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Pakistan's Current Account Deficit: Tackling the Sustainability Issue
Author(s): Zafar-ul-Hassan Almas

Source: Policy Perspectives, Vol. 5, No. 3 (July - December 2008), pp. 85-113
Published by: Pluto Journals
Stable URL: https://www.jstor.org/stable/42909216
Accessed: 04-12-2019 18:10 UTC
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Pakistan's Current Account Deficit:
Tackling the Sustainability Issue
Zafar-ul-Hassan Almas 0
Abstract
[The magnitude of the recent increases in the current account deficit (CAD), bot
relation to GDP as well as in absolute dollar size, has raised considerable concern. T
is nothing inherently bad about CAD, however, the concern about the deficit centers
a specific issue: Does the current account deficit represent a risk to our economic
being in the near term or in the longer term? To answer this question, it is need
need to identify the underlying causes of the deficit. What developments during the
two or three years in the domestic economy and in the world have led us to pur
dramatically more goods and services from abroad? Furthermore, can the Paki
economy sustain a deficit of this magnitude for some years? And, if not, what ar
likely implications of this for the Pakistan economy? Can there be a way out of
quagmire? - Author ]
Introduction
The current account (CA) balance is a key indicator of the strength of an

economy's fundamentals. Fluctuations in this variable are deeply
intertwined and convey information about the actions and expectations of
all economic agents in an open economy; movements in the current
account balance provide useful insights about shifts in the macroeconomic
policy and responsiveness to autonomous shocks.
A long-term review of the current account may require looking at

structural features of the economy, such as levels of economic
development, demographic profiles and structures of consumption and
production. These factors have a role in determining the savings rate and,
hence, the current account balance. As countries move to the next stage of
development, they typically import capital and, therefore, run current
account deficits.
In the 1990s, Pakistan's Current Account Deficit (CAD) averaged 5.0

percent of GDP, which declined substantially after 9/11 and even Pakistan
saw surpluses for three consecutive years. The frequent devaluations of the
1990s were replaced with appreciation of Pakistani rupee in this period.
However, CAD started to re-emerge in last two/three fiscal years and has
now reached the alarming levels. The major driver was the widening trade
imbalance in both goods and services. The easy monetary policy in the
initial phase and expansionary fiscal policy during the last five years since
' Mr. Zafar-ul-Hassan Almas is Deputy Economic Adviser in the Economic Advisor's
Wing, Ministry of Finance, Government of Pakistan. The views expressed in this
article are the author's own and do not, in any way, reflect the opinion or policy of
the government.
[85]
Policy Perspectives
FY04 have contributed to kick-start the spike in demand for imported

goods, especially consumer durables. Consumption has attained new
heights in recent years, although SBP was marginally successful in bringing
it down through a tightening of the monetary policy. Real growth in
consumption stood at 8.5 percent in FY08, far higher than the real GDP
growth of 5.8 percent. The contribution of consumption to GDP growth was
118 percent.
Like most transitional economies, Pakistan has to rely on the current

account deficit because it has been an important factor for its current
higher economic growth. However, the deficit's sustainability is a major
issue that should be analyzed.
The current growth momentum is based upon demand for durables,

mostly imported, and expansion in the financial and the telecom sectors.
These were, collectively, important drivers of inflows and thus the current
account deficit.
Inflationary pressures furthered the depreciation of the rupee that

jeopardized ineffectiveness of demand management policies in Pakistan. It
is a Herculean task for policymakers to prevent the population clustering
around the poverty line from falling below it. To prevent these masses from
falling to a very low standard of living, it is essential that the current
growth momentum be sustained. Only a higher growth trajectory could
alleviate poverty or - at least prevent it from rising further- and put
additional weight to the adverse effects of such policy in a country like
Pakistan.
Earlier, Pakistan did see a period of a current account surplus (FY01-

FY03). It was characterized by lower economic growth, which reinforces the
notion that a current account deficit often leads to higher economic growth
in the initial phase. However, when there is a prolonged period of high
current account deficits, economic growth tends to shrink because of
problems caused by imprudent financing. In other words, current account
deficits support growth to some extent but eventually the economy has to
stabilize itself.
The case of Pakistan is different in that higher current account deficits,

even in the short run, normally lead to worsening of the debt trap and
exchange rate volatility.
The recent deterioration of the current account is multifaceted and has

been caused by both domestic and external factors. On the domestic side,
five years of strong economic growth, strengthening of the domestic
demand, and the consequent pickup in investment spending have led to a
massive surge in imports. The problem of rising imports is further
aggravated by the unprecedented rise in oil prices in the international
market. An unexpected rise in commodity prices in recent years has also
contributed to the surge in the import bill.
86
Pakistan's Current Account Deficit: Tackling the Sustainabiiity Issue
Figure-I: Size of Trade
On the external
broad-based expansion, with growth reaching close to 5 percent. This
helped Pakistan's export growth to expand after a period of dismal growth
during the 1990s. However, Pakistan's foreign trade sector is being affected
by structural rigidities and cyclical factors. During the last five years (FY03-
FY08), the country's exports grew at an average rate of 13.3 percent per
annum whereas imports continued to expand at an average rate of 23
percent per annum. The mismatch between import and export growth has
resulted in a massive rise in the trade imbalance. Pakistan's size of trade
had risen substantially from 25.8 percent of GDP in FYOO to 35.5 percen
GDP in FY06; however, it nosedived to 28.9 percent of GDP in FY08 (Fig
1).
CAD remained supportive in the initial phase of recovery; however,

with a marked slowdown in exports in FY04, it started to deteriorate. It
maintained a surplus of 2 percent of GDP during the period FY00-FY02.
However, despite relatively high GDP growth in both nominal and real
terms (5-7 percent in real terms) since FY04, the current account
developed an imbalance that worsened from 1.5 percent of GDP to 5
percent of GDP during FY04-FY07. This deficit reached a new height of 7.5
percent of GDP in FY08.
Of course, the worsening of the CA deficit would have not been

possible without proper financing arrangements. The orthodox financing
arrangements were not properly managed to make the financing of the
current account sustainable. The non-structural inflows, defined as
potentially non-repeating flows that are not principally driven by
developments in the economy, slowed drastically after FY04, widening the
current account deficit. These inflows included the Saudi oil facility and
receipts for logistic support provided to Coalition Forces operating in
Afghanistan. The Saudi oil facility was abandoned in FY04, while receipts for
logistic support to the US-led coalition in Afghanistan declined substantially.
87
Policy Perspectives
The Coalition Forces also used receipts as pressure tactics against Pakistan
for extracting too much out of unstable political environment.
Greater reliance on foreign savings and a current account deficit to

finance domestic investment leads to greater accumulation of external
debt. The tremendous rise in the accumulation of external debt during the
last one and a half year (FY07 and FY08) bears great similarity to what
happened in Pakistan in the 1990s. Large fiscal and current account deficits
led to the accumulation of both public and external debt, increasing the
country's vulnerability to external shocks, reducing the investment rate,
and consequently slowing economic growth.
As happened in most developing countries in recent years, the deficit

came as a consequence of large inflows of easy foreign capital. In the case
of Pakistan, prior to the 9/11 fiasco, most of the CA deficit was financed by
external borrowing (mainly through grants and loans), whereas, starting
from 2002, the financial account took over the primary role of the financing
of the current account deficit. Foreign direct investments (FDI) along with
other inflows started to become increasingly important and it was assumed
that FDI inflows would continue to remain buoyant in the long run.
However, there was a sudden slowdown in FDI inflows during FY08, which
played havoc with the sustainability of the CA deficit and exposed flaws in
the complacent policy, under which 4.5 percent of GDP's worth of current
account deficit was being financed through mainly non-debt creating inflows
like FDI.
Pakistan's overall balance of payments remained surplus for the period

