Foreign exchange crisis

THE new government has inherited a challenging balance of payments situation, with the current account balance deteriorating precariously over the last six months.

Of additional concern is the decline in foreign exchange reserves from $15.7bn in July 2007 to $10.7bn in July 2008 and the rapid 18 per cent depreciation in the value of the rupee.

The prime reason for the increase in the current account deficit is the massive growth in the trade deficit, which stood at nearly $20.8bn in 2007-08 (with imports of roughly $40bn and exports of $19.2bn) compared to $13.5bn in 2006-07 (a 53 per cent increase). The widening of the deficit is a result of the 31 per cent growth in imports that surpassed the 13 per cent growth in exports by nearly two and half times.

Given that Pakistan also imports shipment and insurance services, the rise in imports of goods led to higher payments for such services. Resultantly, the services and income deficit also increased from about $8bn in 2006-07 to $10bn in 2007-08, a 28 per cent rise.

The root of the problem lay in import growth, led by the growth in import of petroleum products (55 per cent), wheat (1,900 per cent), raw cotton (100 per cent), fertiliser (98 per cent) and edible oils (76 per cent). These items accounted for well over one-third of the import bill in 2007-08. However, petroleum imports (28 per cent of the total import bill) accounted for 43 per cent of the increase in imports.

In absolute terms, of the $9.4bn increase in the import bill in 2007-08, almost $6.6bn was on account of just five items: petroleum products ($4bn), wheat ($818m), edible oils ($762m), raw cotton ($645m) and fertilisers ($440m).

On the export front, textile manufactures have traditionally accounted for about two-thirds of export receipts and remain the mainstay of foreign exchange earnings. But in 2007-08, exports of major textile items declined, in value as well as quantity. Altogether, the value of exports of textile manufactures declined by 2.3 per cent in 2007-08. However, exports of other items showed some improvement.

In absolute terms, of the $2.3bn increase in export earnings in 2007-08, $692m came from rice, $344m from petroleum products and $1bn on account of exports of other goods including cement, chemicals and pharmaceutical products, surgical and medical instruments, leather manufactures, gems and jewellery, and electric fans and other electrical machinery.

As against the 53 per cent growth in the trade deficit and the 28 per cent growth in the services deficit, inflows through net private transfers increased by only 13.6 per cent. Consequently, the current account registered a deficit of $14bn in 2007-08 compared to $7.4bn in 2006-07, an increase of over 90 per cent. And as a per cent of GDP it increased from five per cent in 2006-07 to eight per cent in 2007-08.

The trade and services deficit is financed by net receipts from the transfer payments account, of which more than half is comprised by workers’ remittances. On account of low current account deficits, transfer payments amounted to 146 per cent and 223 per cent of the deficits in 2001-02 and 2002-03 respectively and added substantially to reserves. However, with the increase in the trade and services deficit in 2007-08, receipts from transfer payments now finance only 45 per cent of the deficit.

The remaining part of the current account deficit is financed through capital inflows — largely comprising foreign investment and privatisation proceeds. For the year 2006-07, capital inflows financed almost 50 per cent of the deficit but this figure declined to 34 per cent in 2007-08. Partly this was also due to the absolute decline in FDI and portfolio investment from $8.4bn in 2006-07 to $4bn in 2007-08.

Given this scenario, $6bn have had to be drawn from the reserves, which declined from a peak of over $16bn in November 2007 to less than $11bn in June 2008. Alarmingly, the current level of reserves is sufficient to finance only three months of imports and any further increase in the current account deficit will create an emergency situation.

Certain policy measures have been taken in the 2008-09 budget to suppress the growth in imports. These include levying higher import duty on about 300 non-essential luxury and consumer durables; increasing customs duty on luxury vehicles of 1800cc and on used motorcars and jeeps below 1800cc; and imposing a customs duty of Rs500 on the import of cellular phones. However, the total value of such imports altogether amount to no more than $3.5bn, or less than 10 per cent of total imports. Resultantly, any meaningful reduction in imports of such items seems unlikely through tariff measures.

Pakistan is an import-based export economy and cannot afford to curtail much of its imports that largely consist of petroleum products (28 per cent), industrial machinery (10 per cent) and raw materials (16 per cent). These imports have inelastic demand and import compression measures are likely to adversely affect the cost of production and exports. In addition, Pakistan’s continuing dependence on the import of food items like edible oils, wheat, tea and pulses (altogether 7.5 per cent of total imports) further enhances its import bill.

The problem is structural and there is an urgent need to formulate and implement a strategic policy to finance the rising trade and services deficit in order to avoid depletion of foreign exchange reserves. The policy needs to focus primarily on raising exports, wherein the problem areas are the growing cost of production, insufficient infrastructure, declining productivity growth, product and spatial concentration in exports, etc. That foreign direct investment has not been forthcoming in the manufacturing or export sectors is not surprising.

In respect of export promotion too the measures appear to be directionless. The government has allocated Rs1bn for the establishment of export processing zones (EPZs) in parts of Balochistan and the NWFP. It is to be noted that if the government has not had much success with an EPZ in a metropolitan port city like Karachi (e.g. Textile City), establishing these zones in Balochistan and the NWFP seems to be a mere political sop.

Courtesy: Ms. Iffat Ara / Daily Dawn Lahore 5th Aug. 2008