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Special Edition ISSN 1811-5438


Lahore School of Economics
Papers presented at
The Third Annual Conference on
Management of the Pakistan Economy

Economic Reforms: The Road Ahead (2007 -2010)

2nd May to 3rd May, 2007
Lahore School of Economics, Lahore, Pakistan.

Ishrat Husain M. Ashraf Janjua

Reforming the Government in Pakistan’s External Trade: Does
Pakistan: Rationale, Principles and Exchange Rate Misalignment Matter
Proposed Approach for Pakistan?
A. R. Kemal
Industrial Competitiveness of Naheed Zia Khan
Pakistan (2000-10) Doha Round Baggage: Implications
Shamyla Chaudry for Economic Reforms in Pakistan
Increasing Global Competitiveness: A and other Southern Countries
Case for the Pakistan Economy
Shahid Kardar Samina Shabir & Reema Kazmi
Monetary and Fiscal Policies Economic Effects of the Recently
Shakil Faruqi Signed Pak-China Free Trade
Pakistan Financial System - The Post- Agreement
Reform Era - Maintaining Stability
and Growth
Mehak Ejaz
Muhammad Arshad Khan & Sajawal Determinants of Female Labor Force
Khan Participation in Pakistan
Financial Sector Restructuring in An Empirical Analysis of PSLM (2004-
Pakistan 05) Micro Data
September, 2007
Dr. Azam Chaudhry, Editor
Dr. Theresa Thompson Chaudhry, Editor
Ms. Nina Gera, Co-Editor

Editorial Advisory Board

Dr. A. Mushfiq Mobarak Dr. Javier Arze del Granado Dr. Rashid Amjad
Dr. A. R. Kemal Dr. Kaiser Bengali Dr. Saleem Khan
Dr. Ahmed Kamaly Dr. Kamal Munir Dr. Salman Ahmad
Dr. Ahmed M. Khalid Dr. Khalid Aftab Dr. Sarfraz Qureshi
Dr. Ajaz Hussain Dr. Khalid Nadvi Dr. Sarwat Jahan
Dr. Akmal Husain Dr. Lennart Erickson Dr. Sean Corcoran
Dr. Anwar Shah Dr. Mathew Andrews Dr. Sebastian Eckardt
Dr. Ashish Narain Dr. Michal Jerzmanowski Dr. Serkan Bahceci
Dr. Aslam Chaudhry Dr. Moazam Mehmood Dr. Shahid Amjad Chaudhry
Dr. Baoyun Qiao Dr. Munir Ahmad Dr. Shahrukh Rafi Khan
Dr. Gwendolyn A. Tedeschi Dr. Nasim Hasan Shah Dr. Sohail Zafar
Dr. Inayat Ullah Mangla Dr. Naved Hamid Dr. Tariq Siddiqui
Dr. Irfan ul Haque Dr. Nuzhat Ahmad Dr. Umar Serajuddin
Dr. Jamshed Y. Uppal Dr. Pervez Tahir Prof. Robert Neild
Dr. Jan Warner Dr. Phillip Garner Prof. Viqar Ahmed

Editorial Staff: Tele. No: 0092 – 42 - 5874385

Telefax: 0092 - 42 - 5714936
Publisher: Lahore School of Economics, Lahore, Pakistan.

Correspondence relating to subscriptions and changes of address should be sent to The

Lahore Journal of Economics, 105-C-2, Gulberg III, Lahore - 54660 - Pakistan

Instructions to authors can be found at the end of this issue. No responsibility for the views
expressed by authors and reviewers in The Lahore Journal of Economics is assumed by the
Editors, the Associate Editor and the Publisher.

Copyright by: Lahore School of Economics

Special Edition2007
Contents 2007

Editors’ Introduction i
Reforming the Government in Pakistan: Rationale,
Principles and Proposed Approach
Ishrat Husain 1
Industrial Competitiveness of Pakistan (2000-10)
A. R. Kemal 17
Increasing Global Competitiveness:
A Case for the Pakistan Economy
Shamyla Chaudry 31
Monetary and Fiscal Policies
Shahid Kardar 43
Pakistan Financial System - The Post-Reform Era
Maintaining Stability and Growth
Shakil Faruqi 67
Financial Sector Restructuring in Pakistan
Muhammad Arshad Khan and Sajawal Khan 97
Pakistan’s External Trade: Does Exchange Rate
Misalignment Matter for Pakistan?
M. Ashraf Janjua 125
Doha Round Baggage: Implications for Economic
Reforms in Pakistan and other Southern Countries
Naheed Zia Khan 153
Economic Effects of the Recently Signed Pak-China
Free Trade Agreement
Samina Shabir and Reema Kazmi 173
Determinants of Female Labor Force Participation in Pakistan
An Empirical Analysis of PSLM (2004-05) Micro Data
Mehak Ejaz 203
Editors’ Introduction
The Lahore School’s Third Annual Conference on the Management of the Pakistan
Economy, in May 2007, reflected on the economic reforms that have been
implemented since the 1990s and on the prospects for additional reforms in both
the near and long-term. A number of respected economists and other experts
provided evaluations of the government’s past efforts, and offered advice on the
direction that future reform efforts should take. The Conference focused on a few
key areas which included Governance Reforms, Industrial Competitiveness,
Monetary, Fiscal and Financial Sector Policies, Exchange Rate and Trade Policies,
and Female Labor Force Participation. The key findings of the papers were as

Governance Reforms: Ishrat Husain presented a view of long-term governmental

reform in Pakistan to take place over a period of 10 to 20 years. The need for
such reform is great, given the demands of the “globalized world” that all
economies, including Pakistan, increasingly face. He drew lessons from other
developing countries that have been successful in their modernization efforts. He
also reviewed recent developments in Pakistan that highlighted the need for
change, including: i) the lack of equitable distribution of the benefits of economic
growth and dysfunction in the delivery of public services, ii) the implications of
public enterprise privatization for government ministries, iii) the devolution of
powers and public finances to the provinces and districts, iv) the shift in the
responsibilities of federal ministries toward policy making and monitoring and
evaluation, v) the burgeoning of public-private and public-NGO partnerships, vi)
uncertainty about the future of the civil service, and vii) developments in e-
government. Mr. Husain discussed the broad principles that should underpin
reforms in the civil service, the structures of federal, provincial and district
government, and business process re-engineering. He concluded with suggestions
regarding the timing and sequencing of reforms that would be most conducive to
long-term change.

Industrial Competitiveness: A.R. Kemal began by pointing out that Pakistan is

currently internationally competitive in only a few products, demonstrating the
need for dramatic improvements. He continued by examining in detail Pakistan’s
performance in the various dimensions of the Global Competitiveness Index, in
addition to a brief analysis of total factor productivity measures. Dr. Kemal
concluded with suggestions on how Pakistan can increase its productivity and
therefore competitiveness, in particular by attracting investment via a more
favorable business environment, adapting and adopting new technologies, using
industrial clusters to foster technological up-gradation, improving education,
streamlining business regulation and dispute resolution mechanisms, and improving
infrastructure (especially transport).

Shamyla Chaudry also examined the ratings of Pakistan in various surveys of global
competitiveness and compared Pakistan’s position in these rankings to that of India
and China, two neighbors and competitors. She found that Pakistan has stagnated
by most measures of industrial competitiveness, and is particularly weak in health
and education and human capital development.
Monetary, Fiscal and Financial Sector Policies: Shahid Kardar evaluated Pakistan’s
recent performance in monetary and fiscal management of the economy. While
admitting that macroeconomic stability has been maintained, he argued that the
situation remains precarious, given the level of inflation, current account deficit,
and fiscal deficit. The economy has benefited from inflows from donors post-9/11,
increased remittances of overseas Pakistanis, and privatization receipts, but the
country may not be able to rely on these sources indefinitely. More recently, the
government tightened monetary policy. Mr. Kardar also looked at the fiscal
policies of the government. The government had been financing expenditures
through borrowing from the State Bank, but changes were needed in order to
reduce the inflationary pressures that this borrowing had created. With this view,
the article presented suggestions for reforming both government expenditures and

Shakil Faruqi began with a summary of the financial reform efforts that began in
Pakistan in the early 1990s, in particular the privatization and consolidation of the
banking sector. He assessed the current state of the banking system with regards
to soundness, non-performing loans, intermediation costs and efficiency (spreads),
profitability, banking and exchange rate risks, and sensitivity to shocks. Despite an
impressive performance in several areas, he noted that shortcomings remain; among
these is lack of credit access for large segments of the population, and lagging
levels of financial intermediation as compared to other countries at similar stages of

Muhammad Arshad Khan and Sajawal Khan also looked at financial sector reforms.
The paper begins with a framework for the three major stages of financial sector
reform. They divided Pakistan’s past reform efforts into three phases, starting in
the late 1980s. They evaluated the effects of these sustained reform efforts by
looking at the impacts on interest rates, bank solvency, credit and indicators of
financial deepening, bank profitability, privatization, and corporate governance.
Suggestions for a second generation of reforms were given, including a focus on
macro-stability, governance, institutional capacity building and property rights,
development of venture capital and private equity, and the legal infrastructure for

Exchange Rate and Trade Policies: M. Ashraf Janjua analyzed trends in Pakistan’s
real exchange rate (REER) over the period 1978 to the present, and identified the
domestic policies and events in the external environment that contributed to REER
movements. The article also included an econometric analysis of the equilibrium
real exchange rate (ERER), based on macroeconomic fundamentals. The estimated
equilibrium real exchange rate was then compared to the actual REER to identify
exchange rate misalignments over the last three decades.

Naheed Zia Khan turned the discussion to international trade, by providing a

detailed overview of the history of trade negotiations through GATT and the WTO.
Given the current (stalled) round of trade negotiations in Doha, she paid particular
attention to the issue of agriculture, focusing on Pakistan’s modest support policies
toward agriculture and contrasting them with the strong agricultural support
offered by the US, EU and other developed nations.

Samina Shabir and Reema Kazmi gave a detailed account of the history of economic
cooperation between Pakistan and China, describing the many agreements signed
since 2001 by the two countries on tariff reductions, investment, defense, energy,
infrastructure, and other areas. These agreements (and future planned agreements)
are intended to create a free trade area between Pakistan and China. The paper
also took a detailed look at Pakistan’s exports and its trade deficit with China, and
examined the recent performance of some key sectors of the Pakistani economy
that will continue to receive protection under the FTA, including textiles,
garments, engineering, automobiles, and consumer durables.

Female Labor Force Participation: In the last paper of the special edition, Mehak
Ejaz used recent data from the Pakistan Social and Living Standards Measurement
Survey (PSLM) to conduct an empirical analysis of the determinants of female labor
force participation. Using a limited dependent variable approach, she found that
women were more likely to work outside the home when they belonged to a
nuclear family, had greater education, were unmarried, and had access to a vehicle,
and were less likely to work when there were a large number of children in the
household and had access to home appliances.

This Special Edition of the Lahore Journal of Economics has been compiled from the
papers presented at the Third Annual Conference on Management of the Pakistan
Economy. This Special Edition is meant to disseminate the findings of this conference
more widely at both the national and international levels.
The Lahore Journal of Economics
Special Edition (September 2007)

Reforming the Government in Pakistan: Rationale, Principles

and Proposed Approach

Ishrat Husain*


Though government reforms are viewed as important for most

developing countries, the rationale for these reforms must be clearly
understood if they are to be correctly designed and implemented. From an
international perspective, government reforms in Pakistan must be developed
to integrate Pakistan into a larger global economy and should be based on
the lessons learned from other developing countries. From the domestic
perspective, reforms are necessary for the Pakistani government to adapt to
the changing domestic environment. The reforms must focus broadly on the
Federal, Provincial and District governments, on civil service reform and on
business process re-engineering. This paper details the rationale for
government reform in Pakistan, focuses on critical areas of reform, and
provides a framework for the proposed reform approach.


A legitimate question that is often raised by those working for the

government in Pakistan but not by outsiders is: Why reform the
Government? Most of them believe that things are going well and the costs
of bringing about these reforms will prove to be disruptive for the economy
as well as for administration. We had inherited a strong, robust system from
the British that has been tried and tested over time and there is hardly any
compelling reason to bring about any major structural changes. In order to
address this question we have to provide the rationale for bringing about
reforms in the government which is done in Section I. Having established
the business case for reforms, Section II lays down the principles that would
underpin these reforms. Finally, the proposed approach to design the
reforms will be discussed in Section III.

Chairman, National Commission for Government Reform, and Former Governor, State
Bank of Pakistan.
2 Ishrat Husain


Rationale for Reforms

It must be conceded at the outset that the time horizon for the
consummation and impact of the proposed reforms is long term – the next
10 to 20 years and not immediate or short term. The rationale for this plan
should therefore be viewed in the context of the long term vision of
Pakistan, the external environment in which Pakistan will be operating as a
country, the lessons learnt from other successful developing countries, the
diagnostic studies including public opinion polls about government
performance in Pakistan and the growing expectations of the public at large.

(A) Long Term Vision and External Environment

Vision 2030 prepared by the Planning Commission in consultation

with the private sector, academia, civil society organizations, etc. envisages
Pakistan to be a developed, industrialized, just and prosperous nation at the
end of the next 20-25 years. This vision is to be achieved through rapid and
sustainable development in a resource constrained economy by deploying
knowledge inputs. The transition for achieving this objective is proposed to
be managed by an intelligent and efficient exploitation of globalization
through competitiveness. Pakistan is therefore opting to become an active
participant in the globalized economy for goods, labor, capital, technology
and services, and this option has serious consequences for the future
governance of the country.

The imperative of integrating Pakistan in the larger global economy

places certain essential demands and one of these demands is that the
structures of the state and instruments of the government have to be
redesigned to use knowledge and technology inputs to create opportunities
for increased productivity and competitiveness within the constraints
imposed by depleting resources. Among the 180 nations of the world which
are Pakistan’s competitors for capturing market share in the ever expanding
global economy, only those will survive that remain agile and adapt
themselves to the changing demand patterns, supply value chain and
technological upgradation. The main actors in a country that will together
impinge upon its competitiveness and productivity are the state, market and
civil society. The respective roles of these main actors and their
interrelationships have therefore to be redefined and re-calibrated.

Structural economic reforms to improve Pakistan’s prospects for

competing in the globalized economy require stable, functioning, competent
Reforming the Government in Pakistan: Rationale, Principles & Proposed Approach 3

and responsive institutions for implementation. But unfortunately, we are at

present caught in a difficult logjam. While the economic reforms themselves
create dislocation and displacement in the transition period, strong working
institutions provide the wherewithal and armory to withstand these shocks
thus minimizing the costs of adjustment and maximizing the benefits to the
poor and neglected. The urgency to build strong institutions to implement
these structural reforms is therefore quite obvious.

Following this logical sequence the various organs of the State –

executive, judiciary and legislature – have to be assessed and evaluated to
determine whether they are capable of meeting this new challenge or
whether they need to be re-vamped to develop new capabilities and build
up new response capacity. The task assigned to the National Commission for
Government Reforms (NCGR) is limited to a review and examination of one
of the organs of the State i.e. the Executive branch. The Commission has
been asked to assess whether the government, its structures, processes and
human resources can keep up with these new demands or need modification
or alteration.

(B) Lessons from other Developing Countries

The role and limitations of governments in various developing

countries have been analyzed at great length. The majority view is that
governments should do what they are capable of doing better than in the
past. A strong and effective government is needed rather than a weak and
expansive government. The all wide-encompassing government has become
too cumbersome and centralized with overlapping and competing interests,
inefficient and unresponsive to the emerging needs of the public. Civil
servants are poorly trained, sub-optimally utilized, badly motivated and
ingrained with attitudes of indifference and inertia. It has been argued by
development economists1 that effective government in developing countries
is not only necessary due to abundant market failures but possibly even
sufficient to achieve economic development.

A number of developing countries have successfully reformed their

governments and tackled the market failures as well as achieved rapid
economic development. How have they been able to transform the expansive
government into a well focused, well functioning and result oriented
effective government? The interpretation of the success of East Asian
countries such as the Newly Industrializing Countries (NICs), ASEAN
countries and China is a matter of serious debate among development
economists. Neoclassical economists attribute the success to market friendly,
private led growth and openness to trade with the governments providing
4 Ishrat Husain

macroeconomic stability, security of person and property, infrastructure

services, promoting research and development, investing in education,
health, science and technical training. Others such as Wade (1990) and
Amsden (1989) have argued that an interventionist state which guided and
steered a proactive industrial policy and picked the winners, was largely
responsible for their success. By now, there is some consensus that if the
labels and ideologies are set aside, the evidence suggests that countries that
have tended to promote competition and avoided monopolies or oligopolies,
ensured a level playing field and entry for new comers in the market, made
privatized firms face competition, exercised regulatory vigilance (but
eliminated inefficient and outdated regulations), opened up the economy to
international trade, provided the way for judicial independence, provided
dispute resolution mechanisms and enforced contracts, promoted
transparency, observed the rule of law, have been relatively successful. In
short, the government provided an enabling environment for private
businesses to carry out production, distribution, trade of goods and services
but did not indulge itself in these activities directly.

The other piece of empirical evidence that is beginning to gain wide

acceptance is that decentralization and greater devolution of power,
authority and resources to lower tiers of government also makes a difference
through better allocation and a more efficient utilization of resources.
Devolution also helps in moving towards a relatively more egalitarian
outcome in the provision of basic public goods services.

Another way to promote human development and deliver social

services to the poor segments of the population that has worked is through
the wider participation of the private sector, communities and civil society
organizations. Participation, besides being considered a means to further
human capabilities a la Sen3 is also a way of choosing the right kind of
projects and ensuring that development funds are used more judiciously.
Private–public partnerships and public–NGO or Civil Society Organization
partnerships are being successfully used in many countries for the provision
of infrastructure, education, health and other social services. These
partnerships not only supplement the limited public resources and counter
the governance issues through monitoring, evaluation and corrective actions
but also enable local communities to participate in decision making through
their organizations. The reduced efficiency of public sector expenditure can
also be corrected through these partnerships.
Reforming the Government in Pakistan: Rationale, Principles & Proposed Approach 5

(C) Changes in Pakistani Scene

We now turn to the diagnostic studies and the changes that have
taken place in the landscape in Pakistan in the past several years and are
likely to affect the functioning of the government in the future. A number
of commissions, committees, task forces, and working groups have examined
and made recommendations about the changes in our administrative system.
These recommendations and studies have been scanned and sifted and the
proposals that are still relevant and useful will form part of the NCGR’s
recommendations. But in addition to the historical reasons there have been
at least seven new developments in the last few years that clearly point to
the need for reforms in the structure, processes and human resource
management policies and practices.

First, it is becoming increasingly apparent that the benefits of

economic growth have not been distributed equitably among the lower
income groups, backward districts, rural areas and women. Although the
government has used the channels of devolution and poverty targeted
interventions to spread these benefits, the results have been less than
satisfactory. Almost all studies point out that the institutions of governance
i.e. the governmental machinery at the Federal, Provincial and Local
Governments have become largely dysfunctional due to the protracted
neglect of our institutions. Almost all comparative country rankings,
whether originating from the World Bank* or Global Competitiveness
Report of the World Economic Forum or other think tanks and institutions
consistently rate Pakistan quite low in Public Sector Management,
Institutions and Governance. Along with the low Human Development
Indicators this weak institutional dimension makes the task of poverty
reduction, income distribution and delivery of public services quite difficult.
The impact of good economic policies upon the lower strata of our society,
particularly those who are illiterate and are not well connected, thus gets
muted. The widespread hue and cry about the absence of a trickle down
effect of good economic policies is a manifestation of the dysfunctional
nature of our public sector governance. Government institutions have to be
strengthened to meet this challenge.

Second, the responsibilities of the government in the field of

owning, managing and operating public enterprises and corporations have
undergone significant change both in the thinking as well as action during
the last sixteen years. A large number of government owned corporations,
businesses, industrial units, banks and financial institutions and service
providers have either been privatized or are in the process of privatization.
This will reduce the burden on the administrative apparatus at all levels of
6 Ishrat Husain

government. The shedding of these activities by the government has serious

repercussions for the oversight function of the Ministries/ Departments in
the post privatization period.

Third, the devolution of administrative, operational and financial

powers to local governments since 2001 has introduced a completely new
element in the governance structure that will require suitable modifications
in other tiers of the government. The Federal Government is seriously
considering the transfer of some functions listed in the concurrent list of
the constitution to the Provincial Governments. The projected increased
award of financial resources to the provinces under the National Finance
Commission should provide some fiscal space to them for carrying out
essential public services directly or through the District Governments. This
implies a reallocation of administrative resources and the strengthening of
capacity at the local government level.

Fourth, the unbundling of the policy, regulatory and operational

responsibilities of the Federal ministries has shifted the focus on the policy
making, monitoring and evaluation functions. But this transition has been
incomplete, uneven and mixed across the ministries and needs to be firmly
rooted. The lack of adequate competence and knowledge of regulatory
functions would demand the development of expertise in this field as well as
in policy formulation, implementation and evaluation.

Fifth, some limited success has been achieved by fostering private –

public partnerships in the fields of infrastructure, education and health. But
these partnerships can only be nurtured if the government departments and
ministries have the adequate skills to design concession agreements, B.O.T
or contractual arrangements, monitoring and evaluation tools and legal
recourse to enforce the obligations and stipulations agreed by the private
sector partners. Similarly, the NGOs and community organizations such as
Rural Support Programs have been actively engaged in the delivery of public
services in the fields of education, health, water supply etc. The government
departments and ministries have to be reconfigured to develop the capacity
to design and operate these partnerships.

Sixth, there is a great deal of uncertainty and anxiety among the

members of the civil services of the country about their future career
prospects. Those specialists serving in ex-cadre jobs such as scientists,
engineers, medical doctors, accountants, etc. are demoralized because they
have limited opportunities for career progression. They also feel that they
are not treated at par with the cadre service officers in matters of promotion
and advancement.
Reforming the Government in Pakistan: Rationale, Principles & Proposed Approach 7

Seventh, the switch over from manual to automated processes and

the government’s commitment to move towards E-Government would
require a look at the skill mix and training requirements of the existing and
future civil servants throughout the entire hierarchy. E-Government will
itself flatten the hierarchical texture and make apparent the redundancies in
the system. At the same time it will involve basic computer literacy at all
levels and grades, digital archiving, storage and retrieval of all files and
documents. Consequently, only a few of the clerical and subordinate staff
positions can be utilized in the future government organization.

(D) Expectations-Delivery Gap

The recent political history of South Asia clearly points to the failure
of successive governments to live up to the expectations of the majority of
their population. This trend has become even more acute in the last decade
or so with the advent and spread of the electronic media. Although all the
countries in the region have performed well and attained respectable rates
of economic growth, yet every incumbent government has been voted out of
power at the time of elections. The benefits of growth may have filtered
down but the speed and their distribution have not been able to satisfy the
electorate. The ICT (Information Communication Technology) revolution
that has touched even the remote areas of these countries has, in fact,
tended to exaggerate the disparities and contributed to higher expectations
of government. On the one hand, the capacity of the government
institutions responsible for the delivery of public goods and services has
rapidly eroded and is in a debilitating and feeble state, while a large variety
of goods and services available, advertised and visually observed on the
electronic media has whetted their appetite. They believe that the means
through which they can acquire these goods and services for themselves and
their children is through public sector employment, education and training
and government transfers. In actual practice, the allocation of public goods,
services, employment and subsidies is rationed by access to the government
functionaries or by paying bribes. As these groups have neither the access
nor the money to pay the bribes, they suffer from a relative sense of
deprivation while observing that the influential and well-to-do segments of
the population are preempting and enjoying the benefits of government
jobs, contracts, permits, land, etc. Large, untaxed incomes are also accruing
to the same privileged groups and individuals. The resentment of this poor
and unconnected population is conveyed through the only instrument they
possess i.e. the vote at the time of elections. This gap between expectations
and delivery is one of the biggest challenges for Pakistan too.
8 Ishrat Husain

The popular perceptions as expressed in public opinion polls, media

commentaries and editorials, articles and papers, seminars and discussions,
observations of politicians and civil society actors, all convey with a few
honorable exceptions, a negative image of the civil servants in Pakistan and
a high level of dissatisfaction with the functioning of the Ministries,
Departments, Corporations and Agencies of the different tiers of the
government. These perceptions are in contrast to the views of the civil
servants themselves who see themselves as poorly paid, highly demoralized
and stressed out individuals. They feel that they have been unfairly treated
by their political bosses and unappreciated by the general public. Empirical
studies and casual observations show that the root cause of this
disenchantment of civil society and the disillusionment of the civil servants
can be traced to structural, procedural and motivational deficiencies in the
overall system of governance. Any attempts to treat the symptoms in an
isolated manner without coming to grips with the root causes will be
counterproductive. The reform package should be comprehensive with a
clear blueprint, but the introduction of each set of reforms could be phased
and sequenced. The methodology adopted by the NCGR therefore follows
with logic.


Broad Principles Underpinning the Reforms

In order to lay down the direction in which the reforms will be

undertaken, it is essential that the broad principles that will underpin these
reforms are clearly defined. The following broad principles are outlined
under each area of the reforms.

Civil Services

i) Open, transparent merit–based recruitment to all levels and grades

of public services with regional representation as laid down in the

ii) Performance–based promotions and career progression for all public

sector employees with compulsory training at post-induction, mid-
career and senior management levels.

iii) Equality of opportunities for career advancement to all employees

without preferences or reservations for any particular class.
Reforming the Government in Pakistan: Rationale, Principles & Proposed Approach 9

iv) Replacement of the concept of Superior Services by equality among

all cadres and non-cadres of public servants.

v) Grant of a living wage and compensation package including decent

retirement benefits to all civil servants.

vi) Strict observance of security of tenure of office for a specified period

of time.

vii) Separate cadre of regular Civil Services at the Federal, Provincial and
District levels co-existing with contractual appointments.

viii) Creation of an All Pakistan National Executive Service (NES) for

senior management positions drawn through a competitive process
from the Federal, Provincial and District level Civil Servants and
outside professionals.

ix) Introduction of four specialized cadres under the NES for Economic
Management, Regulatory, Social Sector Management and General

Structure of Federal, Provincial and District Governments

a) Devolution of powers, responsibilities and resources from the

Federal to the Provincial governments.

b) Establishing inter-governmental structures with adequate authority

and powers to formulate and monitor policy formulation.

c) Clear separation of policy making, regulatory and operational

responsibilities of the Ministries/Provincial departments.

d) Making each Ministry/Provincial department fully empowered,

adequately resourced to take decisions and accountable for results.

e) Streamline, rationalize and transform the attached departments/

autonomous bodies/ subordinate offices/field offices, etc. into fully
functional arms of the Ministries for performing operational and
executive functions.

f) Reduce the number of layers in the hierarchy of each Ministry/

Provincial department.
10 Ishrat Husain

g) Cabinet Secretary to perform the main coordinating role among the

Federal Secretaries on the lines of the Chief Secretary in the

h) Revival and strengthening of the Secretaries Committee at the

Federal/ Provincial governments to become the main vehicle for
inter-ministerial coordination and dispute resolution among various

i) District level officers interacting with the general public in day-to-

day affairs should enjoy adequate powers, authority, status and
privileges to be able to resolve the problems and redress the
grievances of the citizens.

j) Police, Revenue, Education, Water Supply, and Health are the

departments which are highly relevant for the day-to-day lives of the
ordinary citizen of this country. The internal governance structures
of these departments, public grievance redressal systems against
these departments and checks and balances on the discretionary
powers of the officials have to be introduced.