FY01-FY07 mainly because of the persistence of non-debt creating inflows.
Private transfers continued to rise and enabled the current account balance
to remain sustainable for this period. Workers' remittances, which
accounted for more than 90 percent of the private transfers, remained
buoyant. (This upbeat mood of the non-resident Pakistanis was not the
result of any conscious policy of the government; if anything, it was there
in spite of the adverse situation in the country - non-resident Pakistanis
were forced to shift their savings to their homeland in the aftermath of the
9/11 fiasco. However, the government failed utterly to capitalize on the
opportunity and properly channel these inflows to productive sectors.) The
above-the-line private transfers helped the current account balance to
remain either in surplus or modestly in deficit, which helped in generating
overall surpluses in the balance of payments, and these were added to the
overall reserves of the country (Figure 4). Although private transfers
remained buoyant in FY08, the overall balance turned into a deficit with the
result that reserves had to be drawn down.
The current account deficit continued to widen with even more vigor.
Unfortunately, official circles had no Plan B for the eventuality that inflows
might suddenly stop or be reduced to a minimal level. When inflows
became inadequate in the first three quarters of the current fiscal year
(FY08), there was excessive borrowing from SBP and a massive rise in
external borrowing, which complicated the already difficult task of
monetary management. The massive influx of non-debt-creating inflows
88
had provided much needed exchange rate stability to the economy in the
past. However, the abrupt fall in these inflows not only put pressure on the
debt stock but also fuelled the free fall of the rupee against all major
currencies. This implies that preventing or limiting foreign capital inflows
could prove to be a costly policy vendetta to reduce the CA deficit in terms
of economic growth.
In the last quarter of FY08, prospects for the current account or fiscal
account deficits were not very good; even the private sector was not
generating enough surpluses to provide ample support. Higher energy
costs, falling purchasing power of consumers, social unrest, an
unexpectedly high price level, poor governance, massive corruption and,
above all, lack of an enabling environment pose serious threats to the hard-
earned macroeconomic stability of the country. In this situation, the
question of sustainability of the current account becomes very important
and especially warrants serious policy attention.
The Question of Sustainability
The sustainability of the current account deficit is frequently analyzed in

terms of sustainability of external debt. Two years ago, the sustainability of
Pakistan's current account deficit was not a major issue since abundant
non-debt-creating inflows were available to finance it and no additional
strain needed to be placed on the external debt stock (which was already
too high by any standards). For the last one and half years or so, however,
non-debt-creating inflows have been absent or very low, leading to addition
to the existing stock of external debt and drawing down of accumulated
foreign exchange reserves.
Notably, during the last few years, there has been an unprecedented
rise in capital inflows in developing countries, sparking an academic debate
throughout the developing world about the judiciousness of relying on this
trend. A cautious approach was advocated towards external inflows on
account of their potential to disrupt an otherwise smooth balance of
payments. However, this concern was not evident in Pakistan while non-
debt-creating inflows were pouring into the country; nobody seemed to be
worried about the inflows' sustainability or long-term implications.
Pakistan's current account deficit, at above 5 percent of GDP, is very

high and unsustainable. In the last 30 years, only small industrial countries
have had current account deficits in excess of 5 percent of GDP that were
sustained for some years. These economies include Australia, Austria,
Denmark, Finland, Greece, Iceland, Ireland, Malta, New Zealand, Norway
and Portugal. What is even more striking is that very few countries,
whether industrial or emerging, have had high current account deficits that
lasted for more than five years. Over the years, a number of authors have
argued that a worsening of a current account balance that stems from an
increase in investment is very different from one that results from a decline
in national savings. Some have gone as far as arguing that very large
deficits in the current account "don't matter" as long as they are originating
from higher (private sector) investment (Corden 1994). In the case of
89
Policy Perspectives
Pakistan, the current account deficit averaged over 5 percent of GDP in the
1980s and the country paid the price in the 1990s when economic growth
was hemorrhaged by the unsustainability of the twin (budget and trade)
deficits.
Studying the dynamics of twin deficits, Dudley and McKelvey (2004)

maintain that the two are intertwined. Chronic budget deficits create a
shortfall of domestic savings. This leads to higher interest rates, a stronger
local currency, and foreign capital inflows. In this way, the initial budget
deficit becomes transformed into twin budget and trade deficits.
In Pakistan, the tolerance for higher fiscal deficits that began in FY05
and attained new heights in FY08 has led to the situation where the
expansionary fiscal policy is more than neutralizing the highly positive
impact of a tight monetary policy. Persistent upward adjustments of
interest rates by SBP since April 2005 proved to be counterproductive and
private sector investment in the productive sectors shrank considerably,
with serious implications for job creation. The competitiveness of the
manufacturing sector went down and the agriculture sectors faced severe
shortages of affordable credit disbursement.
Figure-2: Current Account, GDP and Exports Growth
Freund (2000) and Mann (1999) concluded from their studies of the
experiences of other industrial countries that pressure for correction often
arises when external deficits are in the range of 4 to 5 percent of GDP.
Experiences reviewed by Freund (2000) suggest that growth does slow in
most countries undergoing external adjustment and exchange rate
depreciation. However, these experiences reflect a range of policies
interacting with a range of economic and financial conditions. In FY08,
Pakistan also faced a slowdown in economic growth and depreciation of the
rupee versus major currencies.
90
Pakistan 's Current Account Deficit : Tackling the Sustainabiiity Issue
A very interesting feature about Pakistan is that its current account is

driven either by a slowdown in exports growth or a rise in GDP growth
(Figure 2). Normally, higher export growth is the ultimate result of higher
economic growth because a growing economy generates an exportable
surplus in normal conditions. However, Pakistan's consumers prefer
imported items whenever their incomes are rising, leading to the unique
phenomenon that increase in GDP growth and deceleration of exports go
side by side in the country's economy.
This implies that GDP growth originates from the services sector rather
than the production sector. There was a structural imbalance between the
growth of tradable and non-tradable goods and services.
Another relatively qualitative measure of CAD sustainabiiity concerns

external competitiveness, which plays a major role in determining whether
a country's assets are dearer to the outside world or the deficit is driven by
a consumption bonanza. One of the indicators frequently used by
economists and researchers to identify an increase or decrease in the
competitiveness of the economy is the terms of trade index. Pakistan's
terms of trade index has deteriorated at a faster pace since FY98, the
major contributor being rising import prices rather than falling export
prices. In fact, export prices have risen at a healthy pace but import prices
rose even more sharply (Figure 3). The unit value of imports has risen
substantially while unit value of exports has risen modestly during the last
decade. The real culprit is Pakistan's captive imports and exports basket
and this deterioration in the terms of trade reinforces the need to diversify
the country's trade quantum.
Figure-3: Current Accont and Terms of Trade (1990-

