through transfers, etc.

In conclusion, local governments in Pakistan in the future can take one of three routes:

(1) The district level governments may be rendered so dysfunctional that Nazims or Chairmen may begin to resign and in the subsequent elections genuinely popular local figures may lose interest in local government altogether. Such a process could ultimately result in the failure of the "devolution of power programme".

(2) The local government system as it presently exists may continue to function at such a low level of efficiency that the efficiency gains conceived in the programme may become low or even negative.

(3) The current situation where local government (LG) elected officials have responsibility without appropriate authority and where they are starved of financial resources may be changed. In this case local government officials may be granted authority over appointments, promotions and transfers of all personnel in the district administration.

At the same time, adequate technical and financial resources could be made available to elected LG officials. In such a case, the power of the provincial bureaucracy to establish personalised patron-client relations and the tendency to appropriate economic rent could be transformed into efficiency gains associated with effective decentralisation. We strongly support the third option.

There is also enough evidence from around the globe to suggest that decentralisation through the creation of local government works better for the poor where it is supported by strong community mobilisation. This will require a national campaign to empower the poor at the level of village/mohallah, union council, tehsil and district levels. The idea is to facilitate the growth of autonomous community organisations (CBOs) of the poor at the village/mohallah level to be able to break out of the poverty. These autonomous CBOs should be permitted to form cluster apex organisations with other CBOs. By means of social mobilisation, skill training, increased productivity, increased income, savings and investment these organisations would begin a process of localised capital accumulation.

Such autonomous organisations of the poor could not only become a framework for grassroots economic growth, but would also constitute a countervailing power to local elites. At the same time, these autonomous organisations of the poor would enable the individual poor households to get better access over input and output markets.

In conclusion, Pakistan today is poised at the knife edge. We could fall into the abyss or progress towards a better future. There is no doubt a myriad of problems existing today on the security, economic, political and institutional fronts. But the return to democracy has led to big actions.

(Concluded)

Business Recorder [Pakistan's First Financial Daily]