Business Process Re-Engineering

i) All laws, rules, regulations, circulars, and guidelines issued by any

government ministry/department/agency should be available in its
most up dated version to the general public free of cost in a user-
friendly manner on the web page and in electronic and print forms
at public places.

ii) Service standards with timelines for each type of service rendered at
the District, Thana and Union level should be developed, widely
disseminated and posted at public places in each department.

iii) Rules of business of the Federal, Provincial and District government

should be revised to make them simple and comprehensible,
empowering the Secretaries/Heads of Departments/District
Coordination Officers to take decisions without multiple references,
clearances and back and forth movement of files. Post-audit of the
decisions taken should be used to ensure accountability rather than
prior clearances.

iv) Delegation of financial, administrative, procurement, human

resource management powers should be revisited and adequate
Reforming the Government in Pakistan: Rationale, Principles & Proposed Approach 11

powers commensurate with the authority should be delegated at

each tier of the hierarchy.

v) Estacode, Financial Rules, Accounting and Audit Rules, Fundamental

Rules and all other rules in force should be reviewed systematically
and revised to bring them in line with modern management

vi) E-Government should be gradually introduced in a phased manner.

Technological solutions, hardware and software applications are easy
parts of the process, but the most difficult aspect is the training and
change in the culture, attitude and practices. E-Government should
be driven by business needs rather than crafted as an elegant
technical solution.


Proposed Approach

There are several ways to approach the task assigned to this

Commission. One option is to spend several years in preparing a
comprehensive blueprint and plan for bringing about the desired changes
covering all aspects of the structure, processes and human resource policies
of government. This option has the disadvantage that by the time the report
is ready, ground realities might have changed. Political support for reforms
under this approach is most likely to wane as high costs are incurred
upfront in pushing through complex, unpopular and difficult decisions, but
the benefits of the reforms do not become visible in the lifecycle of the
political regime in power. The advantage of this option is that all
deficiencies and weaknesses are addressed simultaneously in a comprehensive

The second option is to prepare a long term vision and direction in

which reforms should aim and move, but combine this with an
opportunistic approach whereby easy to implement changes are taken up
first and the more difficult reforms are taken up later. The disadvantage of
this option is that the changes introduced may be imperceptible and the
time taken for the whole process to complete may be too long. But the
advantage is that incremental changes that create a win-win situation for all
the stakeholders including politicians have a much better chance of being
accepted and implemented. It is suggested that the Commission may
propose the second option as the modus operandi for its working.
12 Ishrat Husain

The preference for this option which is less elegant and imperfect
lies in a dispassionate reading of the past history of reforms in this country.
A large number of erudite Commissions and Committees have spent virtually
thousands of man years in seeking out views and opinions from a diverse set
of opinion makers and public at large, prepared elaborate diagnostic studies
and presented a very sensible set of recommendations. But except for some
tinkering here and there most of the recommendations were not
implemented because of lack of political will and courage. The two
exceptions to this trend are:

(a) The Civil Service Act. of 1973 which under the leadership of Mr.
Z.A. Bhutto brought an end to the historical covenant between the
government and higher civil servants.

(b) The Devolution Plan of 2001 under the leadership of President

Musharraf which devolved powers from the Province to Districts.

These radical reforms uprooted the existing structures, processes and

relationships but the transition period for their replacement by the new
structures, processes and relationships has been quite long. In both these
cases there was strong political will, but fierce resistance to these changes
was equally strong. Learning from these two examples the second option
appears more pragmatic. We have, at present, strong political leadership for
the reform of the government and we need to develop a long term
framework in which the direction of the reforms is clearly laid down. The
movement towards the ultimate goal post will be more nuanced – by
applying acceleration when the opportunity presents itself, through a brake
or temporary reversal when the resistance is fierce, through second or third
gears when the opposition is neutralized and the results achieved pacify the

The sequencing, phasing and timing of the various reforms and their
implementation will be guided by the speed at which consensus is built
among the stakeholders and the decisions are made by the top policy
makers, but it is important to lay down the overall direction in which these
reforms will move.

While the comprehensive reforms will be implemented

incrementally, a second track will also be followed in which some quick win
reforms will be implemented from time to time as an opportunity presents
itself. For this purpose, the Commission will follow a more flexible route.
For example, it has decided to focus on four major areas where the
Reforming the Government in Pakistan: Rationale, Principles & Proposed Approach 13

interaction between the ordinary citizen and administrative machinery of the

government is most intense. These four areas are:

1. Police and Enforcement of Laws.

2. Land Revenue Administration

3. Education

4. Health

The Commission has formed four sub-committees to review and

examine the efforts being made by the government, private sector and civil
society in each of these areas and come up with solutions that will make the
existing system more efficient and responsive to the needs of the public in
the immediate or short run. The Commission has also formed another sub-
committee to recommend revision in the Rules of Business for removing
impediments in the functioning of the government departments/ministries/
agencies and empowering the heads of the departments to deliver results.

The preliminary recommendations of the sub-committees will be

presented to focus groups of stakeholders drawn from diverse segments of
society – secretaries, committees, political leaders, businessmen, NGOs,
academically refined civil servants, etc. – to solicit their feedback and views.
Once this feedback is incorporated, the sub-committees will finalize their
recommendations which will then be discussed by the Commission and then
presented for consideration and decisions by the Steering Committee. The
high powered Steering Committee is co-chaired by the President and Prime
Minister and consists of the four Chief Ministers. The Committee has
decided to provide a legal cover to the Commission so that the
recommendations approved by the Steering Committee are implemented by
the Federal and Provincial governments without further reviews.

The Commission will also act as a facilitator and conduit for the
reforms formulated by the Federal Ministries/Provincial Governments and
table them, after its own analysis for the decisions by the Steering

To conclude, those who agree that there is a need for these

reforms have serious reservations about their implementation. They
contend that these reforms cannot be implemented in the real sense
unless we insulate bureaucratic actions from political interference.
According to this school of thought, the problem of maladministration
14 Ishrat Husain

and poor governance stems from this interference. It must be recognized

that in democratic forms of governance, elected leaders will have to
respond to their political constituents and the associated vested interests.
The accountability for results rests largely on these politicians and not on
the civil servants. If the interference of the politicians is aimed at serving
the narrow parochial interests of a few individuals or groups rather than
the broader collective interests of their constituencies, they may end up
paying a heavy price at the time of the next elections. Their opponents,
the opposition parties and the media scrutiny will keep a watch on their
actions and expose them before their constituents. The alignment of the
civil servants with their political bosses in violating or circumventing laid
down laws, rules, regulations and procedures would prove to be myopic as
these civil servants will also become tainted and suffer in their career
advancement. If the successive civil servants appointed to key positions
refuse to carry out illegal, unlawful or irregular orders, how many times
can a minster get them transferred or how many of them could be
appointed as OSDs? The strong temptation to indulge in immediate
gratification by keeping the political bosses happy and either ignore or go
along with them is indeed the crux of the problem. The long term
consequences of succumbing to such temptations should always be kept in
mind by this category of civil servants. There is no substitute for personal
integrity and character in public service.

However, to expect that we will be able to induct angels in the civil

services is also unrealistic. The thrust of the proposed reforms is to limit the
discretionary powers of the decision makers, simplify the cumbersome
procedures and processes and make them transparent and realign the
incentives of the individual civil servants with those of the organization. It is
proposed, therefore, that the Commission should remain as a permanent
body responsible for changed management in the government, but limit the
term of the office of the Chairman and members to two years only.
Reforming the Government in Pakistan: Rationale, Principles & Proposed Approach 15


Amsden A, 1989, Asia’s Next Giant: South Korea and Late Industrialization
Oxford: Oxford University Press.

Government of Pakistan, 2007, Vision 2030 Draft, Planning Commission,


Husain I, 1999, The Economy of an Elitist State, Oxford: Oxford University


Kaufmann D and Mastruzzi M, 2005, “Governance Matters IV,” World


Leipzeiger D, 1997, Lessons from East Asia, Ann Arbor: University of

Michigan Press.

National Commission for Government Reforms, Concept paper (website 2006.

Sen. A.K. 1999, Development as Freedom, Oxford: Oxford University Press.

Stiglitz J and Yusuf S, 2001, Rethinking the East Asia Miracle, Oxford
University Press. Bradhan P and Mookherjee D, 2001,
“Decentralization Corruption and Government Accountability: An
Overview” in Susan Rose-Ackerman, Handbook of Economic
Corruption, Cheltenham: Edward Elgar.

Todaro, M.P and Smith, S.C, 2004, Economic Development, Pearson.

UNDP, 2003, Pakistan National Human Development Report.

Wade R, 1990, Governing the Market: Economic Theory and the Role of
Government, Princeton: Princeton University Press.

World Bank, 1993, The East Asia Miracle: Economic Growth and Public
Policy, Oxford University Press.

World Development Report 2000/2001, New York: Oxford University Press.

The Lahore Journal of Economics
Special Edition (September 2007)

Industrial Competitiveness of Pakistan (2000-10)

A. R. Kemal*


Though Pakistan’s exports have increased significantly, analyses have

shown that Pakistan’s industrial competitiveness is limited to a narrow
range of products. This paper looks at the factors affecting Pakistan’s
competitiveness ranking and relates these various factors to trends in
Pakistan’s total factor productivity. In addition to looking at the
components of Pakistan’s competitiveness ranking, this paper details the
steps required for Pakistan to increase its global industrial competitiveness. 
I. Introduction

Whereas Pakistan’s exports have increased from $8 billion to $ 18

billion over the last few years, the level of exports is still just a fraction of
the exports of various South East Asian countries1. The low levels of
Pakistan’s exports may be attributed to its competitive edge in a few
products and that, too, in low end technology products. Since the growth
rate of exports has fallen to around 5% during 2006-07 following the double
digit but falling growth rates over the 2003-06 period, the formulation of a
strategy for the growth of exports over the medium and long run has
assumed great significance. It needs to be underscored that just the
provision of subsidies or devaluation of the rupee can hardly result in a
continuous increase in the export level. If the country has to be a major
player in international trade it must enhance its competitiveness through
improved levels of total factor productivity.

David Ricardo a couple of centuries back on the basis of a 2-country,

2-product and 1-production factor model had suggested that even if a
country is inefficient in the production of both the goods, it would be able
to compete in the world market as long as it specializes in accordance with
its comparative advantage. The inefficiencies in production, however, would
be counterbalanced by the low wage rates and the cost of production of the

Former Director Pakistan Institute of Development Economics (PIDE), Islamabad.
A few decades back their exports were lower than that of Pakistan.
18 A. R. Kemal

export product would be lower than that in the importing country. If the
country improves the productivity levels, wages would rise without
increasing the cost of production and jeopardizing the competitiveness.

Heckhsher-Ohlin suggests that the country would specialize in the

activities that intensively use the abundant factor. They assumed the free
availability of technology and no factor reversals but in practice neither is
technology freely available nor is it the same across all the countries, and
factor reversals do take place which may invalidate the theory. As the theory
is based on factor endowments, any change in factor endowment would
result in changes in comparative advantage over time. Moreover, in a
seminal contribution, Professor Porter suggested that competitiveness may
be derived from human resources and technological development resulting
in innovation and reduction in the cost of production.

In recent years, a number of international agencies have ranked the

competitiveness of each country on the basis of various indicators. The most
important and oft quoted is the rankings by the Global Competitiveness
Report of the World Economic Forum. For the last four years, it has also
reported the competitiveness ranking of Pakistan, which falls below the
median in most of the competitive indicators, indicating that Pakistan has to
travel a long distance even to reach the average of the competitiveness

The Asian Development Bank and the World Bank have examined
Pakistan’s industrial competitiveness. The Asian Development Bank Report on
industrial competitiveness prepared by Lall and Weiss (2004) examines various
technology indices and classifies exports and value added in accordance with
them. They conclude that Pakistan’s competitiveness is not only restricted to a
few products but that its competitiveness has also eroded over time. On the
other hand, the World Bank’s Report (2006) on growth and export
competitiveness suggests that, despite some improvements, the country can
attain an average growth rate of 8% only if there are improvements in almost
all the competitive indicators including institutions, human resource
development and technology. It also suggests policy measures through value
chain analysis for the various export products of Pakistan.

Kemal, Muslehuddin, and Qadir (2002) examined the Revealed

Comparative Advantage of Pakistan and found that it has a comparative
advantage in only a small number of products that are resource based, or at
the lower end of technology. Similarly, Kemal, Mahmood and Ahmad (1994)
found Pakistan’s comparative advantage in a narrow band of products, on
the basis of Domestic Resource Cost.
Industrial Competitiveness of Pakistan (2000-10) 19

The country needs to improve its competitiveness in a large number

of products and the present study examines the possibilities of enhancing
competitiveness and the policies required for that. The plan of the paper is
as follows: After this Introductory Section, the determinants of
competitiveness and Pakistan’s competitiveness ranking are reported in
Section 2. The significance of total factor productivity and its growth in
Pakistan is analyzed in Section 3. The measures required for improving the
competitiveness are discussed in Section 4. Major conclusions and policy
recommendations are summarized in the concluding section of the paper.

II. Determinants of Competitiveness and Pakistan’s Competitive Ranking

Porter suggests that a country can develop competitiveness through

the development of human resource activities including education, health,
skills and technological development. The competitiveness is the ability of
firms to compete with international firms of best practice. No doubt firms
formulate and implement strategies to reduce the cost of production and
improve the quality of products. However, due to market failures in
various activities relating to competitiveness, government intervention
becomes necessary. “The essence of a competitiveness strategy is to
promote in-firms learning, skill development and technological effort,
improve the supply of information, and coordinate collective learning
processes that involve different firms in the same industry, or across
related industries popularly known as ‘clusters’, geographic or activity-
wise” (See ADB, (2004)).

Competitiveness and comparative advantage do change over time due

to various factors which include among others “rapid technical change,
shrinking economic distance, technical progress in information processing,
changes in the form of industrial organizations, development of value
chains, development of clusters.” The countries that develop technologies,
access the markets, absorb and adapt the new technologies, and have an
atmosphere that allows firms to move up the technological scale enhancing
their competitiveness.

Pakistan ranks 91st in the competitive index out of 125 countries

included in the Global Competitive index and its score is 3.7 on the scale
from 1 for the poorest rank to 10 for the highest rank. While Pakistan’s
score is poor, it is encouraging to note that the score has improved from
3.5 to 3.7 and the ranking from 94th to 91st.

There are three sub-sectors of the Global Competitiveness Index, viz.

basic requirements, efficiency enhancers and innovation factors. In all the
20 A. R. Kemal

three indicators, Pakistan lags behind the median except for the indicator
measuring innovation factors where it is around the median (See Table-1). It
suggests that Pakistan is far behind in competitiveness and if Pakistan has to
grow at a rate of 8% on average as envisaged in the Medium Term
Development Framework (MTDF), its score in almost all the indicators must
improve significantly and it should be among the top 25 countries of the
world (See World Bank (2006)).

Table-1: Global Competitiveness Index for Pakistan

Rank Score
2006-07 91 3.7
2005-06 94 3.5
Basic Req. 93 4
1st pillar: Institutions 79 3.5
2nd pillar: Infrastructure 67 3.4
3rd pillar: macroeconomy 86 4.2
4th pillar: Health and Primary Education 108 4.8
Efficiency Enhancers 91 3.3
5th pillar: Higher Education and Training 104 2.8
6th pillar: Market Efficiency 54 4.2
7th pillar: Technological Readiness 89 2.8
Innovation Factors 60 3.7
8th pillar: Business Sophistication 66 4
9th pillar: Innovation 60 3.3

Source: Global Competitiveness Report 2006-07

Institutions are crucial for the growth process and Pakistan lags
behind considerably in all the indicators relating to institutional
development (See Table-2). While the institutions are also important for the
indigenous investors, they are crucial for foreign private investment
especially for the manufacturing sector. The government intends to
implement second generation reforms but so far an improvement in this
direction has been quite limited. Efforts in this direction shall have to be
enhanced considerably.

Table-2: Institutions
Industrial Competitiveness of Pakistan (2000-10) 21

Rank Score
Efficiency of corporate boards 123 3.5
Business cost of terrorism 122 3.1
Property rights 95 3.7
Reliability of police services 85 3.5
Ethical behavior of firms 82 3.8
Judicial independence 80 3.3
Business cost of crime and violence 76 3.8

Source: Global Competitiveness Report 2006-07

Inadequate and poor quality infrastructure increases transaction costs

and erodes the competitive edge of industries. Over recent years there have
been considerable improvements in infrastructure especially in the
telecommunications sector, but that seems to not have found its way so far
into the Global Development Report. Teledensity has improved considerably
than that reported in Table-3, as it is now around 30 per 100 persons.
Incorporating these developments would improve the ranking of Pakistan
further; Pakistan has a reasonably good ranking in railroads, ports and air
travel. However, it is the power supplies that pull down the ranking of
Pakistan in terms of infrastructure.

Table-3: Infrastructure

Rank Score
Overall infrastructure quality 67 3.4
Railroad infrastructure development 39 3.6
Quality of port Infrastructure 52 3.8
Quality of airport structures 59 4.6
Telephone lines 101 3
Quality of electricity supply 87 3.5

Source: Global Competitiveness Report 2006-07

Pakistan has done better in some indicators of market efficiency

including number of days required to set up businesses, hiring and firing
practices and taxation and loans. Moreover, even though its score in easy
access to loans has been low, its ranking is quite good. But despite its score
around 5 in ownership restrictions of foreign firms and soundness of banks,
its rank is low. In other indicators Pakistan ranks poorly (See Table-4).

Table-4: Market Efficiency

22 A. R. Kemal

Rank Score
Efficiency of legal framework 91 3
Hiring and firing practices 26 4.6
Cooperation in labor-employer relations 77 4.4
Intensity of local competition 73 4.6
Brain drain 73 2.9
Foreign ownership restrictions 72 4.9
No. of procedures require to start a new business 70 11 procedures
Time required to start a business 30 24 days
Extent and effect of taxation 33 3.9
Soundness of banks 84 5
Ease of access to loans 42 3.8

Source: Global Competitiveness Report 2006-07

Technological capabilities are determined by education, training,

scientific and technological infrastructure and they are reflected in the
innovations and patents. Table-5 shows various aspects of technological
preparedness. The net enrolment rates at the primary and tertiary levels of
education are 66.2% and 3.0% respectively, the poor quality of education
and, except for market sophistication like value chains and local supplies,
Pakistan ranks poorly in terms of technological development.
Industrial Competitiveness of Pakistan (2000-10) 23

Table-5: Education and Technical Capabilities

Rank Score
Primary enrolment 112 66.2
Tertiary enrolment 106 3
Extent of staff training 91 3.1
Quality of math and science education 85 3.4
Local availability of research and training services 83 3.4
Quality of the educational system 74 3.2
Cellular telephones 115 3.3
Personal computers 113 0.4/100
Internet users 107 131.1/100000
Technological readiness 77 3.4
FDI and technology transfer 75 4.8
Firm level technology absorption 85 4.4
Value chain presence 47 4
Local supplier Quantity 61 4.7
Local supplier Quality 66 4.2
Production process Sophisticate 59 3.6
Nature of Competitive Adv. 54 3.5
Availability of scientists and engineers 78 4.2
Utility patents 78 -
Capacity for innovation 38 3.7
Govt. procurement of technology products 47 3.9
Secondary Event 112 27.2
Quality of public schools 79 29.2

Source: Global Competitiveness Report 2006-07

III. Trends in Total Factor Productivity in Pakistan

It is generally believed that total factor productivity (TFP) in Pakistan

has been small, but it has accounted for one-third of the growth for the
period 1964-65 to 2000-01. TFP has grown at a rate of 1.66% for the entire
economy, only 0.37% for agriculture but 3.21% for the manufacturing
sector, accounting for about half of the growth in the sector. Nevertheless,
24 A. R. Kemal

while productivity growth is quite encouraging it needs to be noted that it

reflects rather poor levels of productivity levels in the base year and has
been just catching up through learning by doing. There has been hardly any
growth in productivity arising from technological development and human
resource development.
Table-6: Trends in Total Factor Productivity
(%age Growth Rates)
Sector Contribution of
Capital Labour TFP
Overall 5.31 2.48 1.17 1.66
Agriculture 3.89 2.70 0.82 0.37
Manufacturing 6.39 2.23 0.94 3.21
Contribution to
Aggregate Growth 46.62 22.12 31.26
Agriculture Growth 69.33 21.11 9.57
Manufacturing Growth 34.99 14.74 50.27

Source: Kemal, Muslehuddin and Qadir (2002)

TFP growth in the manufacturing sector has shown wide variations.

It has accounted for almost a 3% increase in output per annum in the 1960s
and 1980s, but it was quite low in the 1970s and in the 1990s. In the
1990s it was just 0.78%. However, in the manufacturing sector it was
Table-7: Trends in Total Factor Productivity during 1990s (%)

Sector Growth Rates

GDP Capital Labour Residual
Overall 4.41 2.38 1.25 0.78
Agriculture 4.54 2.21 0.81 1.52
Manufacturing 3.99 2.09 0.25 1.64
Contribution to
Overall Aggregate Growth 53.97 28.25 17.78
Agriculture Growth 48.63 17.83 33.55
Manufacturing Growth 52.54 6.26 41.20

Source: Kemal, Muslehuddin and Qadir (2002).

Industrial Competitiveness of Pakistan (2000-10) 25

IV. Preparing for Technological Capabilities and Competitiveness

The Medium Term Development Framework (MTDF) 2005-10 calls

for a growth rate of 8.2% in 2010, with an average growth rate of 7.6%
over the 5 year period. It emphasizes improvements in the productivity
levels by deploying knowledge inputs rather than focusing only on the
accumulation of inputs. However, the MTDF neither provides for sufficient
investment levels, nor for skill development and improvements in
technological capabilities required to achieve the high growth rates
envisaged in the MTDF.

Pakistan can realize the envisaged growth rates provided investment

levels increase to 30% of GDP and total factor productivity increases
through technological development and/or the adoption, adaptation and
diffusion of new techniques. For an increase in investment and technological
change the institutions, regulations, education, and technological personnel
would have to increase and special efforts shall have to be mounted. A
business friendly environment would foster both domestic and foreign
investments resulting in both export competitiveness and diversification.

The World Bank (2006) suggests that if the quality of the investment
environment in Pakistan matches that of the Shanghai investment climate,
then the average productivity of Pakistan’s textile firms operating in Karachi
would improve by 81%, the rate of return to capital would increase by 36%,
and wages would rise by 23%. The increased profitability would encourage
more investment and further improvement in competitiveness2.
Technological capabilities develop slowly but once the process starts, it gains
momentum and a virtual circle of growth, competitiveness and investment
in new capabilities take place. This in turn helps in further technological
capabilities and growth. On the other hand, if the economy is stuck in a
low level equilibrium trap and is unable to fund technological development,
it is caught in a vicious circle. However, it can break out of this circle
through a concerted strategy by improving the human capital and
technological base and improving the institutions and infrastructure.

The essence of the competitiveness strategy is to improve the supply

of information, skills and technology and encourage firms to make an effort
at the learning of skills and the adoption and adaptation of technology. Over
the last couple of decades there have been rapid technological changes

It also suggests that reforms carried out by Pakistan have been mainly responsible for
the high growth rate of per capita incomes in Pakistan in recent years.
26 A. R. Kemal

across the globe which has rendered the old technologies obsolete even in
the low wage economies3.

New technologies are not just new products and processes, but
involve the firms supply chain, human resource development, technology
linkages etc. It amounts to building new capabilities and promoting
structural change in the production patterns, the upgrading of technologies
in activities including finding new markets and marketing niches. Various
industries may need to access, adapt, and add new technologies to remain
competitive. Industrial leaders have to invest in technological innovations
while the followers invest in absorbing and adopting the technology.
Contrary to the general impression that the latter is easy, it needs to be
noted that it is a complex process and involves the development of skills and
technological personnel. The technical change affects all industries though
they are more important in innovation-based industries4.

While technological development is absolutely necessary the capacity

development for technological change is slow, costly and a risky learning
process. The critical factor is not just addition to capacities but the ability
to understand how to operate these at the optimum levels given local
conditions and factor endowments and to upgrade the technologies to lower
the cost of production and evolve new products.

It also needs to be noted that the competitiveness of a country

undergoes changes in response to innovation and the relocation of processes
or functions. The improvements in productivity do not necessarily involve
innovation, but could involve the efficient use of existing technologies. The
reduction in the dispersion of the use of technology across different firms
through the diffusion of technology helps in improving the productivity
levels of an industry. However, it may involve large amounts of investment,
effort, time, risk and constrained interaction with other actors with whom
information and skills are shared.

In most developing countries, firms are not aware of how to upgrade

their technologies to the best practice levels. In general they fail to
understand what new skills, technical knowledge and organizational
techniques are generally available and how these can be accessed.
Cooperation with other firms or institutions requires efforts in over-coming
problems of linkage. Cluster development can be useful in this direction.