91=100)
Milesi-Ferretti and Razin (1996) define a CAD as sustainable if it is not

going to provoke any drastic policy shift. This is not likely to happen as long
as a country's inter-temporal solvency is not violated. In addition, a
country's willingness to repay debts and foreign investors' willingness to
lend must not be jeopardized. Milesi-Ferretti and Razin provide a very
91
Policy Perspectives
useful theoretical framework. Unfortunately, lack of data and the

complicated task of structuring the future prevented the use of its principal
solvency equations. Nevertheless, the unsustainability of Pakistan's CAD is
clear from the recent currency depreciation, which has demanded frequent
policy interventions, and the fact that the trade policy is also under severe
pressure. The country has to make adjustments in the balance of payments
- the sooner the better.
Figure-4: Current AcountV Overall Balance

(% oí GDP)
Economic theory suggests that large external capital inflows have the
potential to cause real exchange rate appreciation. This is an inherent risk
in overdependence on external inflows to finance the current account
deficit, which policymakers have to manage. Appreciation in the real
exchange rate could cause a loss of competitiveness and further structural
worsening of the trade balance, which, in most developing economies like
Pakistan, has been the major driver of the current account deficit. If the
source of the trade deficit is structural in nature, it is likely that the
resultant current account deficit will be unsustainable. Roubini and Wachtel
(1998) observed that, although the current account deficit mainly emanates
from a savings-investment gap, if it is accompanied by a real appreciation
of the effective exchange rate, the deficit could become less sustainable.
When the real exchange rate appreciation is viewed in the context of its
relationship with the current account balance dynamics in Pakistan, it
emerges that movements in the real effective exchange rate (REER) in
Pakistan have tracked both trade balance and current account balance
fluctuations consistently.
92
Figure-5: Real Effective Exchange Rate and Trade Balance
After the re-emergence of a trade deficit-driven current account deficit

since FY04, the appreciation of the real exchange rate has consistently
driven trade deficits and current account deficits in Pakistan. These periods
of appreciating real exchange rate coincide with periods of massive external
capital inflows into the Pakistan economy. The appreciation of the REER has
persistently driven trade deficits, which in turn has driven current account
deficits in Pakistan.
Figure- 5 B: Capital Flows V FDI Inflow
Since September 2007, the REER started depreciating as the nominal

exchange rate started losing ground against major currencies. With the
start of the last quarter of FY08, the nominal exchange rate started free-
falling. The REER followed suit. One positive aspect of the depreciation of
the rupee may be an increase in the competitiveness of Pakistan's exports.
93
Policy Perspectives
Such tremendous depreciation has boosted the probability of the narrowing

of the trade deficit but, still, exports or imports are not responsive. Even
with low elasticities of imports and exports, Pakistan would be able to
narrow the trade deficits to some extent.
Conventionally, it is expected that a current account deficit resulting

from low domestic savings is likely to be more unsustainable than one
resulting from high investment. Obviously, high investment has the
potential of increasing production capacity and, thus, future output and
trade surpluses.
Review of the Current Account Balance
Table 1 shows that Pakistan's trade balance was in deficit even when the
current account balance was in surplus for three years (FY01 to FY04). In
this period, economic growth was lower than its level in more recent yea
i.e. from FY05 to FY08. It is worth noting that an extraordinary focus o
narrowing the gap in the trade deficit can be counterproductive for
developing countries, as they have to import capital goods and
intermediate inputs for domestic production which help them produce an
exportable surplus as well. Pakistan's imports as well as exports increased
substantially for the period FY01-FY05 but fell significantly in FY06-FY08
and the deceleration of exports growth was much sharper than the
deceleration of imports growth, which led to widening of the trade
imbalance. This may be because generation of an exportable surplus hinges
upon imported raw material, or could have been the ultimate outcome of
the demand management policies of SBP, mainly its revision of policy rates
and the signals it sent to the money market.
The growth of exports slowed significantly in FY07 but picked up in

FY08, offsetting a significant decline in import growth during FY07 in
response to a deceleration in credit to the private sector, or monetary
tightening. SBP was able to shave off some demand for imports but,
certainly, at a cost. However, imports growth bounced back amidst rising
commodity and oil prices in FY08 and the differential between imports
growth and exports growth widened significantly. The current account
deficit reached 5.2 percent of GDP (US$7.5 billion) in FY07, one percentage
point higher than in FY06. It had already reached 7.6 percent of GDP during
July-May of FY08. The irony was that no effective policy response came
from official circles.
94
Table-1: Summary Balance of Payments
ITEM FY03 I FV04 FY05 I FY06 FV07 | FY0811

Current account balance 4070 1811 -1534 -4990 -6878 -14016
Current account balance without off.
transfers 3165 1300 -1784 -5696 -7403 -14443
1097 1245 1448 1655 1727
Goods: Exports ť.o.b 4 9 2 3 8 20125
1133 1373 1899 2499 2698
Goods: Imports f.o.b 3 8 6 4 9 35411
Trade Balance -359 -1279 -4514 -8441 -9711 -15286
Services (Net) -2 -1316 -3293 -4430 -4170 -6302
Services: Credit 2712 2644 3319 3769 4140 3590
Services: Debit 2714 3960 6612 8199 8310 9892
Income (Net) -2211 -2207 -2386 -2667 -3582 -3905
Income: Credit 170 187 437 784 940 1613
Income: Debit 2381 2394 2823 3451 4522 5518
Of which interest Payments 1277 1057 1037 1248 1417 2156
1019 1553 1746

Balance on Gds & Serv. & Ine -2572 -4802 3 8 3 -25493
1054 1058
Current Transfer (Net) 6642 6613 8659 8 5 11477
1044
Capital Account and Financial Account 661 -1252 1131 6071 9 8778
Capital Account, 1133 82 685 241 304 69
1014
Financial Account -472 -1334 446 5830 5 8709
Dir. Invest. In Rep. Econ. 798 951 1525 3521 5140 5153
Other Investment Assets 449 -669 -1352 148 -585 397
Other Investment Liab. -1453 -1885 -281 1246 2421 3198
Monetary Authorities -51 2 -5 0 -1 490
General Government -1419 -1792 574 769 1308 2315
Disbursements 1389 978 2163 2238 2669 3485
Amortization 2788 2744 1558 1446 1339 1149
Overall Balance 5254 781 -410 1334 3730 -5780
Reserves and Related Items -5254 -781 410 -1334 -3730 5780
SBP Reserves( Excl. CRR & Sinking 1056 1076 1334
Fund)
Policies to sh
hurt higher li
the last two y
loggerheads. F
tightening; ev
has occurred,
and problems
are likely to
competitiveness of domestic industries exposed to international
competition. This may further exacerbate the already worse CAD.
95
Policy Perspectives
One of the manifestations of the conflict in monetary tightening and

fiscal expansion is that the CAD reached 7.6 percent of GDP or US$13.0
billion in the first eleven months of the current fiscal year (July-May FY08).
The increase in CAD has given rise to suspicions about a sharp contraction
of economic growth, consumption and, consequently, imports, coupled with
major depreciation in the exchange rate against the currencies of main
trading partners. The Pakistani rupee has already depreciated by 7.0
percent, moving from Rs.60.5 per dollar in July 2007 to Rs.68.8 per dollar
in May 2008. SBP has taken some measures to bridle the rupee's free float
against the dollar but has only succeeded in reducing the velocity of
depreciation. The government has thwarted all measures to bring foreign
inflows for maintaining exchange rate stability in the country.
Exports: Deceleration in exports growth is very crucial because it is a

