Saturday, September 23, 2006

Pakistan's worsening trade gap

The worrying trend in Pakistan’s trade deficit has continued in the first two months of the new fiscal year. According to the Federal Bureau of Statistics (FBS), Pakistan’s trade deficit rose by 36.7% to a record $2.13 billion for the months of July and August 2006. The trade gap was propelled by a sharp increase of 17.86% in imports to $4.98 billion which eclipsed the anaemic 6.87% growth in exports, rising to $2.85 billion. The FBS has also indicated that the growing trade deficit will continue to increase over the current fiscal year, calling into question the government’s target of $9.4 billion. If the July-August 2006 trend continues the trade deficit for the fiscal year 2006-07 will approach $13 billion. The key concern for Pakistan is that the widening trade gap will adversely affect the rupee’s exchange rate against foreign currencies, especially the US dollar, which may lead to a spike in interest rates and ultimately squeeze the already pressured common man.

A worsening trade gap leads to downward pressure on the rupee because Pakistani importers will require more US dollars to pay for the higher levels of imports, rendering dollars dearer in the local market. In principle the higher demand for foreign currency can be met in one of two ways: one, an inflow of foreign currency into Pakistan from abroad; and two, Pakistan can tap into its own foreign currency reserves.

The first, inflow from abroad, route, while preferable, is unadvisable or problematic, especially keeping in view the rapid deterioration of the trade balance. The inflow of currency can be achieved in several ways: an increase in foreign investment; increased remittances; foreign aid and/or loans; and an increase in exports. Other than resorting to foreign loans – the least desirable option – the other avenues cannot be short term solutions. Foreign investment will not experience a steep increase so long as the country’s political climate and law and order situation remain volatile and infrastructure bottlenecks persist. The flow of foreign remittances is already considered to be near its potential following the post-9/11 crackdown on alternative, non-official channels.

Enhancing exports may be the most economically sound course of action; however, Pakistan’s export sector is showing worrying trends of not just failing to keep up with imports, but potentially declining in monetary terms. Consider the data from July 2006 (the FBS has not yet released the breakdown of exports and imports from August 2006): growth of cotton exports, still the backbone of Pakistan’s export sector, continue to skew away from high value-added products, such as knitwear, bed wear and cotton cloth, and towards the low-profit cotton yarn and towels segments. Knitwear, bedwear and cotton cloth accounted for Rs. 27.491 billion of total exports of Rs. 73.558 billion in July 2006, but declined by 0.03%, 8.62% and 11.62%, respectively, when compared to July 2005.

A depreciation of the rupee may provide a small, short-term boost to the competitiveness of Pakistan’s exports, but, besides risking higher inflation, such a move is a disincentive for exporters to increase their competitiveness and only encourages rent-seeking behaviour.

The second route that Pakistan can follow to pay for its increased imports is to dip into its foreign currency reserves. However, as already noted, if the July-August 2006 trade trend continues, Pakistan’s trade deficit at the end of fiscal year 2006-07 will be in the region of $13 billion – wiping out the country’s entire stock of foreign currency reserves in a year, were they to be used for this purpose.

The conclusion then is that the current level of imports is unsustainable. Tightening fiscal and monetary policy can help reduce the demand for imports by reducing aggregate demand. However, as sustained, high growth rates are vital for Pakistan’s economy, a targeted regime of import cutbacks is more desirable than blanket measures, which would reduce economically salubrious imports, such as capital investments in manufacturing, plant, machinery, agriculture, etc.

The starting point for identifying possible cutbacks in the country’s import bill must be petroleum products, the single largest imported commodity according to the FBS. In July 2006 the import of the petroleum group of commodities rose by 43.73% as compared to July 2005 to Rs. 43.717 billion. With few economists forecasting a significant reduction in oil prices over the next few years, Pakistan needs to urgently increase its use of CNG and alternative fuels.

July 2006 also saw Rs. 2.269 billion spent on the import of foreign assembled cars. In light of the required belt tightening this is an unwarranted expense. However, it should be noted that were such a cutback established a caveat must be better regulation of the local car industry in order to prevent local manufacturers from exploiting consumers.

The FBS also indicates that in July 2006 Rs. 3.746 billion worth of sugar was imported – an increase of 293.49% over July 2005. While the government continues to prevaricate over the sugar crisis and refuses to launch an independent and transparent investigation of the sugar cartel, the real need for such quantities of imported sugar cannot be established. Clean governance may directly help reduce the country’s import bill in this instance.

Beyond these areas the opportunities for targeted import reductions are limited, suggesting grim choices lie in the months ahead. Macroeconomic measures to reduce imports across the board will hurt economic growth, but so will the alternative of financing the import binge. The present government is truly caught between a rock and a hard place, but it is a situation of its own making; the economic cul-de-sac the government finds itself in is a logical and predictable outcome of its economic policies since 1999.

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