Pakistan’sTwinDeficitsandIMFFiscalConditionalityAstalksbetweentheIMFandPakistancontinue,NadirCheemaexplainswhyfiscalausteritymaybeneededtoreducePakistan’scurrentaccountdeficitandwhyenergysubsidiesmaybeakeytargetforanyfiscalcuts.

Notwithstandingtherecentlysecuredshort-termsupportfromSaudiArabiaandclaimsofsupportfromChina,Pakistan’slargemedium-termexternalfinancinggapcontinuestorenderanIMFprogrammeinevitable.Here,thediscourseonIMFfiscalconditionalityneedstobeexaminedfirstonwhysomefiscalausteritymaybeneededforreducingPakistan’scurrentaccountdeficit;andsecondlyforwhyenergysubsidiesmaybeakeytargetforfiscalcuts—whilethesehavecomedowninrecentyearsduetorelativelylowoilpricesandthe2013subsidyreform,theyarestillsignificant,andmayclimbasoilpricesrise.

Onthefirst,thereissubstantialevidencethatthecurrentaccountdeficitandfiscaldeficitareboundtogetherinthe‘twindeficits’phenomenon.ThetradedeficitisthemaindriverofthecurrentaccountdeficitinPakistan.Asimpletimeplotofthetradedeficitandfiscaldeficitover2000-17tellsthestorywell:thetwovariablesgenerallymovetogether,withacorrelationof0.66.

Pakistan’sTradeDeficitandBudgetDeficitfrom2000-2017|Graphconstructedbyauthor

Severaleconometricstudies,eg‘AnEmpiricalInvestigationfortheTwinDeficitsHypothesisinPakistan’(Mukhtaretal.,2007)anda‘TwinDeficitHypothesis:aCaseofPakistan’(Yasmin,2015)provideevidenceofthis.Thereisalsocross-countryevidence:‘FiscalPolicyandtheCurrentAccount’(Abbasetal,2011),findforalargesamplethatonepercentagepointofGDPstrengtheningoffiscalbalanceisassociatedwithacurrentaccountimprovementofabout0.5percentagepoint.Theassociationisstrongerwheninitialdebtlevelsarehigh,asinPakistantoday.

Itisusefultoreflectonthechannelsthroughwhichfiscalpolicyaffectsthecurrentaccount.

First,ahigherfiscaldeficitdrivesupdomesticdemandintheeconomy,partofwhichfallsonimports,thereforedrivingupthetradedeficit.Asubtlerwaytostatethisisthatwhenthegovernmentraisesitsspending,alargepartofitfallsonnon-tradables(egdomesticallysuppliedconstructionservices)whichjacksuptheirprice.Producers,whorespondtopricesignals,thenshiftresourcestothenon-tradablesector,awayfromproductionoftradables(exportsandimportsubstitutes).Thisamountstoarealexchangerateappreciation,andwhatresultsinabiggertradedeficit.Bythesamelogic,whenthegovernmentreducesitsnetspending,itlowersthepriceofnon-tradables—equivalenttoarealdepreciation—thusincentivisingmoreproductionoftradables,whichreducesthetradedeficit.

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CargoShip|Credit:AliYahya,Unsplash

Second,asKeynesestablished,fiscalexpansionraisesmoneydemand,whichincreasesinterestratesandcrowdsoutprivateinvestment(lowerinvestmentcanreducetheeconomy’slong-runpotentialgrowth).Ahigherinterestrate,iecostofcapital,alsoelevatesthecostofdoingbusinessfordomesticindustry,thusadverselyaffectingexportcompetitiveness.Thesechannelscanalsoexacerbatethetradedeficit.

Havingshownthatfiscalpolicyhasanimportantimpactonthecurrentaccount,aquestioninthecontextofongoingIMFnegotiationsis:whattypeoffiscaladjustmentwouldbemostappropriatetoreducethetradedeficit.Therearemanyviews,butuniversalenergysubsidiesareanobviousareafordiscussion,especiallywhenthereismuchmisunderstandingabouttheirimpact.

Pakistanhasahistoryofgivinglargefuelsubsidiestoitscitizensinthefaceofrisingoilprices.ThesesubsidiesrosetoalmostthreepercentofGDPin2012nearthehistoricalpeakofoilprices.Althoughthesubsidybudgetfellinrecentyearsduetounusuallylowoilprices,therecentuptickinoilpriceswilltestthegovernment’sresolve(includingitscommitmenttothesubsidyreformintroducedin2013).Thefuelsubsidyalsoresultsinagreaterdemandfromconsumersforenergyimportsthanwouldobtainintheabsenceofthesubsidy,thusconstitutingasourceofcommondrainforthefiscalandcurrentaccounts.Thegovernment’sfearthatpassingalargeoilpriceincreasetoconsumerswillhitthepoorismisplaced.

Why?Energysubsidiesareregressive—theylargelybenefittherich,notthepoor.Thispointhasbeenmadeatlength.Forinstance,UnequalBenefitsofFuelSubsidiesinDevelopingCountries(DavidCoadyetal.,2015)findforalargegroupofcountriesthatfuelsubsidiesmainlybenefithigher-incomegroups.Reflectingtheunderlyingunequaldistributionofconsumption(wheretherichconsumeadisproportionateshareofenergycomparedtothepoor),therichest20pccapturesixtimesmoreofthegovernment’sfuelsubsidyexpenditurethanthepoorest20pc.Thebenefitsofpetrolsubsidiesarethemostregressivelydistributed,withover83pcofbenefitsaccruingtotherichest40pcofhouseholds.Theauthorssuggestthatgovernmentsabolishalluniversalfuelsubsidiesinfavouroflifelinetariffsandwell-targetedcashtransferstoprotectpoorhouseholds;andwithanexceptionforexporters.Whilecompletelyabolishinguniversalsubsidiesmightnotbepossible,theunequaldistributionofsubsidiescertainlyneedstobelookedinto.Thegovernmentwouldbewelladvisedtoheedtheseexpertvoices.

ThisarticlefirstappearedonDawn.comon14November2018.

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Thisarticlegivestheviewsoftheauthor,andnotthepositionoftheSouthAsia@LSEblog,noroftheLondonSchoolofEconomics.Pleasereadourcommentspolicybeforeposting.

NadirCheemateacheseconomicsatSOASUniversityofLondonandisaseniorresearchfellowatBloomsburyPakistan.HeTweets@NadirCheema

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