manifestation of the poor sequencing of reforms and failure of targeted
policies. In recent years, the composition of imports underwent substantial
changes while the structure of exports remains more or less the same. All
claims of export diversification proved to be mere rhetoric; exports
remained narrowly based in terms of both products and destinations.
The share of the textile sector in overall exports has declined in the
post-quota liberalization period by almost 5 percentage points and the
share of other items has gone up by more or less the same amount. Over
the years, the textile sector has been nurtured by undue official patronage
leading to poor industrial base in the country. The sector has been heavily
subsidized and lacks competitiveness. The government allowed tremendous
concessional financing facilities to it but it proved to be a disaster, and
most of the investment was done in the spinning sub-sector, which was less
export-intensive.
Pakistan's exports suffer from serious structural issues which need to

be addressed, primarily by the industry itself, with the government playing
the role of facilitator. Structural weaknesses in the textile sector, for
example, include: (i) low value added and poor quality products fetching
low international prices; (ii) considerable depreciation of machinery
installed in recent years relative to Pakistan's competitors; (iii) use of
machines that are power-intensive, less productive and entail high
maintenance costs; (iv) augmented wastage of inputs adding to the cost of
production; (v) little or no efforts on the part of industry to improve
workers' skills; (vi) low spending by industry on research and development;
and (vii) lack of capacity of export houses to meet bulk orders as well as
requirements of consumers in terms of fashion, design and delivery
schedules. For these reasons, wasting further resources to boost textile
exports would prove to be a doomed strategy. The Federal Budget 2008-09
has rightly brushed aside pressure from the powerful textile lobby and does
not offer any new incentives to the sector. The depreciation of the Pakistani
rupee might be a blessing in disguise for the textile sector.
96
Table-2: Structure of Exports
Food Group
Textile Group
Other Manufactures Group 13.7 15.1 18.8 16.7 15.7 17.7 16.4 14.3 18.9
All Other Items
Total
* July-May Source: Federal Bureau of Statistics
During the first eleven months of FY08 (July-Ma

driven completely by non-conventional, non-textile products. However,
export of technology-based products was still almost non-existent.
Exported products ranged from crude items like sports goods and clinical
and surgical items to some negligible software exports. A value added or
knowledge-based component was largely missing.
Another failure of Pakistan's export sector lies in not locating enough

markets for its products. The export base is limited, with only four countries
accounting for more than 50 percent of exports. Trade diplomacy has been
ineffective: Pakistan could have bargained for more market access in the
post-9/11 situation but this did not seem to be a policy priority. In fact, the
country has lost many opportunities in the past where it could have use its
political clout to bargain for concessions and market access. The posting of
trade or commerce staff in embassies across the globe is based on political
or military connections rather than merit and thus Pakistan's diplomats has
failed to deliver when it comes to trade promotion.
Imports: Importantly, in order to reduce the trade deficit and still

accelerate economic growth, it is not necessary to restrain imports- this
could adversely affect domestic production as well as growth in exports.
Hence, the import of necessary inputs for production should continue to be
encouraged, and exports will simultaneously be expanded. More than three-
fifths of Pakistan's basket of merchandised exports include textile items
that have low prices and income elasticity of demand, while its import
basket includes manufactured goods that have high prices and income
elasticity in demand. Therefore, the trade deficit will inevitably be widened
unless reductions in domestic demand drive a decrease in imports. As
mentioned earlier, periods of high economic growth are associated with
periods of large trade deficits in Pakistan, as well as a current account
deficit (Figure 2). This is a reminder of the important theory that reductions
in the trade deficit due to limiting or decreasing imports will constrain
economic growth, as has happened in most developing countries.
97
Policy Perspectives
Table-3: Structure of Imports
Machinery Group
Petroleum Croup
Raw Materials
Food Croup
Consumer Durables
Others 28.7 27.3 1 29.1 1 28.9 31.8 29.2 24.1 37.2 31.3
Total
* July-May Source: Federal Bureau of Statistics.
Like exports, Pakistan's imports are also highly c

items, namely, machinery, petroleum and petroleum products, chemicals,
transport equipments, edible oil, iron and steel, fertilizer and tea. These
eight categories of imports accounted for 85 percent of total imports during
the first eleven months (July-May) of FY08. Pakistan's imports are also
highly concentrated in terms of the origin. The USA, Japan, Kuwait, Saudi
Arabia, Germany, the UK and Malaysia have been major sources of imports
for the last ten years. Over 40 percent of Pakistan's imports continue to
originate from these seven countries. Saudi Arabia, followed by USA and
Japan, remain major suppliers of imports.
The composition of Pakistan's imports has undergone a substantial

change in recent years. The share of petroleum imports declined between
FY01 and FY05 but bounced back with much intensity - rising by almost 10
percentage points - during the last three fiscal years. The more alarming
change is the trend of decline in the machinery group and the raw material
group by around 10 percentages points; this decline is more than offset by
a rise in the "others" category, which includes non-traditional items like
mobile phones and other luxuries. The slowdown in the import of machinery
and raw materials implies a slowdown in the economy. While SBP might be
pleased that the share of consumer durables in the import basket is finally
stabilizing, its monetary tightening might have had a deeper effect on the
investment cycle than on consumer demand.
Pakistan's imports grew at an average rate of 29 percent per annum

during FY03-FY06 on the back of strong economic growth that triggered a
consequential growth in investment and imports. Import growth slowed to
a normal level in FY07 but registered a sharp pickup once again in FY08 on
account of an unprecedented rise in oil import bills and some one-off
elements in the shape of imports of wheat and fertilizer. As a result,
Pakistan's trade and current account deficits have widened substantially in
this year, contributing to serious macroeconomic imbalances. Correction of
imbalances through shaving off of aggregate demand by appropriate
policies should be the topmost priority of the government.
98
During the first eleven months of FY08, imports grew by 29.6 percent
to $35.9 billion with an extraordinary surge in the import of petroleum
products as well as imports of the food group and raw material. Non-oil
imports were up by 22.4 percent and non-oil and non-food imports surged
by 18.5 percent during the same period. Imports of the food group were up
by 51.3 percent in the current fiscal year, mainly on account of
unanticipated imports of wheat, amounting to $860 million, and an
extraordinary surge (71.5 percent) in the imports of edible oil due to the
sky-rocketing price of palm oil in the international market. Imports of food
group accounted for 11 percent of total imports but contributed 16.0
percent in the overall growth of imports in the current fiscal year.
Imports of machinery posted a modest increase of 11.0 percent in the

first eleven months of FY08, reaching $5.2 billion. Within the machinery
group, imports of power generating machines, construction and mining
machines, and other machinery showed a substantial increase of 38.2
percent, 33.1 percent and 9.9 percent, respectively. The rise in the import
of these different categories of machines is attributed to ongoing work on
various power and construction projects in the country. The machinery
group accounts for 14.5 percent of total imports but contributed only 6.3
percent in the overall import growth of this year.
Table-4: Major Contributors to Increase in Imports
July-May H I a_1m J Point Cont. % Cont of