The enterprises had to use new technology to remain viable.
Such industries have grown at double the rate compared to the other industries.
Industrial Competitiveness of Pakistan (2000-10) 27

Lack of skilled manpower is a major constraint to business activities

in Pakistan and is critical to improving the productivity and competitiveness
of Pakistani firms. With a view to improving education and skills, merely
higher allocations to education and skill activities would not be sufficient,
though it is absolutely necessary. Governance needs to be improved through
the strengthening and ensuring of more effective recruitment, management
and performance of teachers keeping in mind their competencies and
absenteeism. It would help in the completion of education. Similarly, skill
development calls for improved syllabi, teachers and laboratories and all the
governance issues discussed in terms of education. Moreover, it needs to be
ensured that intermediate and secondary education is more purposeful and
linked to the economy and the changing needs of the labor market and
careers. It also implies an upgradation and expansion of vocational and
technical education capacity to train individuals who are completing
matriculation, drop outs and the unemployed.

Whereas there have been significant improvements in the cost of

doing business indicators over the last few years, the cost is still quite high.
Corruption continues to be very high. The regulatory environment leaves
much to be desired in all aspects of commercial laws and regulations. There
is a need for operational rules, procedures and a monitoring system which
are universally implemented. There is a need to develop a dispute resolution
system for commercial adjudication outside courts. The infrastructure leaves
much to be desired. In the power sector there are difficulties in obtaining
electricity connections and the supply is unreliable, thus placing an
enormous burden on business. The financial sector reforms need to be
consolidated and expanded. The legal framework and judicial processes need
to be improved.

Despite improvements in recent years, major problems in transport

logistics remain. Long standing problems include the old and depleted
conditions of the transport fleet, serious overloading of trucks, restrictions
on the provision of bonded transport and the high cost for less than
container load shipments. Pakistan Railways do not operate on a commercial
basis and gives priority to passengers rather than cargo. The main problem
at the ports is the congestion at the terminals and the turnaround time of
ships is quite high. Pakistan lacks a coherent strategy for quality and SPS
management in relation to its trade. Pakistan needs to better define and
demarcate the role and responsibilities of different agencies, strengthen
existing technical capacities for administrating science based SPS measures,
and institutionalize and early warning or surveillance system for pest and
disease contaminants etc.
28 A. R. Kemal

V. Conclusions

Pakistan’s exports, despite a sharp increase in recent years, are just a

fraction of the exports of various South East Asian countries and the main
factor behind the low level of exports is the lack of competitiveness and
comparative advantage in limited products the demand for which is growing
slowly in the world market. Exporters are once again asking for more
subsidies and devaluation of the rupee rather than enhancing their
competitiveness through improvement in total factor productivity.
Competitiveness may be enhanced through the development of human
resources including skills and technological development. If Pakistan wants
to accelerate its GDP growth rate to around 8%, it will have to improve its
ranking from 91st in the world.

Whereas total factor productivity over the long run in the industrial
sector has contributed one-half to the growth, its contribution has fallen in
the 1990s to just 0.8%. Moreover, improvements reflect low levels of
productivity in the base year and they reflect just catching up through
learning by doing and there has hardly been any growth in productivity
arising from technological development and human resource development.
Efforts need to be mounted to improve the skills and technological
infrastructure in the country as has been suggested in the MTDF - that
growth would be realized by deploying knowledge inputs.

Whereas there have been significant improvements in the cost of

doing business indicators over the last few years, the cost is still quite high.
Corruption continues to be very high. The regulatory environment leaves
much to be desired in all aspects of commercial laws and regulations. The
infrastructure leaves much to be desired. In the power sector there are
difficulties in obtaining electricity connections and the supply is unreliable,
thus placing an enormous burden on the business sector. Financial sector
reforms needs to be consolidated and expanded. The legal framework and
judicial processes need to be improved.
Industrial Competitiveness of Pakistan (2000-10) 29


Kemal, A. R., Musleh-ud Din, Kalbe Abbas and Usman Qadir, 2002, “A Plan
to Strengthen Regional Trade Cooperation in South Asia” in T. N.
Srinivasan (ed.) Trade Finance and Investment in South Asia, Social
Science Press, New Delhi,

Kemal, A.R., 2002, “Productivity Growth during the 1990s in Pakistan,”

Asian Productivity Organization, Japan.

Kemal, A.R., Muslehuddin and Usman Qadir, 2005, “Exports and Economic
Growth in South Asia” in Mohsin Khan (ed.) Economic Development
in South Asia, New Delhi: Tata McGraw-Hill Publishing Company

Kemal, A.R., Zafar Mahmood and Athar Maqsood Ahmad, 1994, Structure of
Protection, Efficiency, and Profitability. Islamabad, Study prepared
for the Resource Mobilization and Tax Reforms Commission,

Lall, Sanjay A. and Jonh Weiss, 2004, Industiral Competitiveness: The

Challenge for Pakistan, ADB, Islamabad.

World Bank, Pakistan: Growth and Export Competitiveness, 2006.

World Economic Forum, The Global Competitive Report 2006-07, Geneva.

The Lahore Journal of Economics
Special Edition (September 2007)

Increasing Global Competitiveness: A Case for the

Pakistan Economy

Shamyla Chaudry*


The issue of global competitiveness is critical for developing

countries. This paper looks at the drivers that influence industrial
competitiveness and provides a comparison of these drivers for Pakistan,
India and China. The analysis shows that Pakistan lags behind China and
India in most of the main components of the industrial competitiveness
index. The analysis also presents a series of micro and macro level policy
recommendations aimed at increasing Pakistan’s industrial

I. Introduction

The aim of this paper is to explain global competitiveness and its

implications for Pakistan. The paper examines international data on global
competitiveness and tries to develop an analysis to help improve strategies for
today. The paper’s focus is on the empirical literature on competitiveness
using different composite indices. These include the following:

1. United Nations Industrial Development Organizations; World

Industrial Development report (2002-2003)

2. World Economic Forums Global Competitiveness Report (up to WEF


The principal objective of this study is to analyze factors that affect

productivity and hence competitiveness and also to identify areas where
Pakistan can strengthen its competitiveness so as to contribute to the overall
growth performance. In order to do such an analysis, comparisons have been
made with Pakistan’s neighbours, India and China, and their success in
international standings has been evaluated. A question which probably

Assistant Professor, The Lahore School of Economics, Lahore
32 Shamyla Chaudry

comes to everyone’s mind is why India and China, which enjoy the same
geographic region with Pakistan, are well ahead of Pakistan in all aspects of

II. Global Competitiveness Today

The theme of competitiveness has remained the same; that is lower

domestic costs hence lower the prices of goods. But ways to achieve this
have changed over the years: from a pricing approach, that is the end user
approach, there has been a shift to a costing approach, that is, the firm
micro-level approach.

Competitiveness can be defined as sustainable growth in productivity

that benefits the average person. Today, competitiveness in a global
economy should not be confused with abundance of natural resources or
cheap labor or continued exchange rate depreciations or, for that matter,
protectionist policies to support local industries. Though these bring short
term advantages, they do not facilitate the making of a dynamic economy.
Professor Porter’s model for competitiveness is created by a stable macro
economic, political, legal and social environment and also a continuous yet
proactive stance to improve the micro economic environment in which local
firms are taken to the forefront and strategies are developed to foster an
environment for local competition.

A recent study in the Industrial Development Report attempts to

explain the “drivers” that seem to influence a country’s ability to influence
competitive industrial performance (CIP). Skills measured by the level of
tertiary enrollment in technical subjects, research and development (R&D)
which is financed by productive enterprises, foreign direct investment (FDI)
which includes total FDI investment with no distinction between export-
oriented or domestic-oriented flows in manufacturing, royalties and
technical fees which include fees paid to imported technology, and lastly
modern infrastructure (ICT) by the use of telephone mainlines, are the five

• CIP Score = 27.017 + 0.277 skills + 0. 036 R&D + 0. 009 ICT+

0.021royalties + 0.008 FDI.

The equation shows the drivers that enhance the CIP- competitive
industrial performance index (based on a data base of 51 countries for the
year 2000). A 1% enhancement in skills, namely enrollment in technical
subjects such as science, mathematics, computing, and engineering, will
increase the CIP by 0.3. Not all the drivers are significant. R&D, FDI and
Increasing Global Competitiveness: A Case for the Pakistan Economy 33

royalties achieve consistent significance whereas skills and ICT fail to do so

as skills are highly correlated with R&D. What this confirms is that
technological efforts are positively related to the CIP, which are the bases
for industrial success. FDI driven production and the export of high tech
products affects competitive industrial performance positively. Royalties and
technical fees are also positively related with industrial performance.


Country Rank CIP Index Change in Rank for

(2000) (2000) 1990-2000 1980-1990 1980-2000
Pakistan 49 0.235 -2 6 4
India 40 0.275 -4 2 -2
China 24 0.379 2 3 15

Source: UNIDO scoreboard of core sample database)

Starting with a CIP score of 0.192 (rank 53) in the 1980s to 0.219
(rank 47) in the 1990s to 0.235 (rank 49) in the 2000s, Pakistan has lost
ground mainly due to exogenous shocks, political instability, poor macro
management, policy liberalization and an over reliance on primary products.
China started off with a score of 0.240 (rank 39) in the 1980s to 0.323 (rank
26) in the 1990s to a score of 0.379 (rank 24) in the 2000s showing a
sustained improvement in each decade as there have been rapid rises in
manufactured exports and a significant upgrading of technological structure of
exports. But again policy liberalization has slowed the process of improvement
in China’s global competitiveness. A number of studies conclude that China’s
growth would have been relatively higher had policy liberalization not been
forced on China. India’s performance amounted to a CIP score of .243 (rank
38) in the 1980s to 0.262 (rank 36) in the 1990s to 0.275 (rank 40) in the
2000s showing that it has upgraded its technology structure from a relatively
low level and has a medium share of manufactured goods with a low per
capita export value. The reason for the stagnation of Indian competitiveness
can be attributed to slow medium and high technology (MHT) sector growth
in the1990s which was a result of policy liberalization in the form of increased
advertising budgets at the cost of R&D budgets. The small slip in the index
also implies that the neighbouring country, namely China, has been doing

The World Economic Forum defines competitiveness as a set of

factors, institutions and policies that underline the level of productivity; if one
wants to increase productivity, hence competitiveness, one has to
34 Shamyla Chaudry

make better use of the available resources. The Global Competitiveness Index
(GCI) incorporates nine factors that lead to increased productivity and
competitiveness. The GCI incorporates the concept of stages of development,
attaches different weights to different sub-indices and provides individual
countries with a useful tool to identify the barriers to competitiveness. The
pillars are divided into three broad categories, those being the basic
requirements, efficiency enhancers and innovation and sophistication factors.
These are then further sub-divided into the nine pillars, that is, institutions,
infrastructure, macro economy, health and primary education, higher education
and training, market efficiency (goods, labor, financial), technological readiness,
business sophistication and innovation. Pakistan, India and China are classified
as factor driven economies with a GDP per capita of less than $2000. For such
economies the basic requirement sub-index is the most important as it has the
highest weight attached to it in constructing the GCI. Economies with GDP
per capita ranging from $3000 to $9000 are classified as efficiency driven
economies, whereas countries with GDP per capita greater than $17,000 are
classified as innovation driven economies. Naturally all three categories assign
different weights to the three sub indices. Using the three weights the GCI
has been constructed for Pakistan, India and China.

Weights Pakistan India China

Factor driven 3.66 4.44 4.24
Efficiency driven 3.585 3.56 4.125
Innovation driven 3.594 4.461 4.029
Equal weights 3.629 4.47 4.067

Source: GCI index 2005-2006)

Using different weights we can see that for all the countries the GCI
score deteriorates as we move from factor driven weights to innovation
driven weights and only in the case of equal weights, does India show a
minor improvement of 0.03 where as Pakistan and China both lose ground.
This contradicts the report on the state of Pakistan’s competitiveness that
asserted that by assigning equal weights to the sub-indices Pakistan’s score
could have been relatively higher.

Referring to the Table-III one can see a stark contrast between the
three economies that have been classified as factor driven economies.
Analysis has been provided for such differences. Under the first four pillars
Increasing Global Competitiveness: A Case for the Pakistan Economy 35

which make up the basic requirement category, except for infrastructure,

health and education, Pakistan’s ranking has fallen. The fifth, sixth and
seventh pillars that fall under the efficiency enhancer’s category have shown

Considering the eighth and the ninth pillar that come under
innovative factors, Pakistan has slid under the eighth pillar but has shown
considerable improvement in the ninth pillar. Factor driven economies such
as Pakistan define competition based on factor endowments such as
unskilled labor and natural resources.

Today Pakistan lags behind in all the categories of the GCI index.
Though the figures show an improvement in Pakistan’s rank from 98th to
91st, this does not indicate any improvement but merely the fact that more
countries have been included in the index. Health and education when
compared to India (5.9) and China (6.44) are weak areas for Pakistan (4.79).
Human capital development is the weakest in Pakistan as indicated by the
higher education and training (fifth pillar). Pakistan is a low wage, labor
surplus economy with low productivity. However, firm-level comparisons
suggest that while wages in Pakistan are low by international standards, they
are often significantly higher than those in the Sub-continent. Slow growth
in private investment in the large scale manufacturing sector has dampened
Pakistan’s economic growth. Pakistan has liberalized trade but highly
protected domestic markets have reduced the incentives to exports. Also
high costs and poor functioning of infrastructure are considered to be
harmful impediments for Pakistan’s growth.
36 Shamyla Chaudry

Table-III: Global Competitiveness Indexes: Cross-Country Comparisons

2006 – 2007)

China India Pakistan

Rank Score Rank Score Rank Score
Basic Requirements 44 4.8 60 4.51 93 3.96
Institutions 80 3.51 34 4.55 79 3.51
Infrastructure 60 3.54 62 3.50 67 3.36
Macro economy 6 5.72 88 4.12 86 4.19
Health & Primary Education 55 6.44 93 5.90 108 4.79
Efficiency Enhancers 71 3.66 41 4.32 91 3.27
Higher Education & Training 77 3.68 49 4.35 104 2.82
Market efficiency (goods, labor,
56 4.22 21 5.07 54 4.23
Technological Readiness 75 3.07 55 3.52 89 2.77
Innovation & Sophistication
57 3.75 26 4.60 60 3.66
Business Sophistication 65 4.05 25 5.06 66 4.05
Innovation 46 3.44 26 4.14 60 3.27
Overall Index 54 4.24 43 4.44 91 3.66

(Source: Global Competitiveness Report (2005-2006))

India ranked 43rd overall with excellent scores in the capacity for
innovation and sophistication of firm operations. Firm use of technology
and rates of technology transfer are high, although penetration rates of
the latest technologies are still quite low which reflects India's low levels
of per capita income and high level of poverty. A lack of adequate health
services and education as well as a poor infrastructure are limiting a more
equitable distribution of the benefits of India’s high growth rates. When
comparing the infrastructure pillar, India and China have very close figures
which is highly debatable. Indian governments have been ineffective in
reducing the public sector deficit, which is one of the highest in the
world, and that would seem to cause their rankings to slide in the macro
economy pillar.

China’s ranking has fallen form 48 to 54, characterized by

heterogeneous performance. On the positive side, China’s growth rates
coupled with low inflation, one of the highest savings rate in the world,
and hence investment and manageable levels of public debt have boosted
China’s ranking on the macro economy pillar of the GCI to 6th place.
However, a number of structural weaknesses have arisen, including in the
Increasing Global Competitiveness: A Case for the Pakistan Economy 37

banking sector that is mainly controlled by the State. China has low
penetration rates for the latest technologies (mobile telephones, internet,
personal computers), and secondary and tertiary school enrolment rates
are still relatively low. There has been a drop in the quality of the
institutional environment, a slide in the rankings from 60 to 80 in 2006,
with poor results across all 15 institutional indicators, spanning both
public and private institutions. China has created a much more
competitive environment than India or Pakistan considering the tax
structure, infrastructure, capital costs and labor legislation. China is well
known for the low costs of its workforce and its investment rate which is
one of the highest in the world. China invests enormously in education,
infrastructure and technology, yet people mistake China’s competitiveness
as a result of cheap labor and piracy. China’s competition is felt
particularly in some sectors requiring a great deal of manual labor such as
footwear, textiles and small appliances. But in the next five years China’s
auto industry will pose to be a looming threat for other car manufacturing
industries across the world. In China, local firms are gaining ground over
foreign competitors. These companies are receiving a boost from
government policies that require at lease 70% of new machines to be
made at home in sectors such as energy. Such incentives are likely to
increase its growth.

III. Conclusion and Recommendations

Pakistan started out a poor nation at independence with

dependency on agriculture. The economy has seen ups and downs which
have discouraged Pakistan’s growth. In the 60s there was major investment
in infrastructure, huge sugar mills and textile industries, and import
substitution was implemented. It was at this time that Pakistan was
considered to be an economic player of the Sub–continent. By the 70s
political hurdles dissuaded Pakistan’s progress and the nationalization of
industry brought growth to a stand-still. In the next era of the military
regime there was a heavy inflow of US aid and spending by the public
sector was seen to be on the rise. The next decade, that is the 90s, can
broadly be classified as a decade of lost opportunities with heavy
borrowing both in the public and private sector that has resulted in being
a burden on the economy today. Therefore, today prudence in economic
management is crucial. But the trick that needs to be learned is to find
means to support and accelerate rather than hinder enterprise
development. For global competitiveness today is more reliant on the
micro environment as opposed to the macro environment. A number of
recommendations are being cited here with reference to the two
neighbouring countries that have done better than Pakistan.
38 Shamyla Chaudry

Competitiveness today requires a strong base of human and technological

resources. However, in Pakistan per capita R&D spending is amongst the
lowest. Among the high growth newly industrialized economies, there
have been substantial national variances in the way exports were
promoted. The challenge for Pakistani governments will be to provide
support, not direction, for the private sector. Also Pakistan needs to
establish alliances with countries that have technological capabilities in
sectors operating at lower technological levels. The essence of
competitiveness is to promote in-firm learning, skill development and
technological effort and to coordinate the collective learning process. To
compete, Pakistani enterprises must adopt new technologies and
organizational methods and link themselves to the global value chain.
Coping with new technologies calls for new skills, innovative production
structures, improved infrastructure and institutions. Today,
competitiveness will involve the upgrading of technologies in all activities
building new capabilities and finding new markets and market niches.
Pakistan needs to reevaluate its exports, and even with Pakistan’s cotton
resources and upgrading of textile facilities, will it remain a major player
in textile and apparel market, where Pakistan has lost market share to
countries like China, India, and recently to Bangladesh and Sri Lanka? In
the long run export diversification is necessary. Pakistan’s wage rates are
comparable those of India and China but its export structure is biased
towards low technology products. Therefore, Pakistan’s scores are
relatively low on export sophistication. That means that Pakistan
specializes in the low value added section of the textile industry.
Unfortunately, Pakistan is highly dependent on apparel products that are
considered to be one of the most non dynamic exports; with sliding
market shares and entry from other countries, that makes Pakistan’s
position vulnerable. It also faces competition from China and India who
are investing heavily in new technology, designs and skills which may out-
perform Pakistan. Therefore specializing in textile and clothing is not
recommended in the future. It needs to diversify into other sectors where
it has a competitive edge. Should Pakistan switch its production from low
tech goods to primary products? At this point we are not saying that
Pakistan should never produce high tech products, but build on its
capabilities to develop goods that provide value addition.

What should Pakistan do in the meantime? Recent examples of

exports of various citrus fruit varieties, mangoes, flowers, dairy products and
a number of other such products will provide the diversification needed to
strengthen exports. Also a study conducted by the World Bank indicates the
potential for more trade with India, especially light manufactured products
such as bicycle components and fans. Pakistan has to reevaluate its stance on
Increasing Global Competitiveness: A Case for the Pakistan Economy 39

its medical instruments product categories, one of its most dynamic exports,
where Pakistan has been losing its world market share.

With low ranks in the basic requirements sub-index, Pakistan has to

improve at the macro level so that an environment can be fostered for the
individual firm. Pakistan has to improve in areas of health and primary
education and also improve the higher education and training pillar. The
investment climate, coupled with the uncertain national and regional
situation, has kept foreign direct investment (FDI) inflows less than those of
China. For competitiveness today a country requires adequate infrastructure,
cheap labor and liberal economic policies. Therefore Pakistan requires
export diversification, firm level technological upgrading and the
development of clusters.

However, why are some industries in Pakistan doing well despite a

low competitive rating? Are these the results of some ingenious ways of
doing business? Is the Pakistani entrepreneur really proactive? Further
research needs to be directed in this area. The Business Competitiveness
Index addresses firm level operations and the national business environment
with relatively higher weights given to the latter. Pakistan’s performance has
improved over the years from 77th to 67th place where China stands at
57th and India is currently at 31st place. When these ranks are compared
with other countries in the region, Pakistan has to strive hard to develop
not only a strong national business environment, but also try to capture
firm level ingenuity.

Certain high priority areas have been identified by a study

conducted by the World Bank for accelerating Pakistan’s growth and hence
its global competitiveness. Some of these measures require quick decisions
whereas others require long term efforts. The measures include:

• Strengthening the macroeconomic framework (long term)

• Analyzing electricity pricing and structural issues

• Improving SME’s access to financing

• Serious commitment to human capital development and to increase

the supply of skilled labor (long term)

• Improvements in the efficiency of the duty–drawback and sales tax

rebates systems for new or small exporters and new exporting
40 Shamyla Chaudry

• Improvements in transport and trade logistics (long term)

• Enhancing food and safety standards

Increasing Global Competitiveness: A Case for the Pakistan Economy 41


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Competitiveness: The Challenge for Pakistan”, ADB Institute, Asian
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42 Shamyla Chaudry

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The Lahore Journal of Economics
Special Edition (September 2007)

Monetary and Fiscal Policies

Shahid Kardar*


Though the Pakistani economy had recently achieved some level of

macroeconomic stability, at present there are fears that this stability could be
threatened. This paper looks at monetary and fiscal reforms over the last
decade and focuses on the areas that need to be addressed on both fronts. In
particular, the paper looks at how present monetary policy needs greater
clarity and how fiscal policy needs to focus on raising public savings and
diversifying the sources of borrowing.


With inflation still hovering around 8%-despite the monetary

tightening over the last two years, a fiscal deficit threatening to cross 4.2%
of GDP and the reversal of the current account surplus into a large deficit
that could touch 5.5% of GDP, there are understandably fears that the
macroeconomic stability achieved after a long and hard struggle, with a fair
sprinkling of luck thrown in by the events of 9/11, has been lost. These
macroeconomic imbalances are inducing pressures and new challenges for
sustaining the present healthy rates of economic growth.

At a time when monetary policy was the easiest to handle, thanks to

the surfeit of liquidity and the abundance of cheap money in the financial
system (from donors in the form of aid and from overseas Pakistanis in the
form of remittances), the State Bank did not perform its principal duty of
controlling inflation with distinction. Inflation soared not simply because of
the oil and food price inflation but largely because of a loose monetary
policy5. The State Bank allowed a huge increase in money supply, well above
the rate justified by the expansion in the economy. Resultantly, Pakistan has
the dubious distinction of having the highest inflation rate in this region;
inflation has also been outpacing that of its trading partners and
Former Finance Minister, Government of the Punjab.
See Khan and Schimmelpfennig (2006) and Qayyum (2006).
44 Shahid Kardar

competitors. A good part of the problem of inflation has been fuelled by the
consumption (private and public consumption) and investment boom of
recent years, well beyond the production capacity of the economy (a gap of
almost 4% of the GDP). The widening current account deficit is a classic
sign of overheating and excessive demand build-up as domestic output fails
to keep pace with surging demand facilitated by easier availability of credit,
especially in the form of consumer financing.

The gap between government expenditures and its tax revenues

continues to be close to 7 percentage points of the GDP, the differential
that existed in 1999/2000 with the tax to GDP ratio actually worsening
from 13% of GDP in the early 1990s to under 11%. That some of this gap is
presently being filled by non-tax revenues which are expected to decline as
the more profitable enterprises are privatized, cannot be a source of comfort
for the future in terms of sustainability.

Another worrying feature is the growing savings-investment gap.

This is presently being financed through remittances and non-secure sources
of funding such as FDI (largely as privatization proceeds), external financing
from Eurobonds, GDRs, donors and remittances, which also enabled the
government to keep bank borrowings lower than what they might have
been otherwise. Maintaining this large and widening gap will not be
possible over a longer period.

The scope of this paper is, however, limited to an examination of

monetary and fiscal polices to date and to propose a strategy for the future.

Financial Sector and Monetary Policy Reforms

The key measures that lay at the heart of the financial sector reforms
initiated in the early 1990s included the enhancement of competitiveness in
the banking sector through the privatization of financial institutions (FIs) and
the easing of market entry of new FIs, improvements in their capital adequacy,
reduction in the fragmentation of financial markets through the deregulation
of interest rates on deposits and loans, a partial switch over to indirect
marked-based instruments for monetary management6, the gradual
dismantling of the system of directed and concessional credit schemes,
facilitating the flotation of new securities through legal, policy and other
procedural and regulatory reforms, strengthening the health of the banking

The State Bank continues to buy government paper and use primary auctions for
monetary management.
Monetary and Fiscal Policies 45

system through Prudential Regulations (PRs), and by strengthening the

capability of the SBP to fulfill its functional obligations.

In the realm of monetary policy the benefits of the financial sector

reforms are visible in the development of a somewhat competitive money
market for government paper (reflected in the dealers’ market operating on
narrow spreads between the bid and offer rates)7, and a well functioning
secondary market for treasury bills, while the market for corporate debt,
although thin, presently (owing to the lack of liquidity in the market and
the time it takes to settle transactions) is beginning to show promise.
Success has also been achieved in resource allocation by making lending
based on sound economic and financial criteria, creating more developed
money and capital markets that are mobilizing savings and making them
available to the most efficient users, through appropriate incentive systems
instead of discriminatory direct controls.

However, the bulk of the intermediary functions of the financial

sector and the State Bank of Pakistan’s monetary stabilization efforts are
performed for the government or essentially dictated by the government’s
financing requirements. Even after the grant of autonomy to the State Bank,
its principal activity has been to raise financing for the government. Since
its monetary management is virtually driven by the borrowing needs of the
government, 88% of its Net Domestic Assets (DNA) and 39% of total assets
comprise advances to the government. In fact, in FY06, the SBP claims on
the government increased by more than total government borrowings from
banks-the main factor behind the increase in reserve money. Similarly, the
banks hold close to 40% of their assets in the form of cash with the SBP,
government securities or advances to it for commodity financing. Add to it
the savings in the National Savings Schemes (at Rs. 860 billion, 11% of
GDP) and we get an idea of the scale of the economy’s financial savings
mopped up by the government

Moreover, the direct financing arrangements between the GoP and

the SBP, whereby there is an automatic replenishment of the Government’s
account with the SBP without any limit, by issuing treasury bills, has not
been substantially altered. The SBP appears to be lending money to the
government against securities, which it then offloads in the market.
Although the potential inflationary impact of such government borrowings

Although the rate is being forced through the State bank’s intervention and its statutory
liquidity requirements.
46 Shahid Kardar

becomes sterilized, the legal and practical autonomy of the SBP to apply its
monetary management policies independently is compromised8.

