In light of the numerous economic challenges confronting the provisional government of Pakistan, such as the exponential growth of inflation and the accumulation of debt, significant concerns emerge regarding the long-term viability of substantial infrastructure initiatives and the imperative for prompt fiscal consolidation.
The $6.7 billion, Chinese-funded Karachi to Peshawar railway line (ML-1) has garnered considerable acclaim due to its potential to substantially diminish the duration of travel between the two prominent urban centers. Nevertheless, there are apprehensions regarding the viability of such an outlay in foreign currency, considering the current economic climate.
Assuming a three percent interest rate, a two percent insurance cost, and a 20-year payback period, annual payments for the ML-1 project come to $530 million. The government must assess whether it can afford such a hefty expenditure, especially when considering more cost-effective alternatives like investing in a new signaling system for $150 million, which could increase train speed and track capacity by 20 percent.
This is a critical question to ask, given Pakistan’s history of not determining the foreign currency or external viability of projects and policies. Over the years, the nation has pursued policies and projects that have resulted in external debt and liabilities of $125 billion, with minimal foreign earnings to show for it.
One example of this oversight is the amnesty given to the real estate sector in 2020, which diverted funds towards real estate and construction, leading to increased imports and a negative impact on exports. The government failed to consider the effect on tax revenues or the manufacturing sector, resulting in unsustainable import levels by 2022.
Similarly, the rapid expansion of electricity production capacity between 2013 and 2018 was not assessed for its external viability, contributing to a decline in exports and a challenging situation in paying for the new power plants. These ill-conceived policies have come back to haunt Pakistan, resulting in significant domestic and external debts.
The government’s fiscal deficits have surged since the passage of the seventh National Finance Commission (NFC) Award, leading to a situation where revenue after paying the provinces is insufficient to cover interest payments. To meet its debt obligations, the government has to borrow even more, resulting in money creation by the State Bank, driving inflation and devaluation.
The economy faces a Catch-22 situation where the State Bank’s efforts to control inflation through higher interest rates are overwhelmed by the government’s expansionary fiscal policy, fueled by a large budget deficit. This cycle of borrowing to pay off interest costs further exacerbates inflation and currency devaluation.
To address this crisis, the caretaker government should consider reducing spending on the Public Sector Development Programme and provincial Annual Development Programme to cut the aggregate federal and provincial deficit. Only after fiscal consolidation should Pakistan pursue growth through investments that boost exports, deferring projects like ML-1 until the fiscal situation stabilizes.
Inflation is a significant concern in Pakistan, driven by excessive money supply and high demand for goods. The economy’s consumption-driven growth has led to a surge in currency in circulation, further fueling inflation. To address the issue, the State Bank must increase its policy rate, reducing demand and lowering inflation. However, this strategy is challenged by the government’s borrowing and money creation.
The rising imports and an overreliance on dollar debt-financed imports have exacerbated the situation, leading to the devaluation of the Pakistani rupee. The continuous inflation and import-driven consumption have resulted in record imports, contributing to price hikes in essentials like sugar and petroleum products.
The complex relationship between inflation and wage increases is being reevaluated, suggesting that other factors, such as labor share of national income, also impact unit labor costs. With labor shares falling back to 2019 levels, it’s unclear whether compensation is excessively high relative to output.
Inflation is further compounded by the dominance of indirect taxes, such as sales tax, which contribute to the government’s tax revenue but also inflate prices. The informal economy’s substantial size has resulted in a declining tax-to-GDP ratio, posing additional challenges for Pakistan’s fiscal situation.