FY07I FY08
% Change T IncreaseGrowth
T Increase a_1m in Import absolute
increase in
Total imports 27743.2 35943. 29.6 8200.1 29.6 29.6
3
Food Group 2556.5 3867.5 51.3 1311.0 4.7 16.0
Machinery Group 4697.3 5213.1 11.0 515.9 1.9 6.3
Transport Group 931.3 870.1 -6.6 -61.2 -0.2 -0.7
Petroleum Group 6632.0 10094. 52.2 3462.2 12.5 42.2
2
Textile Group 1389.8 2206.1 58.7 816.2 2.9 10.0
Agri Chemicals Group 3956.5 5259.7 32.9 1303.2 4.7 15.9
Consumer Duables 2685.5 2581.1 3.9 -104.5 -0.4 -1.3
Electric Mach & App. 594.3 676.4 13.8 82.1 0.3 1.0
Road motor Vehicles 1288.8 1207.3 -6.3 -81.5 -0.3 -1.0
Mobile Phones 802.4 697.4 -13.1 105.0 -0.4 -1.3
Raw Materials 2749.8 2927.7 6.5 177.9 0.6 2.2
Others
Imports of the pet

52.2 percent, amoun
28.1 percent of tot
import growth for
been the result of a
and Lubricants' (POL
Unlike previous y
decline of 3.9 percent in the first eleven months of FY08. The share of
consumer durables in total imports stood at 7.2 while its contribution to
import growth has been negative 1.3 percent.
99
Policy Perspectives
Imports of raw material, accounting for 8.1 percent of total imports,

grew by 6.5 percent in the first eleven months of FY08. Fertilizers, plastic
material, iron, steel and scrap, accounting for 45 percent of total raw
material imports, grew respectively by 193.1 percent, 12.3 percent and 74
percent. The extraordinary increase in the import of fertilizer was surprising
at a time when the price of fertilizer in the international market was up by
almost 50 percent. As against 1.2 million tons last year, Pakistan imported
almost 2 million tons in the first eleven months of FY08, registering a
growth of 58 percent. Why such large quantities of fertilizer were imported
when its off-take within the country did not grow compared to last year is
not clear. The country had to pay an additional $490 million in imports on
account of the extraordinary increase in the import of fertilizer, which
cannot be explained by looking at the performance of this year's
agricultural crops. Imports of raw material contributed 2.2 percent to the
overall growth of imports this year.
Unlike the trend in the recent past, imports of telecom remained more
or less at last year's level of $2.1 billion, suggesting that the expansion
phase of various cellular companies has saturated for the time being.
Imports of telecom accounts for 5.9 percent of total imports but contributed
only marginally (0.3 percent) to this year's overall imports growth.
It is important to note that the surge in imports during 2003-06 had

been driven by strong economic growth which strengthened the domestic
demand and increased investment. In contrast, the surge in this year's
import is not due to any structural shift in demand but because of rising
international commodity prices, such as crude oil and palm oil, and one-off
increases in the import of wheat and fertilizer. Imports of petroleum
products and edible oil alone contributed 47 percent to the rise of this
year's import. An additional 18.7 percent contribution came from the
import of wheat and fertilizer. Together, these four items accounted for
two-thirds of growth in this year's imports.
Services Trade: Imbalances on services trade have grown at a much

faster pace than imbalances on merchandize trade during the last four
years. Liberalization in the areas of major services during the last eight
years may be the main culprit. The main drivers are transportation and
travel services, insurance and freight payments and more travel expenses
by Pakistanis to travel abroad. This is a new phenomenon in Pakistan's
current account deficit and warrants an immediate policy response.
Pakistan was unfairly placed by the foreign shipping companies in the

post-9/11 situation, which imposed extraordinary insurance and risk
premiums on all cargo originating from or destined to the country. Pakistan
could not negotiate properly with its allies in the so-called war on terror
regarding this unfair treatment, which has been a major contributing factor
in the rising current account deficit. The volume of expenditure on freight
and insurance is rising constantly; the difference between Federal Bureau of
Statistics (FBS) trade data and SBP data is also widening because the
100
difference between the two is expenditure on these counts.
Income Account: On the income account side, the balance was almost
stagnant in absolute terms but declined in relation to GDP in the six out of
eight years since FYOO. However, in the last three -fiscal years (FY06-FY08),
the deficit, even in relative terms, was explosive. The amount includes
mainly income from investment, both in the form of direct portfolio or other
investment, income being generated in non-conventional means or profits
and dividends on investments. The outflow on account of direct investment
or equity increased from $1.2 billion in FY04 to $2.8 billion in FY07, while
outflow on account of portfolio investment increased from $0.2 billion to
$0.6 billion in the same period. The outflow on account of income on equity
has already touched $2.3 billion in Jul-Mar FY08. The deficit on the income
account increased from $2.2 billion in FY04 to $3.6 billion in FY07. Among
the implications of the way the financing of the current account was
arranged in the most recent past will be rising interest payments and
remittance of profits and dividends by investors in Pakistan in the near
future.
Current Transfers: The deterioration in the current account deficit in the

last three years mainly emanated from the sharply rising trade deficit,
along with increase in net outflows from the services and income account.
The strong growth in current transfers, caused by impressive growth in
remittances, almost entirely offset the deficit in the services and income
account, leaving the trade deficit as the fundamental source of expansion in
the current account deficit. Current transfers witnessed an impressive
increase of 16.4 percent during Jul- April FY08 due to strong growth in
private transfers. Notwithstanding this surge in recent years, the quantum
of current transfers fluctuated in the $8-10 billion range. Worker's
remittances have depicted a high double-digit growth but official transfers
fluctuated a great deal.
The future sustainability of the current account deficit hinges on the