It is also interesting to note that the State Bank’s prudential

regulations with respect to capital adequacy requirements for commercial
banks have also reinforced and strengthened the role of the banks in
holding government securities. All commercial banks are required to
maintain a minimum capital to total risk-weighted assets ratio of 8%9.
Resultantly, along with having to bear the cost of funds for holding
government securities, banks are also required to carry the burden of an
additional charge on their activities, which in turn depends upon the
categories of assets held in accordance with the risk-weights assigned to
each. Presently, the risk weights assumed are zero for investments in
government securities and 100% for practically all categories of loans
including those to the most credit worthy corporations and businesses; even
the balances held with scheduled banks are assigned a risk-weightage of
20%. With this difference in relative capital costs owing to these risk weights,
the manner in which the capital adequacy norms are being applied has also
created an incentive for banks in favor of investments in government
guaranteed securities. In other words, the large sums invested by the banks in
government paper are simply the natural outcome of these policies.

The author is aware that the State Bank is moving towards a

refinement of these norms. However, even if these norms are changed, as
they must be, it does not follow that when the commercial banks reduce
their investment in government securities they will necessarily increase their
loan portfolio at the same pace. As other financial institutions pick up these
securities there would be a flow of household savings to them, resulting in a
shrinking in the deposit base of banks with, perhaps, only a marginal
increase in the total value of loans and advances made by them.

While some indicators, especially those pertaining to the availability

of different products, efficiency and customer satisfaction have improved,
other features depict less than satisfactory development. For instance, the
money (M2) to GDP ratio, which is supposed to signify financial deepening,
has risen by just 4 percentage points, from 40% to 44% between 1985 and

In India there is an agreement between the government and the Reserve bank of India
that there will be no automatic replenishment as a result of which the central bank has
acquired a semblance of independence.
The State Bank also has to sterilize large remittance inflows selling government
securities in the absence of other paper for such activities. Thus the banks end up holding
more government securities than what they would have if they had simply followed the
requirements of the Prudential Regulations.
Monetary and Fiscal Policies 47

2006 (suggesting that a major part of the economy is still non-monetized). It

is not clear how much of this increase can be attributed to the reforms.
Similarly, although deposits as a percentage of GDP have declined from
42.4% in 1997 to under 39% in 2006 this is largely because of the GDP
rebasing effect. In comparison with the ratio for 2002 it has increased by 4
percentage points10.

To eliminate the monetary overhang of the previous six years and to

curb demand, the SBP has been following a tighter monetary policy in the
last two years (only in FY06 was the growth in broad money less than the
nominal growth in the GDP) to curb demand. The banking system which
was flushed with funds provided consumer finance liberally resulting in a
further increase in money supply. This contributed to the fuelling of
inflation (Figure 1)11 and forced the SBP to intervene through open market
operations to squeeze money supply, although it did so with an inordinate
delay. This strong monetary growth reflected largely in the abrupt increase
in private sector credit, has sharply raised the general price level and prices
of assets - land and equities.

Money Supply Growth, Domestic Credit

Growth and Inflation
30.0 12
25.0 10
20.0 8

5.0 4

0.0 2
-5.0 1996- 1997- 1998- 1999- 2000- 2001- 2002- 2003- 2004- 2005- 0
97 98 99 00 01 02 03 04 05 06

MSG DCG Inflation

Figure 1: (right hand axis is for inflation and the left hand axis is for MSG
and DCG)

To curb the stubbornly high inflation through a tighter monetary

policy, the SBP raised the Reserve Requirements of banks from 5% to 7%
The low deposit to GDP ratio also raises questions about the efficiency of the banking
system and the level of transaction costs that could be serving as a disincentive to the use
and growth of the banking sector.
I am grateful to Wasim Shahid of PIDE for preparing all the graphs used in this report.
48 Shahid Kardar

and the Statutory Liquidity Requirement on time and demand liabilities

from 15% to 18% and the discount rate by 50 basis points, which while
achieving the objective of a tighter monetary policy also made government
borrowing cheaper than it might have been otherwise if only the discount
rate had been raised. Presently, however, real interest rates on deposits are
negative (the high rate of inflation keeping them negative) which, following
the recent decision to permit institutions to invest in NSS instruments, is
likely to encourage disintermediation, thereby forcing banks to compete for
deposits by raising rates, especially for the longer tenor ones. Interestingly,
the spread between the average deposit and lending rates continues to be
high, having widened since the huge inflow of remittances and the notable
growth in the economy, reflecting poorly on the efficiency and competitive
environment in the banking sector.

In conclusion, however, it could be argued that in view of some of

the trade-offs there is admittedly a need to strike a delicate balance, but
only in the short-term, between the excessive tightening for demand
management reasons and the momentum in economic growth. However, the
question remains if these should be the concerns of the State Bank or
should it merely focus on controlling monetary growth to restrain inflation,
since empirical research has shown that low and stable inflation is conducive
to economic growth, partly by ensuring that the expected rate of inflation
of the general price level ceases to be a factor in business decisions12.

Lack of Clarity on Objectives of Monetary Policy13

A conundrum is the lack of clarity on the objectives of the present

monetary policy. In the absence of the clarity of signals one should be
excused from assuming that the State Bank is still trying to keep interest
rates low as well as maintain, if not fix, the exchange rate, although basic
economics inform us that you can cannot fix both simultaneously over a
long stretch of time.

In other jurisdictions the performance of the central bank is judged

by its success in controlling inflation. In Pakistan, the State Bank’s previous
leadership stoutly defended its monetary management aimed at pump
priming of the economy resulting in inflation almost reaching double digits.
It justified adopting an accommodating monetary policy that stimulated
economic growth by keeping interest rates lower than the rate of inflation

See Feldstein (1997), Goldstein (1995), and Mishkin (1997).
This section of the paper has benefited enormously from discussions with Dr. Nadeem-
Monetary and Fiscal Policies 49

(especially hurting depositors in the process) and did not use the capital
inflows from abroad to retire expensive debt. The pursuit of this strategy
and a monetary policy that was working at cross purposes, however,
compromised its role as an independent agent mandated to keep inflation in
check through interest rate adjustment.

Loose monetary policy, partly owing to the fiscal dominance in

influencing this policy (see below) has fuelled the rate of inflation as well as
the recent widening of the trade deficit. Simple, well-known, economic
propositions inform us that monetary expansion or contraction leads to an
increase or decrease respectively of aggregate demand which in turn directly
impacts on import demand. In other words, monetary contraction will reduce
overall demand and import demand and facilitate the trimming of the trade
deficit. In most cases monetary tightening does not affect exports since these
normally respond to external demand. Contrary to claims that monetary
contraction will raise interest rates and adversely affect export competitiveness
if monetary tightening lowers the rate of inflation and thereby the cost of
production, exports could actually increase. Therefore, monetary contraction
should be the appropriate policy to reduce the trade deficit.

A contractionary monetary policy that reduces aggregate demand will

tend to depress growth. But this is a price that will have to be paid to
return to macroeconomic stability. However, the likelihood of its
recessionary impact tends to get overstated. Empirical studies have shown
that the interest elasticity of investment and GDP growth may not be that
strong; it is issues such as poor governance, policy uncertainty and slow
structural reforms that pose more fundamental problems. Even the Pakistani
case shows lack of any significant increase in investment despite interest
rates being negative in real terms for a significant period.

Allowing monetary policy to inflate the economy has long-term

consequences as economic actors factor in inflationary expectations into their
actions to address the uncertainty induced by decision makers. The State Bank
has to earn for itself the credibility of a responsible monetary manager, which
it lost through the footloose expansion that it had permitted earlier.

The State Bank can use a combination of interest and exchange rates
to manage aggregate demand. The exchange rate policy facilitates switching
of demand from foreign goods to domestic goods, with an undervaluation
making domestic goods cheaper relative to foreign goods, thereby improving
the external balance.
50 Shahid Kardar

Depreciation will also reduce the domestic cost of production and

have a favorable impact on the trade balance. Hence to deal with a trade
problem, depreciation is always a real policy choice. In any case,
depreciation becomes necessary after a period of monetary expansion.
During a longish period of monetary expansion, domestic inflation grows
at a faster pace than inflation among our trading partners and
competitors. This inflation differential will eventually have to be bridged
by currency depreciation. Of course, a depreciation in the exchange rate
will have an impact on the rate on inflation to the extent of the share of
traded goods in the economy.

The rupee is currently overvalued. The standard, and hackneyed,

argument of policy makers that the price of the rupee is no longer determined
by the government but by the market and since capital inflows, most of which
are non-debt creating in nature (foreign remittances, privatization receipts,
donor grants and direct foreign investment) are largely financing the deficit on
the external trade account, the value of the rupee continues to be steady.
Even if their contention that the market is determining the value of the rupee
were to be accepted, the question is whether allowing foreign exchange
inflows (most of which are non-secure in nature) to keep the value of the
rupee artificially higher (while also requiring monetary management to be
more stringent) than it would be otherwise is a good strategy for the
profitability of our exports, especially considering that our domestic rate of
inflation is significantly higher than that of our trading partners and
competitors. The lowering of the profitability rates and levels in the export
and modern sectors of the economy is acting as a disincentive to invest in
these sectors. Hence the movement into other activities like real estate and
the stock exchanges, and to some extent in manufacturing for the domestic
market in the more protected industries.

If China were to follow this advice, the value of the Yuan would be
appreciating (since it has a huge trade surplus with the rest of the world and
is also experiencing large capital inflows). China, by not choosing to sharply
revalue its currency upwards and maintaining a highly competitive currency,
has not only made it exceedingly difficult for the competitiveness of our
exports, but has also kept profitability and investment high in its exporting
industries. So, who is suffering on account of this reality? If, when we find
our strategy unsustainable (especially when there are no privatization
proceeds to finance part of the trade deficit), we decide to adjust the value
of the rupee, some of our export markets would have been lost, having been
captured by others, and our re-entry in these markets is bound to be
awkward, if not impossible.
Monetary and Fiscal Policies 51

The responsibility of the State Bank is to develop a credible

monetary policy that neither inflates nor deflates the economy. This requires
patient research and handling. Without a credible monetary policy, which
lowers inflationary expectations, we could be supporting a vicious circle of
exchange depreciation and inflation. In other words, a devaluation of the
rupee will also have to be backed by a reasonably tight monetary policy to
deal with a trade deficit/inflation problem.

In general, interest rates move slowly in response to changes in

liquidity. According to the SBP Annual Review of the Economy, 2005/6
recent research on transmission lags suggests that monetary tightening
impacts significantly on inflationary pressures over a 28 month period. If
interest rates are to become a policy variable then the government should
become neutral to them. And it will become neutral only if it reduces its
borrowings considerably. This means that the fiscal deficit must come down
for credit markets to function smoothly.

Fiscal Policy

As mentioned above in the introduction, the overall fiscal deficit has

been rising14 (Figure 2). This expansionary fiscal stance of the government,
given weak domestic resource mobilization, has not been consistent with
the SBP’s tight demand management posture and has induced risks through
the stoking of inflationary pressures and the stress it brings to bear on
interest rates for managing demand. The degree of impact also depends
upon the manner in which the government finances its fiscal deficit - its
present monetization through heavy borrowings from the SBP directly
rather than from the financial system.

However, to give the government its due, part of the borrowing was prompted by the
expenditure requirements for earthquake relief and rehabilitation operations, which have
contributed just under 1% of the GDP to the fiscal deficit
52 Shahid Kardar

Fiscal Deficit as a percent of GDP



19 1

19 2

19 3

19 4

19 5

19 6

19 7

19 8

19 9

20 0

20 1

20 2

20 3

20 4

20 5
































Figure 2:

In my view there has been an overemphasis on the revenue side of

the equation and little has been said or examined about the level and
efficiency of government expenditures, with good governance associated
with transparency and accountability as the key drivers for improving the
productivity and efficiency of government expenditures.

There have been no significant reforms in government spending and

a huge problem lies unaddressed on the expenditure side. It is a big black
hole and a great deal of adjustment needs to be made both in terms of the
structure and the efficiency of public expenditures, particularly with respect
to defence related expenditures; while absorbing a third of government
revenues15, they are characterized by complete lack of transparency (it being
reflected as a single line item in the budget). Despite our nuclear deterrent
and the peace overtures to India there is no let up on defence expenditures.
The current strategy is seemingly adamant that defence policy and its
effectiveness cannot be compromised, whatever the costs. Confronted with
such a hypothesis, it is difficult to have a meaningful debate even when our
distorted priorities have resulted in 6 soldiers per doctor and 1 teacher for
every soldier.

The expenditure is higher because military pensions, which are in excess of Rs. 30
billion per annum, are under civilian pensions, and expenditure supported by US military
aid of more than US $700 million per annum for the fight against terrorism has also not
been factored in.
Monetary and Fiscal Policies 53

The composition of public expenditure has also become unbalanced

because of inflexible expenditure commitments. Resultantly, much of the
fiscal space created by the recent rescheduling and re-profiling of debt has
been absorbed by the rigidities in non-development expenditures –
particularly salaries of a bloated civil service with few relevant skills required
to manage a modern economy in a highly globalized world.

This author is of the opinion that there is a need to downsize the

government by means of its steady withdrawal, especially that of the
federal government, from many of the functional responsibilities that it
has taken upon itself. The functions so relinquished should either be
organized by the private sector or should be hived off to lower formations
of government by reducing the multiplicity of agencies engaged in similar
activities. In particular, the government continues to devote a
disproportionate share of its resources to activities that would be more
efficiently provided by the private sector. All this, combined with endemic
governance issues, has resulted in accumulated losses of public sector
enterprises crossing Rs. 250 billion with an annual addition in excess of
1% of GDP16. Although some public sector enterprises and the CBR have
been performing relatively better than other public sector entities, the
woes of PIA, WAPDA, Railways, KESC (even after privatization based on
written agreements with the private owner and operator) etc. continue to
dog the contribution of the public sector to national savings, which are
adding to the rapid growth in the quasi-fiscal deficit. In other words,
there are hidden deficits because of losses of public sector enterprises that
have not been accounted for in the fiscal deficit. Such “creative
accounting” has resulted in lower fiscal deficits. The fiscal deficit would
also be higher if the desirable amounts of funding were to be made
available for improving service delivery in the social sectors.

Another persistent issue concerns the low efficiency of public sector

expenditures in terms of the higher costs per unit of public sector
construction projects because of corruption, poor competence of the
government and other leakages. There is evidence that it would cost the
government at least 50% less to fund schooling through privately managed
institutions (and that too of better quality) instead of delivering education
through the publicly run schools.17

These are estimates obtained from various reliable sources since the government does
not report the financial results of public sector corporations regularly reflecting poorly on
its claims of transparency.
The Punjab Education Foundation is funding private schools by providing Rs.300 per
child enrolled (compared with more than Rs. 450 per child per month that it costs the
54 Shahid Kardar

To check the growth in the fiscal deficit and the level of debt, the
GoP has adopted legal ceilings (as a percentage of GDP) for advances to the
government through the Fiscal Responsibility and Debt Limitation Act.
However, the legislation aimed at reducing the fiscal deficit has several
weaknesses. Some of these are discussed below.

Whereas it proposes to pare the deficit on the revenue account, such

a reduction and the lowering of the debt to GDP ratio could be achieved by
different compositions of budgetary expenditures with sharply different
outcomes. For instance, the same level of revenue deficit can be realized by
cutting back much needed expenditure on the repairs and maintenance of
installed infrastructure (as is happening in Sindh which claims that its
overdraft with the State Bank has turned into a positive cash balance). This
lowering of expenditure, and the resulting deferred maintenance, would
eventually get reflected as development projects in future years- a strategy
that successive governments have been guilty of adopting in the past. Such
an outcome, obviously, cannot be the objective of the proposed enactment.

While the government has been able to lower the debt to GDP ratio
to 60%, a target set for 2013 under the Fiscal Responsibility Act, and has
also succeeded in sharply bringing down the ratio of interest payments to
GDP from 6.9% in FY00 to just over 3% in FY06, the reduction can be
achieved by the government cutting back on priority investment
expenditures and on social safety nets (as is the case today, being barely
0.3% of the GDP) rather than raise taxes or rationalize user charges (as has
been happening in recent years), with all its implications for economic
activity in general. There would be little economic justification for
restructuring government investment that could have a high social return,
since there are externalities of some investments that need not contribute
directly to government revenues.

Furthermore, although the stock of debt to GDP ratio has fallen

dramatically, the debt profile has not improved to the extent that it should
have, given that the financial system was flushed with funds, suggesting that
the Federal Government has managed its debt poorly. When it could have
borrowed long at low interest rates, for a while it stopped issuing 7 to 10
year Pakistan Investment Bonds. It chose instead to offload 6 month T-bills
at 2% or so when inflation had begun to climb and there was every sign
that the interest rate structure would change and rates would rise sharply.

government to educate a child in a government run institution) and running half-yearly

quality assurance tests to ensure that assisted schools are providing a minimum
acceptable level of education in terms of student learning outcomes.
Monetary and Fiscal Policies 55

This flawed strategy cost the government and the tax payers dearly as the
debt profile became skewed in favor of short-term debt. The opportunity
cost of this poor financial management has been massive – it could be as
much as Rs.100 billion over the next 10 years. While the government
would, and should, have raised more long-term relatively cheap debt, it took
the bizarre decision to discontinue issuing bonds of longer term maturities
and relied more on short-term bonds18.

Moreover, there is also a need to distinguish between the structural

and cyclical components of the deficit, a need to improve the cost
effectiveness of government expenditures and to raise the tax to GDP ratio
over time. Without a stipulation separating the structural from the cyclical
components of a deficit, the present government would not have been able
to undertake the kind of capital restructuring of KESC, WAPDA and PIA
that have been, or will be, forced upon it, which, in the past pushed the
fiscal deficit beyond the targeted level.

Treasury bills and other government bonds held by the State Bank
essentially serve the purposes of a monetary policy. This holding may
increase or decrease based on open market operations conducted by the
SBP19. Since one of the implicit aims of the proposed legislation is to
grant greater independence to the SBP to conduct its monetary policy,
then the SBP’s holdings of such government securities should be excluded
from the purview of this legislation. This is because these bonds would
not, in the true sense of the term, constitute a part of the government’s
debt, since the SBP is in itself a part of the government and if a
consolidated balance sheet were to be prepared, this debt would be
cancelled as a contra item. This writer would, therefore, propose that, in
keeping with the spirit of the Act, only that part of government debt held
by households, companies, and financial intermediaries/institutions should
be regarded as public debt, since the servicing of only this debt would
generate a flow of funds (in the form of payments) from the government
to the private sector of the economy.

Revenue Mobilization and Taxation Structure

As a result of poor monetary and debt management a huge opportunity has also been
lost to develop a market for low cost housing finance, hitting the less affluent segments
of society, already suffering from the ravages of inflation, even more.
Ideally this legislation should also prevent the government (on the basis of a phased
program) from accessing the SBP for financing. Under the latter arrangement, the SBP
would only function as an agent of the government in financial markets.
56 Shahid Kardar

Largely owing to the recent rebasing of Pakistan’s national income,

the inclusion of new sectors to reflect the changing structure of the
economy and the revision in the contribution of some sectors to this
emerging pattern, Pakistan’s revenue performance now seems to be out of
line with the tax efforts of other countries with similar per capita GDPs. An
IMF cross-country comparison shows that:

a) Pakistan’s revenues from taxation are still hovering at under 11% of

GDP (Figure 3), the lowest among regional countries, being at least
2 percentage points lower than the average for its South Asian
counterparts Bangladesh, India, Nepal and Sri Lanka; and

b) The tax to GDP ratios of other comparator economies (such as

Bolivia, Egypt, Indonesia, etc.) is 7 to 8 percentage points higher.

Total Tax as a percent of GDP

11.5 11.4

11.0 10.8 10.8 10.8 10.8
10.6 10.6































Figure 3:

A positive feature has been the reduced reliance on revenues from

the taxation of foreign trade. However, since customs duty reductions to
improve efficiency in production and trade were introduced at a rate faster
than the corresponding reforms in GST and direct income tax, there was a
loss of revenues as increased revenue from reforms in GST and direct taxes
did not materialize at the projected pace. Resultantly, so far we have a
narrow and concentrated tax base, almost half of the tax revenues are
contributed by imports, and domestic taxes to GDP ratio continue to be
below 5%. Even in the latter case just 6 items, particularly
telecommunications, fuel and energy, motor vehicles and iron and steel,
account for more than half of indirect tax collection.
Monetary and Fiscal Policies 57

While tax revenues have increased sharply in rupee terms in recent

years, this growth has barely kept pace with the growth in the economy.
The tax to GDP ratio has remained flat, if not having declined, partly
because of continued tax reliefs (e.g of agriculture from income tax and of
freight and services such as railway fares, professionals - lawyers, doctors,
accountants, architects, engineers and tax and other consultants - from
GST) and additional exemptions. The buoyancy in tax revenues has been
substandard20, reflecting on the tax structure riddled with exemptions and
administrative weaknesses in the collection machinery and compliance
systems and procedures- the latter partly owing to express government
policy to reduce the cost of doing business. In my opinion, the
mobilization of tax revenues is also difficult because of the lack of faith of
people that the government will honor its social contract to deliver basic
services and utilize resources judiciously and prudently following generally
accepted principles of propriety (as should be expected from a trustee of
public funds) and not used to finance luxuries and junkets of the rulers
and their cronies.

However, despite the narrow base, one key factor underlying the
high cost of doing business in Pakistan is the system of taxes. Not only is
the system characterized by both multiple taxation and agencies (e.g. GST
on Services, professional tax by provinces and professional fees by district
governments) and high rates of corporate and, until recently, personal
income taxes, taxpayers have to contend with complex rules, procedures and
mechanisms employed to implement tax policies, although much has
improved since the institution of the new tax laws and the introduction of a
universal self-assessment scheme.

As mentioned above, although we have a lower tax to GDP ratio,

our income tax rates are, at 35%, higher than those of comparator countries
and some OECD and ASEAN countries- where they range from 20% to 30%
(although personal income tax rates are higher in Europe), indicating the
need to broaden the narrow tax base by eliminating exemptions, lowering
some of the tax rates and related charges (e.g. commercialization rates) and
revising the tariff structures, and ensuring better documentation of
transactions and improving administrative efficiencies. As illustrations of
tariff structure revisions, we need to withdraw the exemption for capital
gains on the trading of shares of listed companies21, extend the scope of
According to the SBP, although the tax buoyancy has improved from 0.8% in FY05 to
1.2% in FY06 it is still low compared with the average of 1.33% for other economies in
the region.
Just in the last 2 years, the stock market index has jumped from around 6,000 to over
11,000 this month (April/May 2007) with market capitalization shooting up from Rs.1.7
58 Shahid Kardar

GST on services22, make rental income taxable in the same way as income
from other sources23, consider taxing gifts and introducing an inheritance
tax and lowering the high import tariffs to protect the assemblers of motor
cars and motorcycles which results in these enterprises collecting, as
corporate profits, what would have been tax revenues.

Moreover, countries with tax to GDP ratios of 20% and above,

unlike Pakistan, run and manage social welfare systems for their populations;
the mismatch is stark in the visible returns that developed societies and
citizens obtain from the state on the taxes they pay.

Thirdly is the issue of multiple taxes, which raises the effective rate
of tax even further. For instance, the manufacturing sector pays an
additional 5% tax on profit as a contribution to the Workers Profit
Participation Fund, a 2% tax on account of Workers Welfare Fund, a 5%
levy on the wage bill for EOBI, a 7% levy for social security, one month’s
salary as bonus for workers, excise duty (in the case of some industries), an
Education Cess of Rs.100 per worker, a provincial professional tax and a
district government professional fee over and above the GST on its

Furthermore, bonus shares/stock dividends and realized capital gains

from trading in shares, debt instruments and property related transactions
(unless these represent business income) continue to be exempt from tax,
discouraging investment in the productive and real sectors all of which are
taxable. This discriminatory fiscal treatment creates distortions by
introducing a bias in favor of investment in certain instruments and sectors.

Therefore, the existing structure should be replaced with one that

has lower rates - at most 30% for the corporate sector - but with very few

trillion to Rs.3 trillion indicating that a capital gain of more than a trillion rupees
accruing to holders of listed shares escaped taxation because of a specific tax exemption
for capital gains arising from trading in listed securities.
Under the Constitution, the GST on Services is a provincial subject and the Federal
Government is reluctant to extend the scope of this tax to include in its ambit powerful
lobbies like lawyers and other professionals and take political flak for no return, as the
entire proceeds, except for a 2% percent collection charge would go to the provinces. To
improve the incentive for the Federal Government to levy this tax which could contribute
significantly to revenues (since services now have the largest share in the GDP) it is time
to amend the Constitution accordingly so that the GST on Services becomes a part of the
divisible pool to be shared in the same ratio as other taxes under the NFC Award.
A withholding tax at 5% represents full and final settlement of the tax liability from
rental income instead of it being treated as a tax credit in determining the gross taxable
income and accordingly the tax liability of the taxpayer.
Monetary and Fiscal Policies 59

exceptions (to check discretion), remembering that the principle of

horizontal equity is violated through both exemptions and defective
definitions of ‘taxable income’. To this end, therefore, the personal income
tax structure can be further simplified by having just a handful of rates
(ideally just two as proposed by the Kelkar Commission in India) to
minimize the impact of ‘bracket creep’ as tax payers enter higher marginal
tax brackets because of the inflationary increase in incomes (unless the tax
slabs are also indexed). The structure should link the progression in tax
rates with the standard exemption limit of income, which should be fixed at
a level that would ensure a balance being struck between revenue
considerations and the capability of the administrative machinery to exploit
the full potential of the revenue base. Personal income tax should,
therefore, be built around at most three rates (compared with more than 15
slabs today) with a higher exemption threshold, while ensuring that all
realized capital gains and receipts as wages and salaries, benefits in kind
(perquisites), interests, dividends, income from agricultural activities and
rent earned on property form part of the base to be taxed.

In the budget for this year (FY07), the rates of income tax were
reduced after the inclusion of perquisites in calculating taxable income.
While it was a step in the right direction, the main beneficiaries are again
the higher paid executives. Their tax liabilities have actually declined
substantially, by as much as 23%, from the tax reliefs announced, since
under the existing tax regime limits on the tax exemptions on salary related
allowances were already operational and hence being taxed.

There is also a need for more effective audit systems rather than
dependence on voluntary compliance, in view of the high degree of tax
evasion, corruption and filing of fake claims for GST refunds in the country.

Through taxation, the state reduces the spending capacity of its

citizens. Therefore, any effort to raise tax revenues evokes criticism and
protest, even resistance. What is less important is the inherent merit of any
proposal. It is its voter, and media, acceptability which carries more weight,
since tax reform cannot benefit all citizens. The more vocal the losers the
less likely will it be for a proposal to be accepted unless the overall package
distributes the burden fairly and equitably. The government has lost much
of the moral high ground for simplifying the system because of its failure to
understand the imperatives of the political economy of tax reform. A good
example of the weakness in the strategy is the decision to continue to treat
government employees as a special group. The tax exemption that they
continue to enjoy on their allowances results in the loss of moral legitimacy
of the underlying conceptual framework to correct the distortions and the
60 Shahid Kardar

potential for abuse (their perquisites being exempted from tax on the plea
that their salaries were not market driven). This matter should either be
treated separately or the decision not to tax the perquisites of government
employees should be explained in a more transparent manner. A better
policy would be to monetize the entitlement of government employees to
perquisites and benefits.

Since the rules for allowing tax deductions for certain expenses are
much more stringent when it comes to salary incomes than for incomes
from other sources, especially with regard to verification issues, a better
alternative is to raise the standard/threshold income to be exempted from
taxation. There is also a desperate need to bring some conceptual clarity
between the deductions or exemptions that would be allowed for reasons of
horizontal equity or would be treated as critical components of an incentive
framework. An example of the latter case would be the deduction for
medical insurance or medical treatment. These contributions should
continue to be allowed since it is a cost of being healthy and fit so as to be
able to earn – i.e., a cost to earn or to maintain human capital. Medical
expenses are permitted up to certain specified limits in Italy, Japan,
Netherlands, USA and Malaysia.

Moreover, much more needs to be done to enhance transparency

and reduce taxpayer compliance costs by making judgments of income tax
tribunals and higher courts more freely available on the internet, thereby
reducing the role of the intermediaries, tax practitioners, who charge clients
for what should be public information.

Moving on to another major revenue instrument, the customs/

import tariff, its structure remains complex and unwieldy even after several
efforts to reform it since 1991. In almost every chapter there are multiple
rates, several exemptions and several conditions and lists spread over
hundred of pages of the book on tariff code/customs valuation. Then there
are sector-specific or use-based exemptions, for which to avail of, necessitate
queries of appraisers for literature and certificates, thereby not just
providing an opportunity for exercising discretion but also slowing down the
clearance of goods.

On the face of it, the division of all goods into three categories (raw
materials, intermediate and finished goods) that has been made for
developing the customs tariff looks good in theory. It is, however, difficult
to implement in practice. The concept that raw materials should be liable
for a lower rate is impossible to implement practically since a large
proportion of goods, e.g., chemicals, are both finished goods as well as raw
Monetary and Fiscal Policies 61

materials. A similar problem arises when it comes to identifying

intermediate goods that supposedly attract a lower rate than finished goods.
In addition to the problem of dual use, it is also difficult to draw a line
between the final, finished, consumer good and its sub-assemblies. A better
alternative would be One – Chapter One – rate that would address
considerations of revenue, the need for giving only reasonable protection24
to domestic industry and the need for simplification.

A few easily identifiable consumer goods such as air conditioners,

expensive motor car brands, tobacco, liquor, generally viewed as goods for
conspicuous consumption, could also be identified separately and made
liable for a higher rate.

The import duty exemptions should be phased out quickly. Unless

exemptions are withdrawn it will be difficult to achieve the objectives of
simplification and the speedy clearance of imports. Only life-saving goods,
goods of strategic interest and security or those for charitable purposes or
those satisfying international obligations should be exempt from import
duties. Otherwise, relief should be granted as a support through a budgetary
allocation. This will have the added advantage of being transparent, being
open and subject to parliamentary and public scrutiny. However, the free
flow of goods should be permitted, with a focus on intelligence gathering
and valuation checks to deter import duty evasion.

Finally, lest we forget, a computerized system of customs valuation

can be user-friendly only when the tariff is computer-friendly. Automation
alone cannot improve matters unless the tariff structures are decongested of
numerous exemptions, conditions and lists.

Admittedly however, the reality is that there are no quick fixes.

Exercises to simplify tax laws and ensure effective enforcement can take
several years, as the experience of even developed countries shows – for
instance, it took Canada 10 years to implement the proposals of the Carter


The primary objective of the State Bank should be the maintenance

of price stability as a major policy contribution to sustained economic
growth. Hence, tighter monetary and fiscal policies (especially since the

Rather than the high levels of protection provided to assemblers of motorcycles and
motor cars that enable them to pocket, as private profits, what would have been tax
revenues from a more rational import tariff structure.
62 Shahid Kardar

primary surplus of 1.7% of GDP in FY04 has become a deficit of around

0.5% of GDP in FY06) will be required over the medium-term. However,
the domestic and external debt situation, despite the high debt to revenue
and debt to export ratios (essentially because of low revenues and exports),
will remain favorable, as will the interest rate and exchange rate risk (again
despite the rupee being overvalued, by 10% according to the IMF and
around 18% by the World Bank compared with the official admission of a
misalignment by only 2-4%). The State Bank should clearly spell out its
monetary policy and related objectives today to achieve its inflation target of
around 5% over the next 8-12 months.

There is a need to not only to raise public savings through higher

revenues and better expenditure control, there is also a need to diversify
sources of borrowing, in particular, as argued above, to improve the mix of
short-term and long-term borrowings. Moreover, unfortunately even when it
decided to resort to long-term non-bank borrowings, the government chose
to do so through NSS instruments by allowing institutional investors to opt
for NSS, reversing an earlier decision that had closed this option for them.
This has adversely affected the development of a capital market for long-
term debt, critically required to evolve a robust housing finance system and
draw private sector investment into long gestation infrastructure projects.

In conclusion I would like to emphasize that apart from

macroeconomic stability, governance mechanisms, institutions and the
institutional environment such as the rule of law, societal norms and values,
work ethics, enforcement and related costs of property and contractual
rights are important for facilitating economic growth and influencing
economic efficiency.

Ratio to GDP FY02 FY06

Investment 16.8% 20%

National savings 18.6% 16.1%
Domestic Savings 17.0% 14.7%
Monetary and Fiscal Policies 63

Tax Revenues 10.9 10.5

Total Revenues 14.2 14
Expenditure 18.5 18.2
Development Expenditure 2.9 4.2
Current Expenditure 15.9 13.6
Overall Deficit 4.3 4.2

Growth % FY02 FY03 FY04 FY05 FY06

Monetary (M2) 15.4 18.0 19.6 19.3 15.2

Private Credit 4.8 18.9 29.8 34.4 23.5

Sources: IMF, December 2006 and State Bank Annual Report, 2005/06

Growth in Money Supply and Domestic Credit



































64 Shahid Kardar

Total Revenue as percent of GDP

5.0 4.8

4.5 4.1 4.1

3.5 3.1 3.2
3.0 13.0
996-97 997-98 998-99 999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06
Monetary and Fiscal Policies 65


Feldstein, M, 1997. “The Cost and Benefits of Going from Low Inflation to
Price Stability,” National Bureau of Economic Research paper 5469.

Goldstein, M., 1995. “Acquiring and Maintaining Credibility for Low

inflation, The US Experience”, in L. Leiderman and Lars Svenensson
(ed.) “Inflation Targets”, Centre for Economic Policy Research,

Khan, Mohsin and Schimmelpfennig, Alex, 2006. Pakistan Development

Review, 45(2): 185-202.

Mishkin, F., 1997. “Strategies for Controlling Inflation,” in P. Lowe (ed.),

“Monetary Policy Inflation Targeting,” Proceedings of a Conference,
Reserve Bank of Australia, Sydney.

Qayyum, Abdul, 2006. “Money, Inflation and Growth in Pakistan,” Pakistan

Development Review, 45(2): 203-212.

State Bank of Pakistan, 2006. State Bank Annual Report, 2005/06.

The Lahore Journal of Economics
Special Edition (September 2007)

Pakistan Financial System - The Post-Reform Era

Maintaining Stability and Growth

Shakil Faruqi*


The financial system of Pakistan has undergone a sea-change owing

to reforms which were implemented over a period of a decade and a half,
1992-2006. The financial system has moved towards promoting the
efficiency of financial intermediation while maintaining stability and
fostering growth of the economy. Financial repression of the previous
decades has receded though it has not been eliminated. Now a shift is
warranted for the reform and restructuring of sectoral or sub-sectoral finance
which has to be activity based, not institution based. Pakistan’s financial
system has entered the post-reform era with all its potentials, complexities
and challenges. How well the financial system performs in this era depends
on how sustainable the financial regime is and how resilient it is in coping
with change and financial shocks, both domestic and global. 
I. Leading Concerns

The financial system of Pakistan has undergone a sea-change owing

to reforms that were initiated in the early 1990s rather gingerly, but
subsequently gathered momentum, culminating in accelerated change in the
structure of the financial system and a revamping of the policy and incentive
regime that governed its operations. The reform era lasted for nearly a
decade and a half, 1992-2006. A great deal has been accomplished during
this period as summarized in this paper. There has been a paradigm shift in
the financial policy regime that prevailed prior to the reform era and also
during the early 1990s. These achievements have occurred amidst powerful
economic and financial constraints that have persisted for many years and
unprecedented events that have occurred in-between, both domestic and
foreign. The financial system has moved towards promoting the efficiency of
financial intermediation while maintaining stability and fostering growth of
the economy. It is an enviable record of accomplishments by any standard.

Professor, The Lahore School of Economics, Lahore.
68 Shakil Faruqi

Currently, the financial system in its structure, functions and policy

regime that governs it is drastically different from what it was a decade ago.
With deregulation of the financial regime, financial repression of the
previous decades has receded though it has not been eliminated. Purely
solvency concerns that dominated much of the 1990s have yielded to
concerns of efficiency of financial intermediation and stability of the
financial system in the background of a structural shift as well as operational
shift discussed below.

A Shift of Focus

In this sense, the task of macro financial reforms is over, almost, but
the task of financial system development is not over and this phase will be no
less demanding than the previous phase. Therefore, now a shift is warranted
to reforms and restructuring of sectoral or sub-sectoral finance which has to
be activity based not institution based. Front line reforms have been the
centre of attention of policy makers in the past. The focus now has to be on
financial system development under the reformed policy regime and new rules
of the game in an environment vastly different from what prevailed before.
This shift in focus is also needed because Pakistan’s financial system has
entered the post-reform era with all its potentials, complexities and
challenges. How well the financial system performs in this era depends on how
sustainable the financial regime is and how resilient it is in coping with
change and financial shocks, both domestic and global; and how good and
forward looking is the management of the financial system.

There are two powerful implications concerning the functions and the
operations of the financial system. One has to do with the efficiency of
transfer of financial resources between suppliers and users within the
economy. How well this transfer occurs and on what terms and how efficiently
it is performed by the financial system is of immense significance to everyone,
be they households, large corporate or small and medium size businesses, or
the government and its entities. The second set of implications concern a
distorted distribution of resources between various segments of the society
resulting from the operations of the financial system, thereby aggravating
income distribution patterns that are already stacked against the poorer
segments of the society. The mechanisms of resource transfer by themselves
are not neutral to the social implications of the transfer.

Challenges in the Post Reform Era – Stability and Solvency

In managing the financial system during the post-reform era, the

main challenge will be that of maintaining stability and sustaining high
The Post-Reform Era Maintaining Stability and Growth 69

levels of economic growth both over the short run and the long run and
sustaining solvency. Short term stability is to be interpreted rather broadly
to mean both financial system stability as well as economic stability though
both are intrinsically intertwined. Financial system stability encompasses a
viable, market-based interest rate structure free of volatile movements,
strength and resilience of financial institutions to withstand market swings
and external shocks, and stable financial markets free of asset bubbles and
gyrations in share prices. Economic stability is largely interpreted as price
stability with acceptable levels of inflation, in addition to interest rate and
exchange rate stability. It is difficult to argue which one of these is more
important and peg the sequencing of corrective actions, though clearly it is
difficult to think of economic stability in the face of unstable money and
capital markets, or in the face of widespread distress among financial
institutions, or both.

Generally, stability of the financial system is largely understood as

stability of the banking system only, and seldom does it cross over to concerns
of stability of financial markets. Perhaps one of the reasons is that while
something can be done to maintain stability of the banking system, and to
some extent stability of money and short term debt markets, hardly anything
can be done to ensure that capital markets remain stable beyond creating the
necessary conditions with routine monetary management, if that.

This is true of nearly all countries across the spectrum, not just
developing countries. Monetary authorities find themselves saddled with
their mainline responsibilities, and stay away from encroaching upon the
operations of capital markets, known to be notoriously fickle and having a
mind-set of their own. Further, with all the information flow, their
analytical and predictive capabilities, computing prowess for risk and
returns, sophisticated derivatives and hedge instruments, capital market
participants everywhere find themselves upstaged time and again with large
equity price corrections, exploding bubbles, and massive portfolio value
losses. They have yet to discover ways to simply foresee market trends,
much less devise ways to ensure stability.

The comparative experience demonstrates that in the post-reform

era, among newly opened and liberalized financial systems with enhanced
exposure to market-based forces, both domestic and foreign, sooner or later
both the banking system and financial markets have faced the onset of
instabilities that eventually degenerated into financial crises with a rapidity
and severity that surprised everyone. The history of the past three decades
of the post-reform era among many developing countries that have gone
through reform processes, is replete with banking crises or foreign liquidity
70 Shakil Faruqi

crises, or both. The resolution costs of these crises have been

unprecedented in the annals of financial systems. However, this is not to
suggest that Pakistan’s financial system is ripe for a similar crisis.

Are Reforms Reversible?

Ordinarily, this would be a moot question, but in the light of

historical processes, one can not be so sure. It is possible though unlikely. It
is possible because there is a history of system reversals and grand reversals
of unprecedented scale in Pakistan. In the 1970s, the government was
nationalizing financial institutions including the State Bank of Pakistan
(SBP), and ruthlessly rooting out every vestige of private corporation down
to puny rice husking and cotton ginning shacks in remote rural areas in the
name of socialism. Nearly three decades later, private corporations are being
lionized and now the expectation is that they will conduct their business as
per international norms of transparency and corporate governance. There
remains a sense of uncertainty with investment and business decisions and
there is not much commitment to enduring change.

Reversal is unlikely and does not seem to be in the cards given what
has transpired and what has been accomplished thus far. It is difficult to
think of a return to state intervention and ownership; control and allocation
of financial resources that held sway up until the end of 1990s; or that the
openness of foreign finance with increasing global linkages will be
smothered; or that the structure and apparatus of market-based finance
together with a regulatory and supervisory framework and its infrastructure
created with such great efforts, will all be bundled up. Yet, an ominous
development is the transplanting of centuries old and obsolete modes of
finance, reminiscent of barter trade, amidst a modernized system of finance
and heralding this as progress. Only time well tell.

II. Banking System and NBFIs--Evolving Structure in the Post Reform Era

There have been significant structural changes at the system level in

ownership, organization and operations of the banking system and Non-
Bank Financial Institutions (NBFIs) such that the current system hardly bears
resemblance to what it was nearly a decade ago. This happened primarily
due to deregulation and restructuring not only of the financial system but
also of the leading sectors of the economy, restructuring of public sector
enterprises (PSEs), the rationalization of prices, interest rates and the
exchange rate, and opening up of foreign trade and capital accounts.
The Post-Reform Era Maintaining Stability and Growth 71

At the system level, changes in the structure of the financial system

occurred mainly due to the privatization of financial institutions as reflected
in the asset holdings of the public and private sectors over the CY90-05
period; the entry of new commercial banks, both domestic and foreign, new
micro-finance banks, and Islamic finance institutions. Simultaneously,
reforms and restructuring occurred among the clients of the banking
system, mostly PSEs, which facilitated changes in the financial system.
Changes in the operations occurred due to the revamping of the policy and
regulatory regime governing financial intermediation and deregulation. The
directed credit system that prevailed until the mid-1990s with layered
allocative targets for specific sectors, sub-sectors or priority categories has
been replaced by a market based credit system, and the role of DFIs and
specialized financial institutions has been greatly reduced. The interest rate
structure and foreign exchange regimes have been liberalized and are
market-based, more or less.

Privatization and Deregulation

The dimensions of structural transformation owing to privatization

can be gauged from changes in the ownership structure of assets together
with changes in the patterns of financial intermediation and the
participation of public and private sector financial institutions. At the system
level, in CY90 the share of assets owned by public sector institutions, both
banks and NBFIs in the total financial system assets was about 80%, and it
dropped dramatically to about 26% in CY06. The converse holds true for
the share of the ownership of private sector banks and private NBFIs over
these years. Since the banking system is predominant in the financial
system, this shift in the ownership structure was slightly more pronounced,
but closely followed this pattern of change.

While the structure of asset ownership thus shifted towards the

private sector, the share of the public sector in the use of total financial
resources mobilized in the country did not decrease, and this is not
reflected by the share of the public sector in banking credit or banking
assets alone. The reason is that nearly half of the annual flows of financial
resources – the annual flows of financial savings, are being channeled to the
public sector. This is being done through public sector borrowings from the
financial system, NSS operations which are outside of the banking system
but are a part of financial system flows, currency seignorage, and the
inflation tax through their own modalities and mechanisms. Consequently,
the public sector is still able to garner a hefty share of total financial
resources generated in the country through the operations of the financial
72 Shakil Faruqi

system. The crowding out of the private sector has been mitigated, but only
in banking credit, not for resources at the macro financial level.

Privatization, by itself, cannot be successful unless it is accompanied

by major initiatives that have to be undertaken in parallel as part and parcel
of the financial system reforms. The most important is deregulation
involving the elimination of the system of directed credit to market based
credit and liberalization of the interest rate and exchange rate regimes as
happened in Pakistan during the reform period. To ensure that privatization
succeeds, the government undertook the restructuring of financial
institutions prior to their privatization, underwrote the massive costs of
their restructuring embedded in asset revaluation and employee severance;
cleaned up the balance sheet of the dead weight of non-performing loans
and other assets of dubious value through massive loan write-offs and
provisioning for the NPLs. The government also had to undertake legal
reforms, enact new laws or modify the existing laws of exit and entry.

In the glow of the deregulated environment, there is a swing to the

other extreme, where deregulation is being interpreted by some bankers as
a state of free-for-all. This has made the task of the SBP more difficult. If
anything, a deregulated regime has to be more stringent and elaborate in
the body structure of its laws, regulations, directives and stipulations than a
controlled regime for the reason that the task of maintaining order and
stability in an open market environment and free of financial distress is
more difficult. The rules of the game have to be charted out over and over
in an iterative fashion in an ever-changing environment until they come to
grips with market realities. A delicate balance has to be struck between lack
of rules and over-regulation. It is a delicate and complex task.

Consolidation or Fragmentation?

The number of bank and non-bank financial institutions is still large

even though there have been some buy-outs and mergers and the entry of
new banks has become more difficult given substantially increased minimum
capital requirements discussed below. The number of banks is roughly the
same it was five years ago. In 2005, the banking system comprised 44
institutions. Among these, 35 were commercial banks including 4 state-
owned banks, 20 local private banks, and 11 foreign banks. In addition,
there were 5 micro-finance banks and 4 specialized banking institutions,
ZTBL being the largest. The number of NBFIs, is much larger, 160 as of
last count, and their number has increased over the past five years in spite
of closures, mergers and buy-outs. These include five Development Financial
Institutions (DFIs), 8 investment banks, 20 leasing companies, 31
The Post-Reform Era Maintaining Stability and Growth 73

modarebas, 40 mutual funds, 52 insurance companies including 48 domestic

owned and 4 foreign owned, 3 housing finance companies, 3 venture capital
companies, 3 discount houses and more than 400 brokers.

The sheer number of financial institutions, therefore, remains

unwieldy and it is not healthy for the structure since it has led to the
fragmentation of the banking system and NBFIs. Entry into NBFIs continues
unabated, such as the new banks or finance companies which are ensconced
in their niche markets, providing housing finance, consumer finance or
Islamic finance. These new and old entrants, together, are marginal players
in the financial system given the size of their operations relative to the
mainline banking institutions as discussed below. They have ended up
enhancing fragmentation because they perform similar services to existing
institutions, just more inefficiently, and have a potential for mismanagement
or overexposure to various risks which may cause serious financial losses and
ultimately become a source of instability at the system level.

Currently, the entry of Islamic finance and micro-finance

institutions is being heralded as the start of a new era in Pakistani banking
and in some ways it is, given that their entry is driven by societal
preferences of one kind or the other. But it is not going to help with the
diversification of the banking system given that they are likely to remain
appendages of financial intermediation for a long time to come.
Diversification does not occur just because the number of financial
institutions has increased, rather it occurs primarily when new institutions
or old ones launch new business operations, introduce new products such
as term lending, and begin to cover new segments of clientele. Therefore,
in open financial systems, what matters is activity-based rather than
institution-based diversification.

Concentration or Competition?

A look at business shares shows that banking is concentrated among

the top five commercial banks who dominate the banking system in every
category while the remaining banks are small players. Four of these are:
NBP, HBL, UBL, MCB. The fifth one was ABL until recently and has now
been displaced from fifth position by Alfalah Bank. The dominance of these
five banks has diminished over the past years; yet, their combined assets are
slightly more than half of the assets of the banking system; so are the
proportions of their deposits and advances in the banking system. But the
combined NPLs of the original five banks were higher, about three fourths
of total NPLs of the banking system until a couple of years ago.
74 Shakil Faruqi

The financial strength of the banking system, therefore, is closely

tied to the financial fortunes of these large five banks. They are the price
setters; while at the same time in the past, many of them were loss leaders
as well. Their profitability and solvency is of systemic significance to the
banking system and hinges upon the efficiency of their operations and cost
effectiveness, risk management, credit outreach and their business
diversification. Impetus for future improvements will come from institution-
specific initiatives concerning meaningful capacity building and change
management. This will happen mainly owing to pressures of profitability and
efforts to maintain their relative market shares. A direct role of the SBP or
the government in this arena is no longer material as it was in the past.

Financial Intermediation – Structural Change and Growth

The core function of financial intermediation in Pakistan remains

with the commercial banks, not the NBFIs, and this is unlikely to change in
the future. The assets of the NBFIs, both state-owned and private, as a
proportion of total assets of the financial system steadily declined from 24%
in 1990 to 11% in 1995, mainly owing to the closure or privatization of
DFIs, or because of a much faster growth of private banks as a group as
compared to the growth of private NBFIs as a group, regardless of the
spectacular growth of some segments of the NBFIs such as leasing companies
or Islamic finance companies.

This decline in the asset share of the NBFIs is reflective of a faster

decrease in the share of advances, since loans outstanding are the largest
part of assets of a financial institution any time. In 1990, advances of the
NBFIs were 27% of financial system advances, and declined to 7% last year.
If we add Islamic finance, this proportion increases slightly. Currently,
deposits of the NBFIs as a group are a minuscule proportion of the total
financial system deposits, at about 2%. If we add the deposits of Islamic
finance, this proportion increases to about 3%. For these reasons, the focus
has to be on the operations of the banking system. The role of NBFIs has
been marginalized no matter what indicator is used and they are not
significant for the future of the financial system of Pakistan.

The deregulation of the interest rate structure occurred gradually

and the regime has undergone a significant change during the reforms from
administered rates to market-based rates. This transition was not smooth as
there was periodic volatility in interest rates but not destabilizing
movements. This is a considerable achievement of the monetary authority,
the SBP, when observed in the light of comparative experiences of financial
reforms in similar phases in other countries. The SBP discount rate has now
The Post-Reform Era Maintaining Stability and Growth 75

firmly established itself as the anchor rate for the banking system after
several iterations and fine tuning of auction mechanisms during the 1997-
2002 period.

As regards the long term trend of interest rates on the lending side,
the weighted average lending rate of commercial banks was rising
throughout much of the 1990s and reached a peak of about 16-17% in the
late 1990s, though this weighted average hides a significant variation of up
to 20-22% on the high side. Thereafter, these rates began to decline and
reached their lowest point of about 7-8% by CY04. Since then, lending rates
began to rise again and currently they range between 10-12% for
mainstream borrowers and 15-17% for fringe borrowers.

The trend of interest rate changes on the deposit side is similar.

There was significant volatility over the reform period. The weighted
average deposit rate through much of the 1990s ranged around 8%. Towards
1999, a slide of major proportions occurred and the weighted average
deposit rate fell drastically to about 2% by 2004. Since then deposit rates
have recovered to about 4% currently. Deposit rates of NSS have also fallen
from 14% to 10% for long term mainline instruments over the same period
and are about 9% currently.

Thus far, the banking system has withstood volatility of interest rates
and has emerged with stronger earnings and profitability through managing
associated interest rate risks. As for lending, it is unclear how much of the
banking system loan portfolio has been rebalanced with the current
structure of interest rates – the financial liability related turnover of credit,
because borrowers effectively recycle the shorter loan maturities relatively
easily than their medium to long term maturities, which are a small
proportion of the commercial banks’ portfolio.

There has been a strong growth of deposit mobilization by the

financial system, inclusive of NSS during 1995-2005 averaging at about 15%
per year. The rate of growth of deposits during CY90-CY00 was 12%. Later
on, during CY00-05, this rate slowed down to 11%. In part, this growth
occurred because of phenomenal growth of NSS deposits at an average
annual rate of 24%. As it was, banking system deposits also increased at the
rate of 9% annually over the CY95-00 period. Subsequently, this situation
reversed; during CY00-CY06 the annual growth rate of banking system
deposits nearly doubled to 16% while that of NSS dropped to 7%. If NSS
deposits are set aside, then practically deposit mobilization by the banking
system is all that matters at the financial system level while shares of NBFIs
and Islamic banks remain at about 3% and are inconsequential. Deposit
76 Shakil Faruqi

taking activities of fringe segments such as finance companies, Islamic banks,

micro-finance banks and NBFIs do not hold much potential for bringing
about structural changes at the system level.