implications of financing items. The foreign exchange gap was filled by
foreign financial resources during the last eight years, including both debt-
creating and non-debt-creating flows. The composition of capital flows has
changed significantly over the years. Dependence on aid has almost
vanished; foreign direct investment, foreign portfolio inflows, external
borrowing on commercial terms, mostly from multilateral agencies like
World Bank and Asian Development Bank (ADB), and workers' remittances
have accounted for the lion's share in foreign exchange inflows. The
proportion of non-debt-creating flows has gone up substantially.
101
Policy Perspectives
Table-5: Pakistan's Balance of Payments
Net Net Net
1. Current Account 27,006 28,540 -1,534 31,761 36,751 -4,990 32,772 39,866 -7,094 26,835 36,601 -9,766
A. Goods and services 17,801 25,608 -7,807 20,322 33,193 -12,871 21,202 35,289 -14,087 16,584 32,509 -15,925
a. Goods 14,482 18,996 -4,514 16,553 24,994 -8,441 17,080 27,024 -9,944 14,156 25,312 -11,156
1 General
merchandise 14,401 18,753 -4,352 16,388 24,624 -8,236 16,924 26,652 -9,728 14,000 25,016 -11.016
b. Services 3,319 6,612 -3,293 3,769 8,199 -4,430 4,122 8,265 -4,143 2,428 7,197 -4,769
I Transportation 1,062 2,280 -1,218 1,080 2,863 -1,783 1,092 3,135 -2,043 751 2,590 -1,839
11 Freight 112 1,617 -1,505 124 2,083 -1,959 157 2,225 -2,068 124 2,066 -1,942
2 Travel 177 1,172 -995 216 1,411 -1,195 275 1,625 -1,350 205 1,191 -986
3 Other Services 2,080 3,160 -1,080 2,473 3,925 -1,452 2,755 3,505 -750 1,472 3,416 -1.944
B. income 437 2,823 -2,386 784 3,451 -2,667 934 4,503 -3,569 1,316 3,991 -2,675
1 Compensation of
employees 2 1 1 6 1 5 7 - 7 6 0 6
2 Investment
income 435 2,822 -2,387 778 3,450 -2,672 927 4,503 -3,576 1,310 3,991 -2,681
2 1 Direct
investment 18 1,640 -1,622 39 2,115 -2,076 31 2,837 -2,806 42 2,272 -2,230
2 1.1 Income on
equity 18 1,640 -1,622 39 2,115 -2,076 31 2,837 -2,806 42 2,272 -2,230
C. Current transfers 8,768 109 8,659 10,655 107 10,548 10,636 74 10,562 8,935 101 8,834
1 General
government 266 16 250 715 34 681 528 24 504 542 37 505
2 Olher sectors 8,502 93 8,409 9,940 73 9.867 10,108 50 10,058 8,393 64 8,329
2. Capital & Financial
Account 5,890 4,294 1,596 8,486 3,694 4,792 13,085 6,476 6,609 11,352 2,393 8,959
A. Capital account 693 8 685 250 9 241 340 5 335 37 31
B. Financial account 5,197 4,286
Source: SBP
However, the surge in external capital inflows has not been matched
by a commensurate rise in the absorptive capacity of the economy. The
principal reason is the persistent deterioration in the competitiveness in the
industrial sector of Pakistan, mainly because of rising energy prices, higher
overheads, uncertainty and ill-directed incentives.
In the one and a half year from July 2006 to March 2008, most of the
net inflows of foreign capital into Pakistan have been in the form of debt to
be repaid by future generations. The country has added almost $9 billion to
its external debt stock in this relatively short period. Not only has this
mounting indebtedness increased the stock of income-producing capital but
the country's spendthrift bureaucracy, with the collusion of corrupt,
establishment-hatched politicians, has entirely wasted this massive inflow.
It may be said that the capital was shortsightedly and irresponsibly spent in
an orgy of unbridled consumption.
The accretion of foreign exchange reserves was given undue

importance over the last eight years. Most of the inflows were added to the
foreign exchange reserves of the SBP. The capital inflows intermediated
102
through commercial banks resulted In credit expansion which, instead of

stimulating investment, triggered a consumption boom with a strong import
bias in the country during FY02-FY06. SBP had tried to manage commercial
banks' intermediation at low level but even though it has helped in
tremendous rise in imports or higher production of consumer durables. SBP
had done proper sterilization of the inflows to check unplanned expansion
of money supply. It never seemed successful for keeping M2 growth below
nominal GDP growth for the last four years. However, the resultant
monetary overhangs are adding to the inflation miseries of the population
at large.
With US$15 billion in foreign exchange reserves (FER) and a current

account deficit of $7 billion in FY07, Pakistan can expect to finance its
current account deficit for two years in the absence of any kind of inflow.
However, if the trade deficit continues to widen during this period and the
gap is not bridged by proper financial resources, the minimum amount of
foreign exchange required to achieve targeted growth rates will not be
available and economic growth will be constrained by the balance of
payments. Pakistan's total foreign exchange reserves stood at $12.3 billion
at end-April 2008 - significantly lower than the end-June 2007 level of
$15.6 billion. Reserves peaked to $16.4 billion at end-October 2007 but
showed a significant depletion of $4.1 billion during November-April FY08.
During July-October 2007, reserves improved by 5.1 percent due to the
relatively lower current account deficit and substantial inflows in the
financial account. However, from October onwards, net outflows from
portfolio investment and a steep rise in the current account deficit led to a
sharp decline in the foreign exchange reserves of the country. Two other
important reasons for the lack of improvement in the foreign exchange
reserve were the sudden stoppage of many inflows and a financing orgy
over imports in FY08.
Macroeconomic Perspective
In the macroeconomic perspective, a current account deficit may refer to

excess of gross investment over national savings (comprised of public,
corporate and household savings). A current account deficit thus reflects
the inadequacy of a country's national savings to finance its investment
needs and that country's need to resort to the savings of foreigners.
Capital-starved countries like Pakistan have more investment opportunities
than they can afford to undertake with low levels of domestic saving.
Resources acquired to fill this gap have the potential to spur faster output
growth and economic development. However, the experience of Pakistan
negates this notion as external inflows have failed to spur growth.
103
Policy Perspectives
Figure-6: Savings-Investment G a p (% of GDP)
The investment level tells little about the adequacy of incomes or the
productivity of spending on non-tradables compared to spending on
tradables. The current account deficit is determined through developments
in business saving, government saving, investment, exports, imports, and a
host of other factors. All these variables are endogenous according to
standard macroeconomic theory. This means that their values are
simultaneously determined by more fundamental considerations. A high
saving rate cannot cause a low investment rate or a low CAD. Instead, the
levels of investment and saving depend diversely on the underlying
causative factors, such as preferences, new technologies, taxes,
government spending and regulatory environment, and terms of trade. As a
result, any observed correlation might be positive, negative, or zero
depending on the nature of the dominant joint causes during the
observation period. This might explain the growth and investment nexus in
Pakistan's case.
Fig-7: Current Account Balance and Saving-

Investment „C/0 „ of GDP)
104
As Figure 7 shows, the recent deterioration of Pakistan's current

account has largely been the result of a decline in national savings, in
particular, the public and household component of national savings. A
simple implication of this trend is that an improvement in Pakistan's current
account situation will not only imply a REER adjustment, it yill also require
an increase in the national savings ratio, in particular, in household savings.
The government has remained a major dissaver in the last few years, with
the exception of FY04 when it generated a minor surplus. The current
account deficit during the last three years also emanates from a fall in
private surpluses which turned into deficits in the last two years.
As can be seen in Figure 7, since FY04, the increase in the current

account deficit has reflected mostly a decline in both public and private
sector saving because of the growing fiscal deficit and a further decline in
already low household savings rates. Private investment, despite its
welcome pickup since FYOO, remains below its levels in the mid-1980s. The
surplus of private savings over private investment has been shrinking for
the last four years starting from FY 04 to FY 07 and this is the period during
which the CAD has grown. FY08 has been an exceptional year but the
deterioration of the current account deficit was equally supported by
deterioration in both public and private saving-investment gaps. The public
savings-investment deficit has also started worsening in this period and the
collective deterioration has contributed collectively to widening of the CAD.
The expansionary fiscal policy is the main culprit. Reckless public
investment has not yielded dividends; it has worsened the external debt
burden.
Figure-8: Trade Balance and Current Account Balance

(% of GDP)
It is an undisputed fact that the larger part of government spending in

Pakistan is wasteful. The poor quality of government expenditure is not
necessarily wasteful from the point of view of politicians, who are spending
money to attract votes or considering only the point of view of the
beneficiaries of the expenditure. Owing to lack of fiscal discipline and
accountability, the ruling elite enjoy substantial discretionary powers and
the favored constituencies a>e protected. When the government is spending
without serious examination of overall value-for-money considerations, it is
105
Policy Perspectives
to be expected that the scale of the waste would be of economy-wide

significance.
There is also much - well-justified - disquiet about the quality of the

government's regulations and institutions. No significant productivity gains
from recent increases in social sector and development expenditures are
observed, which are mainly funded by foreign borrowings. The costs and
delays in getting infrastructure projects under way are a pervasive concern.
The widespread acknowledgement of the poor quality of the regulatory
mechanism, even in official circles, has led to a weakening of the
investment, growth and employment nexus in Pakistan. Consequently, even
when a higher level of investment is being experienced, it is not
accompanied by commensurate generation of jobs or expansion of
productive capacity in the economy. This also explains the captivity of
exports in some sectors and some regions.
Pakistan has experienced a tremendous surge in FDI inflows, which

have increased more than tenfold in the last six years and reached well
above US$5 billion in FY07. A surge in FDI flows (excluding privatization
proceeds) and portfolio inflows resulted in a record-high surplus in the
financial account in FY06 and FY07. During the first ten months of FY08, the
euphoria of FDI inflows dissipated; nevertheless, the inflows have shown
great resilience and managed to remain at $3.6 billion, which may seem
low compared to the unprecedented inflows of the previous year but augurs
well given that average inflows were at $300-500 million in the 1990s. This
development reflects the anticipation of foreign investors of improved
macroeconomic stability, and responsiveness to progress in liberalization
and investor protection regulations. The current mode of reckless and
directionless inflows of foreign investment will not serve any purpose, be it
job creation, technological up-gradation or financing of the current account
deficit through non-debt creating inflows.
More than 80 percent of FDI inflows are in four sectors of the

economy, namely, power, telecommunications, oil and gas, and financial
businesses. Since none of these sectors is employment-intensive, the
contribution to growth has been jobless and joyless. The remittance of
profits and dividends in these sectors is enormous and prompt. This is
visible from the massive growth of remittance of profits and dividends
during FY07. The trend is likely to persist in the years to come and thus
likely to cause great problems for exchange rate stability and sustainability
of the current account deficit.
Sustainability Outlook
The current account deficit, in its present shape, is unsustainable by all

standards. Even without the aid of sophisticated econometric models, it is
possible to assess that the prevalent practices do not augur well for CAD
sustainability. The following indications support this conclusion:
❖ The increasing external debt-to-GDP ratio is an indication of

unsustainability. This implies that a current account balance that
106
leads to increasing external liabilities is an indication of un-

sustainability of the deficit. In Pakistan's case, until now, the
current account deficit has not provoked an increase in the external
debt-to-GDP ratio. However, Pakistan was hardly able to maintain
this ratio during July 2007-March 2008. This ratio is likely to
explode by end-June 2008 and thus may break the condition of
sustainability.
❖ According to Summers (1996), a CAD-to-GDP ratio higher than 5

percent sends a strong signal for an evaluation of sustainability and
a review of strategy. Pakistan's current account deficit had already
breached that level by the end of FY07. However, a careful
evaluation of the sources of the higher deficit must be undertaken:
a deficit driven by investment growth is more likely to be
sustainable than a deficit driven mainly by falling national savings
(or higher budget deficits). In Pakistan's case, only in FY07 was the
CAD driven by rising investment; otherwise, for most part of its
history, it has been driven by falling national savings.
❖ A fall in national savings is problematic for CAD sustainability.

Inasmuch as a fall in the public component of national savings is
associated with a higher budget deficit, trends in the fiscal deficit
become an automatic indicator of the sustainability of the CAD. In
Pakistan, CAD is driven by public dissavings. National savings in
Pakistan declined substantially from 18 percent of GDP to as low as
13 percent of GDP in FY08. The budget deficit has also increased to
7 percent of the GDP.
❖ The current account deficit may broadly be decomposed into trade

deficit and net factor income. The composition of the current
account deficit is very crucial in determining its sustainability. A
current account deficit may be less sustainable if it is being driven
by a large trade deficit than by a large negative net factor income
(Roubini and Wachtel 1998). Persistently large trade deficits are
indicative of structural competitiveness problems whereas large
negative factor incomes may be due to a fall out of higher external
debt profile. Higher trade deficits are normally associated with
countries where the trade-to-GDP ratios are low. So the size of the
overall trade in relation to the GDP may be a good indicator of
competitiveness but the level of the exports-to-GDP ratio is an even
more accurate indicator of structural competitiveness. Furthermore,
the real effective exchange rate could be used as a measure of
structural competitiveness and, thus, the sustainability or otherwise
of deficits.
Pakistan has been passing through structural problems in

promoting its export base. Its overall trade-to-GDP ratio as well as
exports-to-GDP ratio have been falling for the last two fiscal years
(FY07-FY08). The country's REER was appreciating for FY06, FY07
and the first half of the FY08. However, sharp nominal depreciation
in the second half of FY08 led to depreciation of the REER as well.
107
Policy Perspectives
❖ In the aftermath of the East Asian Currency turmoil of 1997, gross

international reserves have been given much importance and
regarded as an important tool in external sector stability. A higher
level of foreign exchange reserves is widely used to measure the
sustainability of current account deficits. A higher ratio of gross
international reserves to debt stock is also regarded as indicative of
sustainability of current accounts. Gross foreign exchange reserves
are also regarded as a cushion for a number of weeks of imports;
specifically, forex reserves in excess of 16 weeks of imports are
normally considered to imply the sustainability of a current account
deficit.
In the case of Pakistan, foreign exchange reserves have not only

been falling in terms of cover for weeks of imports in FY07 and
FY08 but they have also declined substantially in absolute value
from as high as $17 billion to just under $12 billion by the end of
April 2008.
❖ The sustainability of current account deficits is believed to be

contingent upon a sound and stable domestic financial system that
includes strong supervision and regulation. This has been lacking in
Pakistan in recent months - during FY07 and FY08, the vigilance of
the State Bank of Pakistan came under furious attack on various
counts and its vulnerability was exposed more than once.
❖ The current account deficit is basically a financing gap and some

part of it has to be filled by foreign capital inflows, which are very
sensitive to the state of political stability and the predictability of
economic policies. These two factors, in turn, ultimately hinge on
the continuity of the system of governance and confidence of
investors. Unfortunately, during FY08, Pakistan scored very poorly
on creditworthiness; its credit ratings were downgraded several
times. Scarcity of foreign inflows has created many problems in
FY08, including monetary financing and very significant exchange
rate depreciation. Massive creation of debt to finance the current
account deficit has generated a future stream of payments that
might create problems for current account sustainability.
❖ The role of debt-creating and non-debt-creating capital inflows has

changed substantially during the last few years. The composition,
size and direction of such inflows have become crucial. Short-term
inflows are more dangerous in financing the current account deficits
than long-term inflows; however, the latter may enhance current
account vulnerability in the long run. These inflows are expected to
have real effects as the real exchange rate would tend to appreciate
and compromise the competitiveness of the economy and,
consequently, re-introduce structural trade deficits, which would
worsen the initial current account deficit, making it more
unsustainable.
108
Policy Recommendations
Pakistan needs an extensive external sector adjustment in the medium

term because the current high level of the current account deficit is
exerting pressures on external borrowing. From July 2007 to end-March
2008 , Pakistan added around $5.4 billion to its stock of external debt- the
highest ever addition made in a single year. This is generating a future
stream of repayments which is likely to exert tremendous pressure on the
balance of payments.
The origins of the exceptional size of the current account deficit should
be analyzed in more detail and it should be determined whether:
i) Domestic investment is too high and/or national saving is too low;
ii) Total domestic spending is too high and/or total domestic income
is too low; and
iii) Domestic spending on tradables is too high and/or domestic
production of tradables is too low.
A current account deficit is a norm rather than an exception in