One could argue that NSS operations are not financial

intermediation, NSS instruments are not deposit instruments, and deposits
mobilized by the NSS are a part of government operations of unfunded
debt, not deposit mobilization as such, and these deposits are an expensive
way of debt financing. That is largely the case because as the SBP estimates
show, if the government had borrowed Rs. 230 billion through the financial
market instead of NSS during FY02, it would have saved about Rs 11 billion
in borrowing costs per year. The NSS, therefore, is neither a low cost
borrowing source, nor a debt management system but has led to distortions
in savings mobilization because of its negative impact on banking system
deposits, though institutional depositors are now banned from investing in
NSS instruments.

There has been significant growth of financial system credit

throughout the reform period, accompanied by structural changes in the
sources of credit along the privatization patterns. During much of the
1990s, the rate of growth of credit remained fairly stable at around 9% per
year, but during CY00-05, this rate increased to about 12% per year with
significant volatility from year to year. This expansion of credit at the
financial system level mirrored patterns of growth of banking credit but in
an accentuated pattern in the late reform period. The average annual
growth of banking credit during the decade of CY90-00 was about 11%, and
thereafter rose to about 16% during CY00-05. Lately, there are signs of a
slowing down of credit expansion amidst rising interest rates. Nonetheless
credit expansion is occurring at a record rate of growth. The issue is
whether these spectacular increases in banking credit can be sustained, and
if so, does it represent an exception to the trend, or is it the vanguard of a
structural change in bank lending that was the expected outcome of decade
long financial reforms and dissipation of financial repression.

There has been a reversal both in the sources of credit and

allocation of credit between the public sector and the private sector owing
to privatization, deregulation and the elimination of a layered system of
credit allocation that prevailed earlier. At the start of reforms, in CY90 the
proportion of credit extended by public sector banks was 86%, while the
share of credit extended by private sector banks was only 14%. Later on, the
share of private sector banks began to rise and by CY00 it was about 42%,
and then it jumped to about 80% in CY06 in the wake of the privatization
of UBL and HBL. There was a corresponding decrease in the share of credit
The Post-Reform Era Maintaining Stability and Growth 77

extended by public sector banks over the same period. As regards allocation
and use of credit, the share of private sector borrowings from the financial
system was 55% in CY90, and slowly rose to about 60% in CY00, and then
jumped to 71% by CY06, representing a significant change in uses of credit
over the patterns that prevailed before.

A major issue concerning the credit system is overdraft lending

which is preponderant with short term maturities, and there is not much
term lending in the system. One could argue that overdraft lending with
variable interest rates is effectively term lending given the perpetual roll-
over of loan maturities at call, but that is stretching the point. Overdraft
borrowing has a higher repayment flow than contractual term-borrowing
with or without variable interest rates. Hence, term lending is more
conducive for promoting longer term investments. This is the same rationale
that underpinned the DFIs’ era in Pakistan in the 1950s and 1960s and also
in other developing countries.

Overdraft lending creates a bias in favor of large, well-heeled

corporate borrowers – the premium borrowers with substantial cash flow
potential. Almost all banks prefer premium borrowers to extend large loans,
thereby keeping their banking risks and cost fairly low, and are averse to
diversifying their client base in favor of small and struggling new borrowers
who are left high and dry. This is why SME lending, or micro-credit has not
made significant inroads in the mainline banking system, not only in
Pakistan but in many developing countries as well. This has forced the
authorities to revive SME banks, and offer incentives for the establishment
of micro-finance institutions and to revive housing finance. These are issues
of sectoral finance which need an in-depth evaluation.

As a result of the above, there is loan concentration since the large

amounts of credit flow to premium borrowers, though it has diminished
somewhat with the drive to bring in new borrowers whose number has
increased substantially. By implication, the amount of banking credit
extended to medium and small borrowers is fairly low. In this regard,
lending practices of banks in Pakistan are similar to those in other
countries. There is also sectoral concentration of banking credit which has
always persisted both in the pre-reform and post-reform period. The textile
sector is the major borrower as traditionally it has been, and its share in
total banking system credit has ranged between 25-31%, followed by
consumer credit whose share was about 10%. In contrast, the share of
agriculture sector credit has been less than 10%, and the share of trade
credit to exports and imports about 8% in recent years.
78 Shakil Faruqi

In spite of attention given to housing finance, the proportion of

house building finance remains an insignificant fraction at only about 2% of
banking system credit as compared to 12-18% in Asian countries and 25-
35% in advanced countries. Until some years ago, the housing sector was
classified by many commercial banks as an unproductive sector, even though
there are roughly 38 industries whose growth is directly linked to housing
construction and is a leading indicator in advanced countries to gauge the
performance of the economy over the short term. Mortgage lending is beset
by two issues: the prime one is the bankability of property collateral
tendered and the mismatch in the maturity structure of bank funding and
house building loans of long term maturities.

III. Post Reform Era – Management of Financial System

The objectives of managing the financial system are to maintain

stability, growth, soundness and solvency which boils down to maintaining the
sustainability of the financial system. These issues have been front line
concerns of the SBP and form the core of its strategic objectives. These are:
maintaining price stability with growth, broadening the access of borrowers to
banking credit and the provision of financial services, ensuring the soundness
of the financial system, exchange rate and foreign exchange reserve
management, and the strengthening of the payments system. Stability is the
prime focus of monetary management, while soundness and solvency are the
prime focus of banking supervision and regulation, though there is no hard
and fast division as such. The practice turns out to be that way.

Review and analysis of financial reforms in Pakistan and their impact

has already been done in an exhaustive fashion in the series of the Financial
Sector Assessment (FSA) reports and Banking System Review (BSR) reports
launched by the SBP nearly five years ago. These two annual series are
unique in that hardly any central bank among developing countries has
undertaken this task as systematically as the SBP has done over the past five
years. At the start, the focus was on the impact of reforms on the financial
system. It has now shifted to maintain the soundness of the banking system
as viewed through CAMEL indicators, and the evaluation of improvements
in the system of banking supervision and regulation.

The focus of maintaining soundness and solvency centers around

what the banking system does, given that on the intermediation side its role
is overwhelmingly significant. The front line issue is how the banking system
has fared thus far regarding soundness and solvency, and what are the
prospects in the post-reform era? In this sense, managing a financial system
The Post-Reform Era Maintaining Stability and Growth 79

is more than simply monetary management, though it is a critical element

in maintaining stability and fostering the growth of the economy.

For maintaining stability and fostering growth, the foremost issue is

what are the remaining distortions or weaknesses in the financial system,
how significant they are, and where do they originate from? The issue for
the policymakers is what is the nature of future interventions, and how to
balance them with economic and social priorities? What are the intervention
points, and how effectively can those be managed in fast moving financial
markets, both domestic and global. The complexity of these issues will
grow, not diminish, as the financial system progresses and becomes more
sophisticated in a fairly open and liberalized financial regime.

On the financial markets side, the main objective is to keep money

and capital markets stable and avoid volatility, swings and market
corrections, if that can be achieved, though markets have a way of
surprising everyone. Financial market behavior is notoriously unpredictable
and there is not much that can be done to avoid periodic episodes of swings
or even volatility in financial market prices and transactions. Therefore,
maintaining the stability of interest rates, prices and exchange rates is
regarded as a necessary condition for the stability of financial markets; that
is the role of the SBP, while maintaining orderliness, participation,
transparency and the integrity of financial market operations is the role of
the SECP at a time of open capital accounts and FDI inflows.

Financial Deepening and Growth

A widely used indicator of financial system growth is the M2/GDP

ratio because M2 is a reflection of resource mobilization of the financial
system, and are liabilities of the financial system. After all, M2 is basically
currency, a statutory but non-binding liability of a central bank while
deposits are liabilities of the banking system. The larger the M2, the larger
is the magnitude of macro-financial resources mobilized. Conversely, in
repressed financial regimes with relatively low levels of financial deepening
roughly at one third of GDP, economic growth would be stifled compared
to what it would have been otherwise. This is the prevailing view of
financial deepening.

During the second half of the 1990s, the M2/GDP ratio in Pakistan
was nearly stagnant at about 37%, then jumped to around 44% during the
last five years. This is a reflection of the extraordinary growth of deposits
over the last six years. This seven point move of the M2/GDP ratio within a
relatively short period of five to six years does not imply that a structural
80 Shakil Faruqi

change of this magnitude has erupted from within the economy. For one, a
good deal of increase in this ratio owes to expansion of net foreign assets
and a large part of the economy still remains undocumented and operates
outside the financial system.

Currently, Pakistan’s M2/GDP ratio is much lower than that

prevailing in other Asian countries. In 2005, this ratio in India was 67%; in
the Philippines 53%; in Thailand 96%, and in Malaysia, 106%. Therefore,
there is ample room for further increase in the M2/GDP ratio and growth.
This shows that the necessary conditions for future development of the
financial system have largely been taken care of and now is the time to
tackle sufficient conditions through diversification and consolidation of the
banking system, restructuring of priority sector financing at the sectoral
level, capacity building, and corporate governance of financial institutions.
The reliance on the M2/GDP ratio to gauge the depth of financial
intermediation is weak and may be supplemented by looking at the trends
on the asset side, the asset/GDP ratio, which has increased from 54% in the
mid-1990s to about 62% currently. This ratio also reconfirms that financial
deepening has a long way to go to reach levels observed in many countries
where it exceeds 100%.

Monetary Management – Stability

It is in this background that we need to have a look at monetary

management in Pakistan. Overall, the SBP has been very successful at
monetary management over the past years and has been attuned to the
needs of maintaining stability at a time of transformation within the banking
system and volatility in financial markets. The SBP has achieved a skillful
switch-over from a system of direct monetary controls that prevailed until
the late 1990s to the deployment and calibration of indirect monetary
instruments in a liberalized environment such as cash reserve requirements
(CRR), statutory liquidity requirements (SLR), SBP discount rates, and open
market operations. More importantly, reserve money has finally acquired the
backing of large foreign exchange reserves, which was not the case some
years ago. The role of the interest rate has been enhanced after the
withdrawal of the Credit Deposit Ratio (CDR) as the leading instrument of
credit control. Therein lies the shift from a direct to indirect system of
monetary management.

The SBP has also been quite successful in steering a tight or easy
monetary policy stance during the past four years as warranted by short
term trends and has established good operational mechanisms. The
movements in the structure of interest rates has followed a monetary policy
The Post-Reform Era Maintaining Stability and Growth 81

stance over the past years, by and large, led by the SBP discount rate which
has always been a powerful tool of monetary management. The banking
system is responsive to signals conveyed by the monetary authority though
there is periodic slack in the speed of adjustments and there are rigidities.

These elements have helped to keep inflation under control and

maintain price stability over previous years, though the price level has been
under severe pressure for the past couple of years. The rate of inflation
declined steadily from about 13% in FY95 to about 3%, then to 9.3% in
FY05. Since then, there has been some moderation in the levels of inflation
but it remains a major concern as inflation currently is about 7%.
Historically, inflationary pressures originated mainly from fiscal deficits and
the consequent monetary expansion by the then banking system to meet
public sector borrowing needs, and the same pattern prevails today given
soaring levels of fiscal deficits from Rs 134 billion in FY04 to Rs 325 billion
in FY06.

A good part of inflation during the 1990s occurred from imported

inflation and steady depreciation of the exchange rate. These pressures
were mitigated over the past few years but now have re-emerged as fiscal
deficits and current account deficits have continued to rise substantially.
The issue is: what are the threats to price stability and how serious are
they? And how far will monetary policy be able to cope with these
pressures in the future? In such circumstances, the SBP had no option but
to pursue a tight monetary policy, which it has over the past couple of
years, though the SBP realizes that it has to strike a balance between
inflation and growth; has to moderate pressures on the exchange rate
while keeping interest rates stable. However, in times of swiftly rising
fiscal deficits and large inflows of FDI, a restrictive monetary stance can go
only so far in maintaining short term price stability, together with
exchange rate and interest rate stability.

In spite of an open foreign trade regime, liberal incentives for

export, a market determined exchange rate and a large foreign exchange
reserve position, current account deficits have returned with a vehemence
that is reminiscent of the old days, to a record level of $5 billion in FY06
and is likely to be higher in FY07, since the trade deficit in the first nine
months of this fiscal year is approaching nearly $9 billion. The silver lining
is that foreign exchange reserves of about U$13 billion are sufficient for
nearly a year of imports rather than for just a few weeks as in the past.

The SBP has been successful in maintaining exchange rate stability,

over the past five years together with a strong foreign exchange reserve
82 Shakil Faruqi

position which began building up from a modest level of US$ 1.35 billion in
CY00, to around US$ 13 billion currently under the free floating foreign
exchange rate and inter-bank foreign exchange market. There have been
periodic ups and downs but in a narrow band. Recently, there has been a
noticeable increase in the inflows of FDI, but nearly a third of it is in one-
time foreign exchange privatization proceeds which will not recur. There is
also growth of portfolio investment, but nowhere near the levels that
occurred in East Asian or Latin American countries, whose abrupt return
became the cause of a full blown crisis for them. There are no FDI induced
bubbles to cause worry, though the capital market boom is beginning to
look like a bubble situation.

Comparative experience has demonstrated that attempts to stabilize

or to maintain some targeted level of the exchange rate by central banks
have been unsuccessful. Some of the spectacular failures were in the early
1990s when the Bank of England tried to maintain the parity of the British
pound and then had to withdraw after staggering losses within a matter of a
few days. Subsequently, Bank Negara Malaysia tried to do the same, and
suffered heavy losses with stunning rapidity. It is now firmly understood that
foreign currency trading to corner the global currency market is suicidal
which has a turnover approaching two trillion dollars per day. Therefore,
maintaining the stability of the exchange rate through currency market
manipulation when the Pakistani rupee is being traded actively is not an
option available to the SBP except in a narrow band and for short duration.

This perception of monetary policy management amidst conflicting

objectives is familiar among countries at similar stages of financial reforms.
After the era of the control regime is over and the external sector is
liberalized, the monetary authorities can pursue either domestic price
stability or exchange rate stability, but not both with the same degree of
success. Once the financial system is liberalized and financial markets begin
to assert their role, and large inflows from overseas begin to occur with
open trade and capital accounts, be they remittances or FDI, price and
exchange rate stability then become difficult to maintain simultaneously,
because the opening of capital accounts reduces the influence of the
monetary authorities on interest rates and hence its capacity to affect
aggregate spending.

If the authorities pursue exchange rate stability to stabilize foreign

exchange inflows and keep the current account balance intact, the domestic
interest rate and price stability comes under pressure because of the
sterilization of FDI and other foreign currency inflows, no matter how it is
done. Conversely, if they shift to maintain interest rate and price stability,
The Post-Reform Era Maintaining Stability and Growth 83

sooner or later the exchange rate comes under pressure. For example, in
times of inflation, if the monetary authority were to raise interest rates and
they become higher than the international rates, it will encourage capital
inflows and will depress the real exchange rates.

Banking Regulation and Supervision - Solvency

Improvements in the system of banking regulations and supervision

at the SBP has been one of the leading items from the start of the reform
period and it has paid rich dividends. Since then it has undergone a
significant transformation and the system that prevails today is far superior
than it was at the start of the reforms. Its procedures and practices have
been modernized and these are as sophisticated as one would expect to find
anywhere among the leading countries. The process is supported by the
installation of an upgraded payments system, IT facilities at the SBP as well
as at leading banks, thereby significantly improving the speed and accuracy
of financial information flow so vital for banking supervision.

A major change from the old to the new is transparency in the

processes of supervision and regulation as to what is being regulated and
why and by whom. There hardly was any meaningful information flow in the
public arena concerning the operations of financial institutions, much less
on the state of their financial health or their relative standing with regard to
impaired capital and other systemic weaknesses that were at the root of
their financial distress. This information flow, together with the analysis and
evaluation of financial institutions, started with the launching of annual
series of FSA and BSR reports. This transparency is critical in the post-
reform era if stability, soundness and solvency of the financial system are to
be achieved.

Nearly all banking and financial crises that have erupted during the
previous decades, occurred in countries which had a well established system
of supervision and a full awareness of the potential for crisis. It seems that
no amount of banking supervision is sufficient enough to prevent the
emergence of crises, and that is a sobering thought. In times of financial
distress, banks and quasi-banking institutions have a way of going belly-up,
not because of any lack of supervision, but mainly because of excesses of
placements, untenable risk exposure, and herd behavior in garnering golden
opportunities of profit or large capital gains in a red-hot market, be it the
loan market, financial market, exchange market, or real estate market. That
is why there is such rapidity in the onset of the crises and its monumental
dimensions, once it unravels. This has happened in developed countries such
as Japan and the US during the 1990s when a few large commercial banks
84 Shakil Faruqi

became insolvent and before any remedial action could be taken, they had
folded up, in spite of an enviable system of information flow and a modern
supervision system.

Similarly, the Mexican crisis of the mid-1990s and East Asian crisis
of the late 1990s happened even though their banking supervision and
regulation systems and the sophistication of bankers and financiers and
their expertise in handling capital inflows was regarded at par with
international standards. They also had the knowledge and experience of
similar crises that erupted previously. What went wrong and why so
swiftly? The post-crisis diagnosis reveals that one of the common elements
is herd behavior and overexposure of a speculative variety in a few sectors
in anticipation of more than normal market returns. As soon as the inflow
began to dry out, the specter of foreign exchange illiquidity loomed large,
and investors wanted to exit before imminent devaluation of the Mexican
peso in the face of foreign currency illiquidity. This mass exit of foreign
capital, the reverse flow, is akin to a bank run domestically. There is no
safeguard against it, much the same way as there is no safeguard against a
bank-run on any given day.

Further, good bankers have been known to become bad bankers,

and this process unfolds right under the nose of bank examiners and
supervisors. Spotting this trend is difficult; it is a matter of experience and
ultimately it is a judgment call. This has happened time and again in
developed and developing countries alike. How it happens is explained
briefly below. Why it happens boils down to the inability of bankers or
financiers to keep a lid on acceptable business risks, and tame these risks
when they get out of line, but well before they are beyond any reprieve.
This is a precarious rope walk. There is always an unwillingness to close
losing operations, take early losses and quit in the early stages when these
losses are still smaller than later on when the crisis erupts full scale.

The instinct of the bankers is to keep the borrowers alive through

recycling and renewals of bad loans into loans, a window dressing exercise;
or worse yet, advancing additional fresh loans to effectively insolvent
borrowers to tide over what is perceived as cash flow problems and
imminent illiquidity, thereby getting deeper into financial distress. In this
sense, insolvency occurs first, illiquidity follows later. The borrowers are
already in deep distress by then, and they are well past the stage of routine
rescue operations because their illiquidity originates not from their routine
business turnover and cash flows, but rather from structural weaknesses in
their operations. The same occurred in the nationalized banking era in
Pakistan when banks kept bailing out insolvent PSEs, lending more
The Post-Reform Era Maintaining Stability and Growth 85

intentionally because of collusion or bad judgment, or on government

directives, then writing off the loans while the banking supervision outfit
was alive to these perils.

Soundness and Solvency – the Banking System

Maintaining soundness and solvency of the financial system has been

the uppermost concern of the SBP. The BSR reports of SBP are focused on
the latest developments in the leading indicators of soundness of the
banking system, based on timely reporting by financial institutions, required
under disclosure laws and regulations. The analytical approach is the
CAMEL framework which is a rating system of financial institutions. The
evaluation of the banking system’s soundness, as given in the SBP reports,
clearly shows that financial strength and soundness of the banking system
has considerably improved as evidenced by various soundness indicators at
the system level, and its capability is fairly strong to withstand various types
of shocks within plausible limits. It may, however, face difficulties in
extreme situations, the probability of occurrence of which is largely remote.

Among the soundness indicators, the first one is capital adequacy

inclusive of minimum capital requirements and an assessment of the ratio of
capital to risk weighted assets. For years, the minimum paid up capital
requirement was fairly low at around Rs. 500 million, and was raised to Rs.
1 billion in 2002 and again to Rs. 2 billion in 2004. This increase in paid-
up capital together with cleaning up of the loan portfolio was the main
element in reducing the risk factor in assets, and has led to a significant
improvement in the risk weighted capital adequacy ratio, a statutory
obligation for all banks regardless of their ownership.

Since the time the SBP began publishing soundness indicators in its
FSA and BSR reports covering the period CY97-05, the data shows a
significant improvement in the Capital Adequacy Ratio (CAR). In 1997, it was
4.5% for all banks, and jumped to 11% within a year, and since then has
stayed at around the same level, though there have been variations from year
to year. For state owned banks, private banks and foreign banks, the same
pattern prevailed. There were annual variations in between, but the ratio
remained fairly high and was not a cause for concern. In contrast, this ratio
for specialized banks has never recovered from negative levels.

As part of the Basel II implementation, the banks are required to

further increase their paid-up capital by Rs one billion per year until they
reached Rs 6 billion by the end of 2009 by all banks and DFIs. This is an
unprecedented increase in base capital. After the increase materializes by
86 Shakil Faruqi

2009, the CAR for banks will range from 8% to 14%. The shift to such
levels of capital adequacy is the first insurance against the insolvency of
financial institutions, and once the range is reached, solvency at the system
level is assured. A swift rise of minimum capital requirements to such levels,
however, would be a powerful barrier to entry for new banks seeking
incorporation, though not for non-bank entities which are incorporated
under the companies charter. These requirements will discourage not only
the entry of new banks, but will also hurt competition, and will encourage
non-bank companies to enter the NBFIs group which is likely to add to the
fragmentation of the financial system.

Burden of NPLs - Asset Quality

The asset quality indicator revolves around the proportion of risk

weighted assets or the proportion of non-performing loans (NPLs) in total
assets. These ratios indicate that there are no threats to solvency of the
banking system that loomed large during much of the 1990s mainly due to
the rise of NPLs. The management of NPLs by the banking system has
considerably improved over the past years, and the burden of NPLs does not
pose a threat to the solvency of the banking system, large though it is.
There has been a reduction in NPLs from an all time high of Rs 244 billion
in CY01 to Rs 184 billion in CY06 largely because of the resolution of loan
defaults, loan write-offs and several recovery drives. The proportion of NPLs
in the total loans of the banking system has fallen from about 24% to about
8% in CY06. A great deal of provisioning has been done by the banks since
the early 1990s and the total amount is estimated at Rs 139 billion in
CY06. The amount of net NPLs, therefore, has decreased from Rs 92 billion
in CY97 to Rs. 45 billion in CY06; their proportion in banking credit has
likewise decreased significantly.

Hence, NPLs are no longer a systemic risk as they were in the

1990s. The solvency risk has been mitigated, though NPLs remain a drag on
the profitability of leading banks and this situation will persist in the future.
The resolution of problem banks, likewise, is no longer a pressing issue as it
was during the 1990s when a large part of the banking system was in
financial distress. There are now only three problem banks and they do not
pose a systemic threat. Private banks are likely to impose a much tighter
discipline on lending practices to prevent the incidence of loan defaults, but
how far new NPLs will be contained remains a concern given the recently
reported rise of defaults. The culture of default may have been weaned but
has not disappeared. It will take a long time before good borrowing
behavior is restored coupled with good lending behavior as well.
The Post-Reform Era Maintaining Stability and Growth 87

Intermediation Costs and Spreads - Efficiency

The intermediation cost is not a CAMEL indictor, but it reflects the

operating efficiency of banks though only on the funding side since it is the
ratio of administrative expenses to the average amount of deposits and
borrowings of a financial institution. BSR estimates show that intermediation
costs during the late 1990s was about 3.5%, and then began to decline and
is currently around 2.7%. This suggests that banking efficiency improved at
least on the funding side over the late reform period, but still it is above
the cost range prevailing in comparator countries at around 2.0%, and is
much higher than the range of 1.5 to 2.0% observed in leading countries.

These intermediation costs are exclusive of provisioning costs for

NPLs. Provisioning for NPLs adds close to one percent to banking
intermediation costs over and above the current level of 2.7%. This is a
major reason for high intermediation costs, especially for the recently
privatized large banks. Part of the cost of provisioning and equity
replenishments have been assimilated and recycled into the balance sheets of
financial institutions thereby raising the costs of operations and thus
intermediation costs, which refuse to be compressed beyond current levels.

Banking spreads have remained around 7% during most of the 1990s

and have remained around the same over the recent period, even higher, at
around 8%. This is not surprising because structural changes in the credit
system occurred concurrently to significant volatility, both in the deposit
rates and lending rates over the reform period discussed earlier. The
concern that banking spreads are high is valid, but in a deregulated system
there is hardly much that the monetary authority, the SBP, can do to help
reduce the spread since it is embedded into the bank funding structure on
one side, and into lending operations and investments on the other.

Profitability – Banking System

Recently, commercial banks have returned to profitability after

persistent losses for many years, though specialized banks are still
unprofitable. There has been an astounding increase in profitability which
has mitigated but has not eliminated the specter of insolvency at the system
level, though not at the institutional level. Nothing prevents a single
financial institution becoming insolvent while the rest of the banking system
is doing well and is profitable.

Profitability may be gauged through the return on asset (ROA) both

before and after tax, or return on equity (ROE) before and after tax, or the
88 Shakil Faruqi

ratio of net interest income to gross income, or the cost income ratio. All
these indicators unanimously show a marked improvement during the CY97-
05 period in the profitability of the banking system in Pakistan. After tax
ROA for the banking system was negative until CY01 and then turned
positive and swiftly rose to the current levels of about 2%, ahead of
international benchmarks. After tax ROE likewise was negative until CY01,
but thereafter it became positive and shot up to 26% in CY05. This jump is
a one time phenomenon and is unlikely to be replicated in the future,
though it is a broad indicator of a trend towards profitability. Net interest
income as a proportion of gross income showed a remarkable increase from
49% in CY97 to 72% in CY05, owing to the scissor like pattern of interest
rates on deposits and lending over this period discussed earlier.

A number of factors have contributed to enhanced profitability.

Banks were able to lower their interest expenses faster than the decline in
their interest income owing to low borrowing needs, re-pricing of their
interest bearing liabilities and a large growth in non-interest income from
investments and other assets over the past few years. In addition, improved
operating and business practices and financial services, restructuring and
reorganization and downsizing, staff reduction, branch closures, tightened
internal costs, and controls on administrative expenses have helped to
reduce their operating costs. Above all, a decline in the corporate taxes on
banking business from 56% to 42% have improved after tax profits, and will
get a further boost when the tax rate is lowered to 35%. Specialized banks
have continued to suffer heavy losses throughout this period and their
profitability indicators never returned positive. Lately, their losses have
narrowed down but profitability remains as elusive as ever.

Managing Banking Risks

In the above context, the issue is how well the banks are able to
manage banking risks with market-based interest rates, floating exchange
rates and exposure in the foreign exchange reserve position, open external
accounts, increased participation in FDI and capital inflows. The pattern of
credit risk in routine bank lending to sectors of the economy has not
changed much. If anything, it has increased owing to a move to new lines of
lending such as consumer credit; but as long as exposure of the banks
remains concentrated towards prime borrowers, this shift in the profile of
credit risk will be manageable. If credit risk is not managed properly it
eventually shows up in NPLs, or the concentration of banking credit in a
few sectors of the economy, or in a few segment of borrowers, or a rising
proportion of riskier loans in its portfolio during times of rapid expansion of
banking credit.
The Post-Reform Era Maintaining Stability and Growth 89

Exchange rate risk concerns the exposure of banks on their foreign

exchange liabilities. The banking system was shielded from exchange rate
risk in the past owing to a number of explicit and implicit safeguards
extended to them by the SBP in return for their surrendering their foreign
exchange inflows, be they on FCAs, remittances, or export earnings. All this
has changed since then in the new foreign exchange regime whereby
commercial banks are practically on their own with regard to foreign
exchange risks on their reserves, exporters’ balances, foreign currency
deposits, foreign exchange loans extended to the foreign companies or
customers, and on their portfolio related operations in the foreign exchange

The impact of interest rate risk is on the portfolio of the bank, both
investment portfolio and loan portfolio, and is central to asset/liability
management at the institutional level. The impact of interest rate changes is
severe if there is a serious mismatch of maturity structure between the loan
portfolio and deposit portfolio because of a significant divergence in interest
rates associated with these maturities. Unless the bank is able to compensate
on both the asset and liability sides of its balance sheet, it is likely to suffer
a loss. Interest rates were falling during most of the CY95-03 period, and
then they stabilized. During this period, the overall profitability of banks
was not compromised. Thereafter, when interest rates began to rise over the
past two years, this was accompanied by a significant growth in banking
profits to record levels. This indicates that during both periods, banks were
able to absorb the impact of interest rates on their portfolio, be it the
investment portfolio or loan portfolio.

Likewise, banks have been able to manage the equity price risk over
this period. The sustained fast growth of stock market and equity prices
continues unabated, and it has further accelerated this year. The SBP placed
a cap on the direct exposure of banks in stock market placements estimated
at about Rs. 35 billion in CY05, though it has grown further since then.
This exposure of the banking system in equity investment is not a cause for
concern, because the share of direct exposure in total investments held by
the banking system remains small. The indirect exposure through carry-over-
transactions, badla financing, was about Rs. 8 billion in CY05, and since
then it has decreased further owing to restrictions placed on badla
financing. In view of this structure of the banking system’s exposure in the
equity market, the degree of equity price risk is not a major concern.

From the point of view of soundness, the proposition that banks

become insolvent first and illiquid later is likely to generate much debate
among bankers and financiers. No matter how one perceives it, liquidity
90 Shakil Faruqi

risk has to be managed well. Since the observance of liquidity levels is a

statutory obligation, and the SLR is closely monitored by the SBP, the
banking system has to keep adequate liquidity levels all times in
compliance of the SLR. Observance of the SLR by itself does not eliminate
liquidity risk which has emerged for the banking system partly from
inflation, and partly from the rapid growth of banking credit. Currently,
liquid assets are nearly one third of total assets, and this is a reasonably
comfortable position for the banks; their liquidity position is in excess of
the statutory requirement.

Banking System - Sensitivity to Shocks and Stress

The crux of the management of the soundness and solvency of the

banking system, to the extent that it can be system analyzed, is to enhance
its resilience so that it can successfully absorb moderate levels of financial
system shocks and moderate levels of economic instability, while operating
in the market environment with open capital accounts and a vibrant
external sector. To assess the resilience of the banking system, the SBP
conducted its own stress tests as reported in the BSR05 involving 12 largest
banks. The exercise covered all three market risks, namely the interest rate,
the exchange rate and equity price risks, and a fourth one as well, the
liquidity risk. Four stress scenarios were developed for each of these risks
and their impact was estimated on the combined profitability and capital of
these banks as an approximation to the impact at the system level. The
results show that among these four risks, the liquidity risk is relatively more
worrisome and the impact of a shock is more severe because liquidity
margins are thin if the liquid assets exclude near-liquid government
securities. If these are included, the amounts of liquid assets with the banks
increase and consequently liquidity shocks are not so severe.

Stress tests of credit risk shocks show that the degeneration of

position of NPLs is not a material threat to their solvency; it is manageable
and banks will be able to withstand a degeneration of their portfolio quality
except for extreme situations which are unlikely to occur. The impairment
of the quality of the portfolio is exhibited in rising levels of NPLs. Test
results show that the capital adequacy of these banks will be unimpaired and
they will be able to tolerate a 10% increase in their NPLs together with a
50% degeneration of their loan portfolio into classified loans. Further, if the
ratio of NPLs to loans currently estimated at 6.7% were to degenerate to as
much as 33.5%, only then will it wipe out the capital of these banks,
meaning that banks are fairly strong and their solvency will be at stake only
in extreme cases of far-out shocks.
The Post-Reform Era Maintaining Stability and Growth 91

Similarly, the impact of shocks of upward interest rate movements

together with parallel shifts of the yield curve on the value of the bank’s
portfolio is tolerable, except for a large shock in the case when interest rate
increases by 100 basis points or 200 basis points and there is a parallel shift
and flattening of the yield curve. The impact on gross income is more
pronounced and the percentage loss is substantial. The shock of a decrease
in equity prices, that is, a fall in the stock price index in the range of 20-
40% will also not have much of a negative impact on the banks, and banks
will be able to ride out these adverse movements.

The shock of exchange rate movements is more manageable because

the foreign assets of banks are larger than their foreign currency liabilities.
Therefore, a depreciation of the exchange rate of as much as 25% does not
have any negative impact on their capital; in fact their CAR appreciates.
Their borrowers, however, will face difficulties in loan servicing of foreign
credits; therefore the value of their foreign currency loan portfolio will
decrease. If there were to be an appreciation of the exchange rate by 20%,
it will lower the rupee value of their assets and their CAR will decline but
only slightly. It seems that banks are resilient enough to absorb shocks of
any combination of exchange rate movements within these ranges together
with the counterpart impact of exchange rate changes on their clients.
There is a corroboration of the central conclusion of these SBP tests with
those of the IMF-WB FSA05 report based on its own sensitivity and stress
tests. Their results show that Pakistan’s financial system is resilient enough
to absorb various types of moderate shocks and there is no imminent threat,
except in situations where several types of shocks may occur simultaneously
and in combination, though the report does not elaborate upon the
combination or their severity.

Looking Ahead

The future of financial system development will in good part depend

on capacity building and improved corporate governance. Capacity building
needs priority attention because it is not a once for all activity, rather it is a
continuous process. As soon as one threshold is scaled, another one looms on
the horizon owing to fast moving changes in the business world and also in
the financial system owing to increasing global linkages. Hence, the need for
continuous revival and rejuvenation from within at the institutional level will
always be there if the dynamism of modern banking is to be internalized.

Further gains in efficiency and improvements in the operations of

the banking system simply can not be achieved without adequate investment
and efforts at capacity building. Frontline institutions have already gone
92 Shakil Faruqi

through a few rounds of their capacity building led by the SBP, which
embarked on this process some years ago with considerable success. Many
small private banks and foreign banks went through capacity building efforts
of their own and completed their transition earlier on during the late
1990s. Recently, privatized large banks embarked on their capacity building
a few years ago and they are in the midst of catching up to their fast
growing needs.

There are three main elements to capacity building. These are:

improvements in management orientations and dynamism, investment in
training, and investment in infrastructure such as IT facilities in parallel
with IT training if this investment is to yield dividends. All the three
elements are a relatively recent experience for Pakistani banks, but these are
not unfamiliar or new to them. Investment in training, unfortunately is still
regarded as an administrative expense rather than investment in human
capital. That mind-set has not changed. Currently, most institutions spend
only a fraction of their routine administrative budget on training, perhaps
no more than 3% of their annual administrative outlays and it is not
considered as investment in human capital.

Further, training is widely interpreted as improving basic skills or is

regarded as improving abilities in procedures as compared with functional
training. For example, training a branch manager is not the same as training
a banker; or for that matter, training a central banker, say, in currency
regulations is not the same thing as preparing someone to become a central
banker. This involves the enhancement of capabilities, re-orientation of the
mind-set and attitudes which are much harder to come by. Functional
training was not needed in a nationalized system, directed as it was from the
centre, or so it seems. That is why training came to a grinding halt and
with it the culture of self-improvement at the institutional level disappeared.
In the current business environment financial institutions cannot prosper
without sustained efforts at capacity building.
The Post-Reform Era Maintaining Stability and Growth 93


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96 Shakil Faruqi

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The Lahore Journal of Economics
Special Edition (September 2007)

Financial Sector Restructuring in Pakistan

Muhammad Arshad Khan and Sajawal Khan*


In this paper an attempt has been made to review the financial

restructuring process and its importance for economic growth and
macroeconomic stability. The main focus is on the financial restructuring
efforts undertaken by the government of Pakistan since 1990. We also
analyze the impact of financial restructuring by using various financial
indicators. The overall results suggest that the financial industry in
Pakistan is showing remarkable and unprecedented growth. Unlike 1990,
the performance of the financial sector is much better today. After the
successful completion of first generation reforms, the introduction of second
generation reforms is required, which will help to further strengthen the
financial system and transfer the benefits of the first generation reforms to

I. Introduction

In a modern economy, an efficient financial system is essential to

facilitate economic transactions, specialize in production, and establish
investor-friendly institutions and competitive markets. A stable and efficient
financial system not only reduces uncertainty and the cost of transactions but
also improves overall economic efficiency through the efficient allocation of
resources. A more balanced and vibrant financial system will contribute to
economic growth and the stability of the economy. In contrast, regulated
financial systems lead to underdeveloped and incompetitive markets, with a
financial sector dominated by government owned financial institutions that
impose constraints on economic growth. It is now widely recognized that
weak and inefficient financial systems are more vulnerable to contagion, less
able to cope with volatile capital flows and exchange market pressures, and
more likely to propagate and magnify the effects of financial crises. This

The authors are respectively Associate Professor Government Post-graduate College
Muzaffarabad (Azad Kashmir) and Lecturer Government Degree College Ghazi, Haripur
(NWFP) and both are currently working as Research Associates, Pakistan Institute of
Development Economics, Islamabad.
98 Muhammad Arshad Khan and Sajawal Khan

recognition has highlighted the need for the global adoption of strengthened
standards for banking supervision (IMF, 1996). The appropriate sequencing of
financial sector restructuring and supervision policies have also become
pressing issues in many LDCs, where a large part of the banking system is
undercapitalized and insolvent, reflecting major macroeconomic shocks, large
structural changes and weak banking supervision. The resulting distress in the
financial system has, in turn, complicated monetary management and affected
the effectiveness of stabilization policies (Sundararajan, 1996).

Since the early 1990s, many developing countries have started to

restructure their financial sector as a part of broader Structural Adjustment
Programs (SAP) which includes fiscal consolidation, reforms of the trade and
exchange rate systems, price liberalization, deregulation of financial sector
activities and other wide-ranging measures to enhance efficiency and supply
responsiveness of the economy. These reforms were expected to bring about
significant economic benefits, particularly through a more effective
mobilization of domestic savings and efficient allocation of resources. Policies
for restructuring the domestic financial system are aimed at strengthening the
role of market forces and competition through liberalization of interest rates,
adoption of indirect monetary instruments, strengthening of prudential
supervision and related market information systems in order to deal effectively
with interest rate and exchange rate risks and other banking risks, particularly
in the context of capital account liberalization by enhancing banks’ soundness
and by promoting equity markets (IMF, 1995). Moreover, the liberalization of
current and capital account transactions are aimed at better integrating the
domestic financial system into world financial markets.

During the pre-reform period, the financial sector in Pakistan mainly

accommodated the financing needs of the government, public enterprises
and priority sectors. Private sector investment remained modest, and efforts
to mobilize savings lacked the dynamism of a competitive financial system.
Financial intermediaries were insulated from competition in the domestic
market through oligopolistic practices and barriers to entry in the sector,
and from outside competition through tight restrictions on current and
capital accounts transactions (Khan, 1995).

In such an environment, which was typical of many pre-reform

situations, distortions were widespread, interest rates were generally
negative in real terms, incentives were provided to inefficient investment,
credit was rationedon the basis of government determined priorities and
excessive regulations hindered the activities of financial intermediation.
Consequently, economic efficiency remained low and growth suffered from
relatively low savings and investment rates in the private sector.
Financial Sector Restructuring in Pakistan 99

Like many other developing countries, Pakistan undertook the

process of financial restructuring through reforms in the early 1990s to
establish a more market-based system of financial intermediation and
government financing, conduct monetary policy more efficiently through
greater reliance on indirect instruments and contribute to the rapid
development of the stock markets. These reforms were primarily designed to
correct the distortions implicit in the administered structure of rates of
returns on various financial instruments, to abolish the directed and
subsidized credit schemes, to allow the free entry of private banks in the
financial sector in order to enhance competition and efficiency in the
financial sector and to strengthen the State Bank of Pakistan’s (SBP)

The main objective of this paper is to examine the financial

restructuring efforts undertaken by the government of Pakistan to gain
efficiency in the financial sector. Moreover, the study also examines the
outcomes resulting from financial restructuring and suggests further
improvement in this regard. The rest of the study is structured as follows:
Section 2 discusses the theoretical rationale of financial restructuring.
Section 3 describes the financial restructuring process carried out so far in
Pakistan, while Section 4 assesses the results of restructuring in Pakistan.
Some concluding remarks are given in Section 5.

II. Theoretical Rationale of Financial Sector Restructuring

The theoretical support for financial restructuring as a policy goal

can be traced back to the fundamental theorem in welfare economics and
the efficient market hypothesis. The fundamental theorem suggests that
competitive markets lead to Pareto optimal equilibria, while the efficient
market hypothesis argues that the financial sector uses market information
efficiently. A combination of these two ensures the efficiency in the financial
sector. The reform of the financial system removes market distortions that
impede free market conditions (Eatwell, 1996; Mavrotas and Kelly, 2001).
Mckinnon (1973) and Shaw (1973) argued that financial deepening is an
essential ingredient to the process of capital accumulation, which in turn
enhances economic growth through savings and investment. They further
stated that financially repressed economies remain below its market clearing
values thereby generating less than the optimal amount of savings and thus
detracting from the pool available for investment. The policy message is that
both financial and real sector development requires a comprehensive
package of financial restructuring that frees up interest rates to their
market-clearing levels and eliminates administratively-determined selective
credit allocation (Chowdhury, 2000).
100 Muhammad Arshad Khan and Sajawal Khan

There is now general agreement among economists that

inappropriate regulatory and supervisory policies not only retard long-term
economic growth but also increase the likelihood of a financial crisis that
could spread beyond the country’s own borders. Table-1 provides the
importance of prudential and related regulations in the efficient
management of the financial system.

Table-1: Types of Financial Regulation: Objectives and Key Policy


Type of Objectives Key Policy Instruments

Macro- -To maintain control over Reserve requirements, direct
economic aggregate economic activity. credit and deposit ceilings,
-To maintain internal and interest rate controls,
external balance restrictions on foreign capital
Allocative -To influence the allocation Selective credit allocation,
of financial resources in compulsory investment
favour of priority activities. requirements, preferential
interest rates.
-To control the possible Entry and merger controls,
abuse of monopoly power geographic and functional
by dominant firms. restrictions.
Prudential -To preserve the safety and Authorization criteria,
soundness of individual minimum capital
financial institutions and requirements, limits on the
sustain public confidence in concentration of risks,
systemic stability. reporting requirements.
Organizational -To ensure smooth Disclosure of market
functioning and integrity of information, minimum
financial markets and technical standards, rule of
information exchanges market making and
Protective -To provide protection to Information disclosure to
users of financial services, consumers, compensation
especially consumers and funds, ombudsmen to
non-professional investors. investigate and resolve

Source: Vittas (1992, p. 63)

Financial Sector Restructuring in Pakistan 101

It is clear from Table-1 that the debate relating to liberalization has

focused on the allocative aspect of the financial sector rather than
prudential, organizational and protective regulations because of information
problems. Barth, et. al. (1998) suggest that the following initial steps should
be taken to reduce the likelihood of a financial crisis:

• Develop and improve legal systems and information disclosure;

• Impose rate ceilings on bank deposits;
• Establish limits on the rate at which banks can expand credit or on
the rate of increase in their exposure to certain sectors, such as real
• Required greater diversification of bank portfolios; and
• Reduce the restrictions on the range of activities in which banks can

They maintain that it is not possible to determine a priori which

combination is most appropriate for individual countries because of the
different stages of development. Despite this, it would be essential to
maintain that the central purpose of prudential and organizational
regulations is to deal with failures associated with moral hazard while
protective regulations focus on the need to design a fair financial system
that protects the interests of the users of financial services.

Sheng (1996) defined financial restructuring as “the package or

macroeconomic, microeconomic, institutional and regulatory measures taken
to restore problem banking system to financial solvency and health”. The
problem banking system may be defined in terms of non-performing loans
(NPLs) and shortfall of credit requirements. Sheng states that “as a rule of
thumb, banking distress is likely to become systemic when NPLs, net of
provisions reached roughly 15% of the total loans”. The Narasimham
Committee on Banking Sector Reforms (1998) defines that “a weak bank
should be one whose accumulated losses and net NPLs exceed its net worth
or one whose operating profits less its income on recapitalization bonds is
negative for three consecutive years”. Practically, financial restructuring is a
complex process but it strengthens the balance sheet structure of banks and
non-bank financial intermediaries (NBFIs). It can be argued that appropriate
efforts are necessary to reverse the insolvency and poor profitability of
banks. Moreover, the regulatory environment and supervisory institutions
must be modernized and restructured (Hoelscher, 1998). These steps are
102 Muhammad Arshad Khan and Sajawal Khan

necessary to ensure that banking failure does not jeopardize the stability of
financial institutions. The process of financial restructuring consists of four
phases i.e. diagnosis, damage control, loss allocation and rebuilding
profitability and creating the right incentives. If the diagnosis is done
correctly, it would help the banks to know the extent and causes of loss by
applying uniform accounting and auditing standards ─ especially loan
classifications and interest accrual standards ─ for all banks. Damage control
is basically intended to stop the flow of future losses either by liquidating,
enforcing hard budget constraints, changing management, etc. Loss
allocation among different parties25 is the most difficult part of financial
restructuring and successful restructuring depends on the loss allocation.
Finally, rebuilding profitability and creating the right incentives requires
good policies, reliable and efficient management and a strong institutional

There are two types of restructuring mechanism: one is market

based solutions such as shareholder capital injection, sale or merger,
liquidation without deposit compensation, etc. and the other involves
government intervention such as liquidation with deposit insurance,
formation of asset recovery trust, supply side solutions, etc26. Dziobek and
Pazarbasioughu (1988) propose two types of restructuring mechanisms:
financial and operational restructuring. According to them, the aim of the
restructuring program is to restore the solvency and profitability of the
banks. Bank solvency would emanate from shorter-term financial
restructuring measures such as capital injection, long-term loans, swapping
bonds for NPLs, etc. While a return to profitability requires more difficult
and longer-term operational restructuring such as improved cost
effectiveness, better internal governance, effective risk management, etc.
Hence, bank insolvency is dealt with by financial restructuring, while poor
profitability is caused by some combination of NPLs and high operating
costs. These problems are dealt with through operational restructuring.

Mishkin (1996) has noted that “a non-linear disruption to financial

markets in which adverse selection and moral hazard problems become much
worse, so that the financial markets are unable to efficiently channel funds to
economic agents who have the most productive investment opportunities”.
There are four factors promoting a financial crisis: increases in interest rates,
increases in uncertainty, asset market effects on balance sheets, and bank
panics. Hence, a strong regulatory and supervisory system is necessary to cope
with a financial crisis and promote the efficient functioning of financial

Such as, owners, borrowers, depositors, regulators and government.
See Sheng (1996), p. 36.
Financial Sector Restructuring in Pakistan 103

markets. Caprio and Klingebiel (1997) showed that a mixture of bad policies
and bad banking causes bank insolvency. Furthermore, excessive expansion of
credit is also one of the main causes of insolvency. Besides bad banking and
excessive credit expansion, there are many causes which are cited in the
literature such as asset-liability mismatches, insufficient diversification,
directed lending, fraud, etc. Therefore, the challenge is to devise an
appropriate regulatory framework that enables the banking system to be more
resilient to insolvency. In addition, timing, sequencing, and speed of
restructuring measures are very important for successful restructuring
(Khatkhate, 1998 and Alawode and Ikhide, 1997).

The experiences of economies in transition illustrate that the

sequencing of bank restructuring and supervision policies have had a great
impact on macroeconomic performance and financial market development.
In Eastern and Central Europe, bank restructuring policies-recapitalization
with government funds (Hungary, Czechoslovakia, Poland), carving out bad
loans (Poland, Czech Republic), conversion of enterprise debt-to-equity
(Bulgaria and Croatia) - were implemented in varying degrees since 1991
(Sundararajan, 1996). The effectiveness of financial restructuring requires
sustained efforts towards stabilization and proper design and the
enforcement of bank restructuring and prudential supervision policies in
order to avoid major disruption to growth and stability.

The sequencing of financial restructuring and prudential supervision

policies may be divided into three stages (Sundararajan, 1994 and Alexander
et al, 1995). These three stages (Table-2) can provide guidelines for every
country, pursuing restructuring and financial liberalization policies.

Table-2: Financial Restructuring during the Various Stages of Financial

Sector Reform

Stage 1: Preparatory
The preparatory stage include:
Introduction of a minimal program of financial restructuring
policies to deal with fixed rate loans, selected nonperforming
loans, capital adequacy and subsidized selective credit.
Review of legal and organizational arrangements for banking
Strengthen the licensing and entry regulations. Put in place a
framework for orderly intervention and liquidation of banks.
104 Muhammad Arshad Khan and Sajawal Khan

Stage 2: Initiating Market Development

This stage includes the following measures:
Phase in the reform of commercial bank accounting and bank
reporting systems, help to enforce prudential norms and facilitate
monetary analysis.
Phase in the prudential regulations, particularly loan classification
and provision, credit concentration limits, credit appraisal
guidelines and foreign exchange exposure rules based on new
accounting standards.
Strengthen and phase in the capital adequacy norms in line with
bank restructuring strategy.
Introduction of a strategy to combine off-site, on-site, and
external audit, and the balance among the components such as
the availability of resources and technical assistance.
Active pursuit of institutional development of banks.
Formulation of a comprehensive program of bank restructuring,
bank liquidations, loan recovery and loan workout arrangements.
Implementation of simple financial restructuring policies for banks
- supported by enterprise financial restructuring (e.g. policies to
reduce debt-equity ratio of non-financial firms and recapitalize
banks through portfolio restructuring) as a part of this program.

Stage 3: Strengthening Financial Markets

During this stage the following steps are needed:

Continuation of comprehensive reforms to foster bank and
enterprise restructuring systematically in line with the program
designed in stage 2.
Promotion of well-capitalized and well-supervised dealers in
government securities (and money market instruments) as part of
strengthening security market regulations and supervision.
Completion of reforms of bank accounting and prudential standards.
Strengthen financial risk management in payment systems.
Strengthen supervision of asset-liability management (interest rate
risks, liquidity management), internal controls, and management
systems of banks.
Financial Sector Restructuring in Pakistan 105

Achievement of appropriate balance between off-site supervision,

on-site inspection and external audit through technical assistance
and training.
Close monitoring of risk implications of financial innovations and

III. Financial Restructuring in Pakistan

In Pakistan, banking sector reforms were launched in the early

1990s. The objective of these reforms was to make the financial industry
more competitive and transparent by privatizing formerly nationalized
commercial banks, liberalizing interest rates and credit ceilings,
strengthening the supervisory capacity of the central bank and standardized
accounting and auditing systems (Iimi, 2004).

Prior to the 1990s, the financial sector in Pakistan remained heavily

controlled27. Interest rates were set administratively and usually remained
negative in real terms. Monetary policy was conducted primarily through the
direct allocation of credit. The money market was under-developed, and
bond and equity markets were virtually nonexistent. Commercial banks
often had to lend priority sectors with little concern for the borrowing
firm’s profitability. Despite the opening of the non-bank financial sector for
private investment in the mid-1980s, state-owned financial institutions held
almost 93.8 % of the total assets of the entire financial sector at the end of
the 1980s. Moreover, the status of financial institutions was precarious due
to, inter alia, high intermediation costs resulting from overstaffing, a large
number of loss-incurring branches, poor governance with low quality
banking services, accumulation of non-performing loans and inadequate
market capitalization. These inefficiencies and distortions caused severe
macroeconomic difficulties in the late 1970s and 1980s and distorted
economic growth. In order to remove these distortions and spur economic
growth, the Government of Pakistan undertook a wide range of reforms in
the early 1990s to strengthen its financial system and to provide an
adequate macroeconomic environment.

The financial sector reforms included: (i) the liberalization of interest

rates by switching from an administrated interest rate setting to a market
based interest rate determination; (ii) the reduction of controls on credit by

All commercial banks were nationalized in January, 1974, with the aim of making
credit availability to high priority sectors of the economy which previously had limited
access to investable funds (see Haque and Kardar, 1993 for a detailed account).
106 Muhammad Arshad Khan and Sajawal Khan

gradually eliminating directed and subsidized credit schemes, (iii) the

creation and encouragement of the development of a secondary market for
government securities, (iv) strengthening the health and competition of the
banking system by recapitalizing and restructuring the nationalized
commercial banks (NCBs) increasing their autonomy and accountability, (v)
improving the prudential regulations and supervision of all financial
institutions, and (vi) allowing free entry of private banks in the financial

The financial sector reforms which were launched in the early 1990s
can be classified in three phases. These three phases of financial sector
reforms can be termed as the first generation of reforms.