developing countries like Pakistan. What is expected is that it be kept at a
tolerable level and that it not force abrupt policy adjustments that may
distort the economy's growth momentum. The threshold level in the given
structural rigidities and potential of the economy is around 4 percent of the
GDP, and that too should come from rising investment rather than falling
national savings. The persistence of a high current account deficit over an
extended period of time has serious implications, such as haphazard
fluctuations in the exchange rate; accumulation of external debt beyond a
sustainable level; and development of undue concerns about the
vulnerability of the economy towards external shocks. A higher external
debt burden constitutes a serious constraint to development because debt
repayments absorb resources that could be channeled into domestic
investment and development efforts. High external debt burdens
discourage foreign investment because they create a high-risk environment
in which there is exchange rate depreciation, capital flight, uncertainty
among potential foreign investors about the possibility of profit repatriation,
and higher taxes to service debts.
Pakistan is facing a double problem of depreciation because the Pak

rupee is depreciating against the US dollar and the US dollar is depreciating
against major currencies. In July-March FY08, Pakistan's external debt
went up by $5.4 billion but the disbursement effect was only US$1.2 billion,
while $4.2 billion was translation effect emanating from the depreciation of
the dollar against major currencies like the Euro, Japanese yen and others.
If Pakistan's rupee depreciates by Rs.l, it means Rs.46 billion are added to
the foreign currency payable debt in rupee terms. Pakistan has to take
depreciation seriously and should diversify its currency basket by engaging
in professionally executed currency hedging.
Pakistan faced all sorts of problems in FY08 owing to widening of the

current account deficit beyond unsustainable limits. The country's problem
is structural in nature and rigidity of exports and imports, external debt
109
Policy Perspectives
servicing commitments, volatile external inflows and, above all, a

complacent economic policy have provided very little room for its
management.
Pakistan has to make arrangements for non-structural financing, like

the Saudi Oil Facility, by using its leverage and importance on a sustained
basis.
The structure of trade has to be reviewed in detail. The structure of

imports was driven by food and petroleum in FY08, the combined impact of
which was explosive growth in imports by 58 percent. Clearly, Pakistan
needs to reduce its reliance on imported food and energy. The import
substitution strategy of the 1960s has to be revised and a task force should
be formed to look into viable options for resorting to alternative food and
energy sources. The world has made much progress in identifying
alternative energy resources and Pakistan is bestowed with enormous wind,
solar and water energy potential. The task that awaits is the capitalization
of these options. Similarly, reliance on domestically produced edible oil has
to be extended and farmers should be provided incentives to diversify their
low-yielding crops with cultivation of edible oilseeds. Pakistani farmers need
price incentives as well as technical support, especially improved seeds, for
growing alternative edible oil. The current poor management of water
resources, which is causing enormous loss in potential agricultural output,
is another key issue to be addressed.
Pakistan's imports still include a large concentration of luxury items,

tariffs upon which have been substantially lowered in recent years. It may
be pertinent to review the tariff structure for such items, including cars and
cell phones.
Exports, which are captive in terms of both regions and products, have
to be diversified, and non-conventional products need to be marketed to
non-conventional markets. Knowledge-based exports are crucially missing
from the country's export basket, while its neighbor, India, is earning
billions of dollars through export of high-tech or knowledge-based products.
Pakistan has to develop a sound production base with state-of-the-art
application of technology and quality standards. To build a high-tech
industrial base, trained manpower and investment in human capital are
needed. Quality education and skill enhancement should be emphasized.
In addition, the traditional focus on merchandize exports needs to be

broadened; there is potential to enhance foreign exchange earnings by
boosting services exports. Pakistan has a comparative advantage in
information technology services and tourism, and there should be emphasis
on obtaining outsourced contracts from the industrialized world.
Remittances can be boosted as well by negotiating labor market
opportunities in the East Asian economies and the Middle East countries. In
this regard, the productivity of Pakistani labor should be enhanced by
imparting quality training and apprenticeships.
The combination of these actions would narrow the country's trade

imbalance and help restore the sustainability of its current account deficit.
110
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Pakistan's Current Account Deficit: Tackling the Sustainability Issue

Author(s): Zafar-ul-Hassan Almas

The current account (CA) balance is a key indicator of the strength of an

A long-term review of the current account may require looking at

In the 1990s, Pakistan's Current Account Deficit (CAD) averaged 5.0

FY04 have contributed to kick-start the spike in demand for imported

Like most transitional economies, Pakistan has to rely on the current

The current growth momentum is based upon demand for durables,

Inflationary pressures furthered the depreciation of the rupee that

Earlier, Pakistan did see a period of a current account surplus (FY01-

The case of Pakistan is different in that higher current account deficits,

The recent deterioration of the current account is multifaceted and has

Figure-I: Size of Trade

CAD remained supportive in the initial phase of recovery; however,

Of course, the worsening of the CA deficit would have not been

Greater reliance on foreign savings and a current account deficit to

As happened in most developing countries in recent years, the deficit

Pakistan's overall balance of payments remained surplus for the period

The Question of Sustainability

The sustainability of the current account deficit is frequently analyzed in

Pakistan's current account deficit, at above 5 percent of GDP, is very

Studying the dynamics of twin deficits, Dudley and McKelvey (2004)

Figure-2: Current Account, GDP and Exports Growth

A very interesting feature about Pakistan is that its current account is

Another relatively qualitative measure of CAD sustainabiiity concerns

Figure-3: Current Accont and Terms of Trade (1990-

Milesi-Ferretti and Razin (1996) define a CAD as sustainable if it is not

useful theoretical framework. Unfortunately, lack of data and the

Figure-4: Current AcountV Overall Balance

Figure-5: Real Effective Exchange Rate and Trade Balance

After the re-emergence of a trade deficit-driven current account deficit

Figure- 5 B: Capital Flows V FDI Inflow

Since September 2007, the REER started depreciating as the nominal

Such tremendous depreciation has boosted the probability of the narrowing

Conventionally, it is expected that a current account deficit resulting

Review of the Current Account Balance

The growth of exports slowed significantly in FY07 but picked up in

Table-1: Summary Balance of Payments

ITEM FY03 I FV04 FY05 I FY06 FV07 | FY0811

1019 1553 1746

One of the manifestations of the conflict in monetary tightening and

Exports: Deceleration in exports growth is very crucial because it is a

Pakistan's exports suffer from serious structural issues which need to

Table-2: Structure of Exports

All Other Items

* July-May Source: Federal Bureau of Statistics

During the first eleven months of FY08 (July-Ma

Another failure of Pakistan's export sector lies in not locating enough

Imports: Importantly, in order to reduce the trade deficit and still

Table-3: Structure of Imports

* July-May Source: Federal Bureau of Statistics.

Like exports, Pakistan's imports are also highly c

The composition of Pakistan's imports has undergone a substantial

Pakistan's imports grew at an average rate of 29 percent per annum

Imports of machinery posted a modest increase of 11.0 percent in the

Table-4: Major Contributors to Increase in Imports

July-May H I a_1m J Point Cont. % Cont of

Imports of the pet

Imports of raw material, accounting for 8.1 percent of total imports,

It is important to note that the surge in imports during 2003-06 had

Services Trade: Imbalances on services trade have grown at a much

Pakistan was unfairly placed by the foreign shipping companies in the

difference between the two is expenditure on these counts.