III.A. First Phase of Financial Reforms (1988 –1996)

The first phase reforms were aimed at creating an efficient,

productive, and enabling environment for operational flexibility and
functional autonomy. The first phase of financial reforms28 included: first,
the government liberalized the market entry of private and foreign banks29
in order to gain efficiency and enhance competition within the financial
sector. Secondly, two of the state-owned commercial banks, i.e. Muslim
Commercial Bank (MCB) and Allied Bank Limited (ABL), were partially
privatized between 1991 and 1993. Thirdly, major state-owned
commercial banks and DFIs were downsized in terms of branches and
employees. Fourthly, credit ceiling as an instrument of credit control was
abolished, the Credit Deposit Ratio (CDR) was also abolished and open
market operations is now an instrument of monetary policy and the State
Bank of Pakistan (SBP) at regular intervals has conducted auctions of
government securities. Fifthly, the loan recovery process was strengthened
by establishing banking courts and standardizing loan classification and
accounting rules. Finally, the State Bank of Pakistan was granted full
autonomy. However, the segmentation of financial markets continued
owing to continuing controls on interest rates on government debts and
specialized credit programs.

The early phase of financial reforms as a part of financial restructuring policies started
in the late 1980s to early 1990s.
Ten new private banks started their operations in 1991 and 23 private domestic banks
operating in the country including HBL, ABL, MCB and UBL. The process of
liberalization started in the early 1990s and except NBP, more than 50 % shares of the
public sector have been privatized. There are about 14 foreign banks that have been
operating in the country.
Financial Sector Restructuring in Pakistan 107

III.B. Second Phase of Financial Reforms (1997-2001)

In late 1996 the financial sector was on the verge of collapse

(Table-3) with about one-third of banking assets stuck in the form of Non
Performing Loans (NPLs). Liquidity problems had begun to emerge as
disintermediation spread and banking losses increased. Most cases of loan
defaults remained unresolved because of the ineffective judicial system.
These problems were rooted in a failure of governance and lack of
financial discipline. Political interference had vitiated the financial
intermediation function of the banking system and the borrowers expected
not to repay loans they took, especially from National Commercial Banks
(NCBs) and Development Finance Institutions (DFIs). NCBs and DFIs were
the main loss makers because over 90% of their loans were in default.
Excess manpower, large branch network and undue interference by labor
unions resulted in large operating losses. Poor disclosure standards and
corruption were widespread. These serious problems created a demand for
further reforms. As a result, the second phase of banking sector reforms30
was introduced in early 1997. These reforms addressed the fundamental
causes of crisis and corruption and strengthened corporate governance and
financial discipline. In this regard, the cost structure of banks was first
restructured through capital maintenance and increased by public funds.
Secondly, partially privatized commercial banks were privatized
completely. Thirdly, bank branches were fully liberalized which allowed
private banks to grow faster and increase their market share. Fourthly,
loan collateral foreclosure was facilitated and strengthened to reduce
default costs and to expand lending to lower tier markets, including
consumer banking. Fifthly, national savings schemes were reformed so as
to integrate with the financial market. Sixthly, the mandatory placement
of foreign currency deposits was withdrawn. Lastly, the SBP was
strengthened to play a more effective role as regulator and guardian of the
banking sector and phase out the direct and concessional credit programs
to promote market integration.

The second phase of banking sector reforms started from 1997 to 2001.
108 Muhammad Arshad Khan and Sajawal Khan

Table-3: Selected Indicators of Vulnerability in Pakistan

(Period ended 1996)

Macro Indicator
Inflation > 5% 10.7
Fiscal Deficit > 2% of GDP 6.5
Public Debt > 50% of GDP Yes
Current Account Deficit > 5% of GDP 7.4
Short-term Flows > 50% of the Current Account Deficit Yes
Capital Inflows > 5% of GDP Yes
Ratio of Short-term Debt to International Reserves >1 Yes
Financial Sector Indicators
Recent Financial Sector Liberalization Yes
Recent Capital Account Liberalization No
Credit to the Private Sector > 100% of GDP 17.1%
Credit to the Private Sector (real growth) > 20% No
Emphasis on Collateral when making loans Yes
Estimated Share of Bank Lending to the Real Estate Sector>20% No
Stock of Non-performing Loans > 10 % of Total Loans Yes
Stock Market Capitalization as %age of GDP 20.11%

Source: Lindgren et al (1999), p. 11

III.C. Third Phase of Financial Sector Reforms (2002-2004)

In this phase there were several major changes and significant

positive shifts in the regulatory atmosphere to strengthen the financial
system and introduce structural improvements. Some of the more important
developments have been seen in the following areas:

Consolidation, Privatization and Regulation: During the 1990s,

mushroom growth in commercial banks and non-bank financial institutions
has been witnessed, a few of which have low capitalization,
inadequate/inappropriate staffing, poor risk management practices and a
marginal portfolio quality. The central bank sought out to consolidate the
Financial Sector Restructuring in Pakistan 109

banking sector by raising the minimum capital requirement. The minimum

capital requirement was 1 billion for 2003, 1.5 billion for 2004 and was set
at 2 billion for 2005. There have been 17 mergers and acquisitions and
there are several in the pipeline. Weak entities have been eliminated. The
average capital base of a commercial bank has risen from 1.8 billion in 2000
to 3.7 billion in 2003. Now all banks are required to maintain at least 8% of
the risk weighted assets as capital requirement.

The regulatory oversight for a sizeable chunk of the financial system

(such as leasing companies, modarabas, investment banks, mutual funds and
insurance companies) has been moved to the Securities and Exchange
Commission (SECP), but SECP failed to build capacity in order to handle
this inflow. The SECP lacks on-site inspection capability.

Universal and Consumer Banking: Banks are allowed to form separate

subsidiaries to function as mutual funds, asset management companies,
venture capital, foreign exchange companies, etc. Furthermore, banks are
encouraged to expand their lending operations to middle and lower income
groups. A large range of consumer asset products such as credit cards, auto
loans, clean installment loans, housing finance, etc., are being marketed
aggressively. The NPLs in this sector are significantly lower than that of the
corporate sector. Similarly, Small and Medium Enterprise (SME) financing
has also become part of the lending toolkit. However, several banks shy
away from this sector because of high-risk perception.

Automation and Prudential Regulations: ATM coverage is relatively low

and on-line banking is offered by most of the banks. The Central Bank itself
is making significant progress in this area. Credit information data and
credit rating agencies data are now available on line.

Similarly, the Central Bank has been steadily moving away from its
tradition of intrusive regulation and directed lending. Unlike the late 1980s,
a much more permissive regulatory atmosphere prevails today. The Central
Bank also modernized and revised prudential regulations for corporate and
commercial banking, SME financing, microfinance institutions and consumer

Banking Audit, Supervision and Corporate Governance: The

SBP’s compliance with the Basle Core Principles is generally high. The SBP
now conducts comprehensive on-site inspections using a standardized
110 Muhammad Arshad Khan and Sajawal Khan

CAMELSS31 for rating the overall condition of a bank. The SBP is also
developing an early warning system called IRAF32. For corporate
governance, both the SBP and SECP issued codes of corporate governance.
Corporate disclosure standards have improved. However, there is a need to
reform the taxation structure and the tax collecting institutions.

Out-of-Court Settlement of NPLs: Two thirds of the stock of

NPL involve a single lender. Recovery of NPLs involves internal and
external hurdles. The pressure from influential borrowers is often exerted
through the government. To reduce the level of NPLs, the government
and the SBP established the committee for the revival of sick industrial
units (CRSIU) and corporate and industrial restructuring corporation
(CIRC). The committee claims that it has revived 172 industrial units
involving outstanding NPLs of Rs. 46 billion. However, the World Bank
concluded, regarding the assessment of CIRSU, that “in the absence of
operational analysis, there would generally appear little increment in the
value of the project. Future viability and renewed distress of these projects
are of concern. No track is kept of financial or operational details of the
projects after revival.” In 2002 because of growing NPLs and the failure of
CIRC, the National Accountability Bureau (NAB) and CIRSU, the SBP
issued guidelines whereby banks are actively encouraged to settle NPLs
with borrowers at the Fore Sale Value (FSV) of the underlying collateral.
Under this scheme, borrowers were required to deposit 10% down
payment at the time of signing the settlement agreement and repay the
remaining amount in 12 quarterly installments. This scheme encourages a
lot of defaulters to come forward and settle their long-standing liabilities.
Similarly, under the debt recovery program, EDR (Excess Debt Recovery)
had a write-off efficiency ratio of 5:1(i.e. for each of the provisions
written off it would generate a cash recovery of Rs. 5). Under these
guidelines Rs. 52 billion of NPL have been settled at the cost of around
Rs. 35 billions.

IV. Results of the Financial Restructuring

The objectives of financial restructuring policies were to forestall a

collapse of the generalized banking system and to establish a viable banking
system in the country. It was expected that financial and operational
restructuring policies strengthened the microeconomic foundations of the
banking system. However, commercial banks have been slow to mobilize

CAMELSS indicate Capital, Assets, Management, Earnings, Liquidity, and Sensitivity
to Market Risk, Systems.
IRAF indicate Institutional Risk Assessment Framework.
Financial Sector Restructuring in Pakistan 111

deposits, which play a significant role in financial intermediation. As Akhtar

(2007) pointed out, the successful transformation and restructuring of the
financial industry depends on some critical factors such as: (i) promoting a
higher degree of depth and efficiency in the financial intermediation process
by effective resource mobilization and channeling these resources to
promote economic growth, (ii) improving the financial performance and
strengthening the soundness of financial institutions, and (iii) extending the
outreach of financial services to the poor segment of society.

We therefore, briefly discuss the impact of the financial sector

reforms under the following headings:

IV.A. Interest Rate Policies

Interest rates directly affect business conditions and economic

activities and thus represent a powerful policy instrument. In Pakistan,
before financial reforms, interest rates were set administratively and were
often negative in real terms. For example, deposits were paid negative real
return, thus discouraging savings in the country. Ceilings on interest rates
were imposed with the desire to provide low-cost financing to encourage
investment, particularly in the priority sectors. However, restrictions on
interest rates led to financial disintermediation, as savers and investors
sought alternative outlets outside the formal financial system. Consequently,
financial deepening was hindered, and financial resources were not directed
into productive activities.

After liberalization, the price of financial services was intended to be

determined by the banks on a competitive basis, with little intervention
from the SBP. To achieve the twin objectives of reducing the government’s
cost of borrowing on domestic debt and encouraging private sector credit
expansion, the SBP had been pursuing a relatively easy monetary policy from
July 1995 to July 2000. The weighted average lending rate gradually came
down from 15.6% in 1998 to 8.81%33 in June 2005, but the real interest
rate increased from 3.6% in 1996 to 10.9% in 2000 and then following a
declining trend, reached –0.49% in June 2005 (see Table-4). This reduction
in the lending rate indicates little improvement in the profitability of the
banks but is purely ad hoc and not in the line with liberalization. Similarly,
the weighted average deposit rate declined from 6.8% in 1998 to 1.37% in
June 2005; the real deposit rate remained negative except for the period
1999-2002. This reduction in the deposit rate will reduce savings even

Although in 2004 the rate fell to 7.28 %.
112 Muhammad Arshad Khan and Sajawal Khan

Table-4: Interest Rate Behavior in Pakistan

Weighted average Weighted average Interest Rate

Year Inflation
Lending Rate Deposit Rate Spread
Nominal Real Nominal Real Nominal Real
1990-95 10.57 12.55 1.98 6.53 -4.05 6.02 5.95
1996 10.8 14.4 3.6 6.4 -4.4 8.00 8.00
1997 11.8 14.6 2.8 6.8 -5.0 7.8 7.8
1998 7.8 15.6 7.8 6.8 -1.0 8.8 8.8
1999 5.7 14.8 9.1 6.5 0.8 8.3 8.3
2000 3.6 13.52 10.9 5.47 1.9 8.05 9.00
2001 4.4 13.61 9.21 5.27 0.87 8.34 8.34
2002 3.5 13.19 9.69 3.61 0.11 9.58 9.58
2003 3.1 9.40 6.3 1.61 -1.49 7.79 7.79
2004 4.6 7.28 2.68 0.95 -3.65 6.33 6.33
2005 9.3 8.81 -0.49 1.37 -7.93 7.44 7.44

Source: SBP Annual Reports (various issues).

The interest rate spread34 is an important indicator for the financial

sector’s competitiveness, profitability and efficiency. Spread typically declines
when competition among banks increases to access the financial market to
increase their customer’s base. But in Pakistan, the high lending rate and low
deposit rate have generated a large spread35 nearing 7.44% in June 2005 as
against 6.33% in 2004. The high lending rate will increase the cost of
borrowing and hence discourage investment. The low deposit rates discourage
savings, resulting in a high debt/GDP ratio, deterioration of the banks balance
sheets, lowering economic growth, and increasing poverty. Furthermore, the
large spread also reflects a perceived sovereign risk (Khan, 2003).

However, the efforts of the SBP to enhance competition helped to

narrow the spread to 6.33% in 2004. But this trend was reversed and the
spread rose again to 7.44% by the end of June 2005 and the commercial

Interest Rate Spread = (Average Lending Rate – Average Deposit Rate).
High interest rate spread is generated by factors such as high administrative costs,
overstaffing and unavoidable burden of non-performing loans (for further detail, See
SBP’s financial sector assessment 2003-2004).
Financial Sector Restructuring in Pakistan 113

banks re-priced their loans in line with the upward adjustment in the SBP
repo rate in the wake of high inflation without any rise in deposit rates.
Hence, measures should be taken to bring down the interest rate spread close
to zero in order to enhance both savings and investment in the country.

IV.B. Performance and Efficiency of Financial Institutions

The performance and efficiency of a financial institution involves two

aspects, namely, solvency and sustainable profitability. Solvency improving
measures affect the bank's balance sheet while profitability measures affect
the bank's income. The improvement in the banking performance emanates
from financial restructuring operations. NPLs can be used as an indicator to
measure the performance of financial institutions. In Pakistan, the NCBs and
the DFIs have been facing the problem of NPLs, which increased from Rs.
25 billion in 1989 to Rs. 128 billion in June 1998, or 4% of GDP.
Moreover, the NPLs increased from Rs. 230.7 billion in December 1999 to
Rs. 240.1 billion in December 2000. However, some significant efforts were
made by the government to recover default loans. As a result, NPLs, in
gross as well as net terms have followed a declining trend since 2001
showing an improvement in loan appraisal standards and market discipline.
Furthermore, as the banking sector registered a growth in advances, the
ratio of NPLs to advances showed a sharp declining trend (Table-5).

Table-5: Non-performing Loans of the Banking System

Year NPL’s (in Gross NPLs to Provisions to Net NPL to Net

Billions) Advances (in %) NPLs (in %) Advances (in %)
1997 173.0 23.5 46.6 -
1998 183.0 23.1 58.6 11.1
1999 230.7 25.9 48.6 15.3
2000 240.1 23.5 55.0 12.2
2001 244.1 23.4 54.7 12.1
2002 231.5 21.8 60.6 9.9
2003 222.7 17.0 63.9 6.9
2004 211.2 11.6 70.4 3.8
2005 177.3 8.3 76.7 2.1

Source: SBP Annual report (various issues)

114 Muhammad Arshad Khan and Sajawal Khan

The financial institutions succeeded in bringing down NPLs from

25.9% to 8.3% of the total advances of the banks and DFIs at the end of
2005. The net NPLs (net loan ratio), which is a more appropriate measure,
was still about 2.1%. These indicators reveal a very impressive performance
by the banking sector because in late 1996, the banking system was on the
verge of a crisis with about one-third of its assets stuck in the form of
default and NPLs.

IV.C. Money and Credit Policies

In the late 1980s and early 1990s, Pakistan conducted its monetary
policy through direct control on credit and interest rates. The banking
system was not generally competitive and major banks were owned by the
state. In addition, banks and other financial institutions were required to
hold part of their portfolios in government debt at below market rates. The
government directed bank loans to state owned-enterprises. The range of
financial instruments available to banks and the public was intended to be
narrow with maturity structures and yields unrelated to risk and liquidity.

In recent years, Pakistan has started to reform its monetary policy by

using indirect or market-based instruments to achieve macroeconomic
stability. In 1995, the SBP shifted the emphasis from direct to indirect
instruments i.e. open market operations including a rediscount window,
liquidity auctions, repurchase agreements and overdraft facility. The
monetary authorities have sought to reduce direct government intervention
and strengthen the role of market forces in allocating financial resources in
order to improve the capacity of institutions to mobilize domestic savings,
improve the effectiveness of monetary policy, enhance competition among
banks and strengthen the banks’ financial soundness.

To measure the improvement in the financial intermediation

capacity of the banking system following the financial restructuring process,
the standard indicators used in this paper include the ratios of currency to
broad money (M2), ratio of currency to GDP, M2/GDP, M3/GDP, M1/M2,
the ratio of private sector credit to GDP and market capitalization36. Table-5
presents the entire situation after the introduction of financial sector

M1 is the currency in circulation plus demand deposits. M2 is M1 plus time deposit,
foreign currency deposits. M3 is M2 plus other type of deposits, as well as short-term
money market instruments such as certificates of deposits. In the case of Pakistan M3
includes M2 plus NSS, NBFIs.
Financial Sector Restructuring in Pakistan 115

The ratio of currency to broad money (M2) would tend to fall in the
financial environment where market forces dominate, where there are
alternative saving investment instruments (stocks, bonds, mutual funds etc.)
that raise the real rate of return, where there is confidence in the banking
system and where access to the banking system has expanded. The ratio fell
from 37.56% in 1990 to 23% in 2005. This implies the dominance of
market forces and retains the confidence of the customer in the banking
system. Furthermore, the low ratio of currency to money mainly reflects
advancement in the payment system, which heavily relies on credit cards,
the development of the banking system and that money can be transferred
between checking and savings accounts easily without any significant cost.

Table:- Indicators of Financial Deepening (in %)

Indicators 1961-70 1971-80 1981-90 1990 2000 2001 2002 2003 2004 2005
Currency/M2 45.13 32.29 32.28 37.56 27.80 26.02 25.30 25.04 23.99 23.00
Currency/GDP 16.06 13.53 13.29 14.73 10.82 10.31 11.08 11.77 11.84 11.18
Broad Money 34.03 33.90 41.24 39.24 38.93 39.64 43.80 46.99 49.36 48.61
M3/GDP - - 51.60 60.63 57.98 55.90 60.8 64.36
M1/M2 - - 67.10 76.01 59.32 58.48 58.01 61.23 61.78 72.48
Private Sector 19.60 19.24 21.45 19.92 22.33 22.02 21.92 24.87 29.30 28.44
Stock market 8.42 4.08 3.75 4.68 10.24 8.15 9.26 15.48 24.05 30.95

Sources: Calculated by authors using IFS and SBP data

During the financial restructuring process, the ratio of M2 to GDP

tends to rise as access to banking and saving instruments spreads. But as
markets mature, the ratio M2/GDP tends to decline as other financial
instruments outside the M2 aggregate become available. The ratio M2/GDP
which was 39.24% in 1999, touched 48.61% at the end of 2005. This is
mainly due to the improvement of the domestic financial system.

The ratio of currency to GDP has decrease from 14.73% in 1990 to

11.18% in 2005 implying that the banking system is relatively developed.
There are significant foreign currency deposits in the banking system and
substantial real rates of interest on saving accounts in domestic currency.
116 Muhammad Arshad Khan and Sajawal Khan

The ratio of M1/M2 provides a proxy for the extent to which the
financial system of a country has succeeded in mobilizing savings. In 1990,
the ratio was 76.01, which came down to 58.01% in 2003. This is mainly
due to the development of the banking sector, a significant increase in
foreign currency deposits and substantial real interest rate on savings. It
started increasing from 58.01% from 2003 and touched 72.48% at the end
of 2005. This implies a reduction of savings due to the negative real rate
returns on deposits.

The share of private sector credit to GDP is one of the important

indicators of allocative efficiency when compared with that of the
government sector. Credit to the private sector would be expected to
expand when banks are successfully restructured. In addition, this ratio also
reflects whether the private sector receives sufficient resources to carry out
its economic activities. It has fuelled economic activity, revived and
enhanced industrial capacity and supported steady growth in the services
sector, the contribution of which to GDP is nearly 52.3%. The ratio of
private-sector credit to GDP increased from 19.92% in 1990 to 28.44% in
2005. In addition, fiscal adjustment efforts, privatization of some public
enterprises and the liberalization of interest rates had all clearly enhanced
the private sector's access to the banking system.

Stock market capitalization, which was 4.68 % of GDP in 1990, is

30.95 % of the GDP in 2005. This indicates the promotion of trading
activities. However, the secondary market is not yet operating efficiently and
remains very thin and bank financing remains the main source of funds for
productive investment. Furthermore, foreign access to the stock market is
limited because of a number of factors including macroeconomic
weaknesses, inadequate transparency and accounting standards and a
cumbersome and opaque regulation environment. In addition, there are
some restrictions on the capital movements for non-residents and also
ceilings on non-residents’ shares in companies’ equity. Moreover, bond
markets barely constitute 5-7% of GDP and there is low pension and
insurance coverage.

IV.D. Profitability and Financial Soundness

After years of poor profitability, the returns on assets and equity are
beginning to increase. Net interest income decreased from 69% in 2001 to
58.2% in 2003. This reduction of net interest income is mainly due to a
contraction in interest margin. As a result, the share of net interest income
in gross income declined to 58.2% (Table-6).
Financial Sector Restructuring in Pakistan 117

Table-6: Banking Sector Earnings and Profitability.

Earning and Profitability 1999 2000 2001 2002 2003

Return on assets after tax -0.2 -0.2 -0.5 0.1 1.0
Return on equity after tax -6.2 -0.3 -0.3 13.8 22.1
Net interest income to gross income 54.3 61.2 68.9 67.4 58.2
Non-interest expenses to gross income 76.9 71.6 62.7 57.3 50.4
Personnel expenses to non-interest 57.0 54.3 52.6 51.4 50.1
Non-interest income to total income 17.6 16.5 14.5 18.1 30.9

Source: State Bank of Pakistan

Akhtar (2007) has pointed out that the profits of commercial banks
crossed over $1 billion for the first three quarters of 2006. She further noted
that from 2000-2006, the returns on assets of banks rose from -0.2% to 2.1%
and return on equity from -3.5% to 26.1%. This increase in profit may be
attributed to many factors such as: (i) a rise in earning assets of commercial
banks to 85% in September 2006 which is significantly above the pre-reform
period and a rise in advances to total assets from 49.1% in 2000 to 55.1% in
September 2006, (ii) a decline in total and operating expenses, (iii) a rise in
the SME, consumer finance and agriculture sector lending which constitutes
over one third of total outstanding advances, (iv) a high share of non-interest
bearing deposits and declining share of fixed deposits, and (v) a growth of
service charges by the use of electronic banking. Furthermore, it can be
argued that the privatization of the financial industry has had a distinct impact
on the profitability of the banking sector, though its impact on efficiency is
relatively weak37. However, it is expected that over a period of time there will
be more progress in these areas.

IV.E. Privatization Policy

The structure of the financial sector in Pakistan has substantially

changed following privatization of the state-owned commercial banks. In
1990, the financial system was fully dominated by five state-owned
commercial banks. During the first round of financial sector reforms, two
state-owned commercial banks ─Muslim Commercial Bank (MCB) and Allied
Bank Limited (ABL) ─were privatized between 1991 and 1993. The reform
process was subsequently delayed for several years and again resumed in the

State Bank of Pakistan (2005).
118 Muhammad Arshad Khan and Sajawal Khan

early 2000s. With the privatization of the third largest commercial bank,
United Bank Limited (UBL), in 2002, the domination of the state-owned
commercial banks was ended. As of September 2003, the asset share of
domestic private banks and public sector commercial banks was 47% and
41% respectively. Furthermore, when the privatization of Habib Bank
Limited (HBL) was completed in 2004, the share of the assets of the
banking system held by public sector commercial banks decreased to less
than 25%. Today, the National Bank of Pakistan (NBP) is the only state-
owned commercial bank with a market share of approximately 20%.

The privatization of nationalized commercial banks and DFIs poses a

serious challenge to the government. The government facilitated bank
restructuring process by recapitalization of banks through (i) equity injection
of Rs. 46 billion in some of the public sector banks and write offs equivalent
to Rs. 51 billion, (ii) lay-off of close to 35,000 employees in two phases38 from
public banks, and (iii) the closing of over 2000 loss incurring bank branches.

IV.F. Corporate Governance

The efforts of SBP helped in bringing a positive change in the

corporate governance standards of banks. Banks and other financial
institutions are now managed by a better cadre of professionals and
stakeholders now play an active role in the affairs of banks. Regular board
meetings, financial reporting standards, disclosure and transparency helped
to improve corporate governance. Improvement in corporate governance
helped to ensure a high degree of financial stability.

From December 2002 to December 2005, the balance sheet of the

banking system has recorded a growth of 64.5%, which is quite significant.
Since 2002, the deposits of the banking system registered a growth of 69%.
Returns on assets after tax increased from 0.1% in 2002 to 1.9% in 2005
and further increased to 2.1% by the end of September 2006. The loan
portfolio of the banking system doubled in the last three years. Credit
growth is now fairly diversified. All these achievements have resulted owing
to good governance policies.

On the basis of the above analysis, we reached the following conclusions:

• Financial markets have now become more competitive and relatively

efficient but still remain shallow. There are many financial

In 1997 almost 24000 employees were laid off and in the second phase around 11,700
employees were relieved (Akhtar, 2007).
Financial Sector Restructuring in Pakistan 119

instruments available for transactions but the evolution of new

instruments has to remain on track.
• Although financial infrastructure has been strengthened, the legal
system is still complicated, time consuming and costly for ordinary
customers. Furthermore, the regulatory environment has been
improved and the monitoring system is much better today but
enforcement and corrective capabilities need to be further
• The further development of long-term bond markets, further
improvements of corporate governance, reinforcement of regulatory
and supervisory arrangements, the expansion of investors’ base,
improvement of equity market infrastructure, revaluation of market
volatility-controlling mechanisms and sequencing the reforms also
need to be enhanced.

The Second Generation of Reforms

The first generation of reforms launched in the early 1990s gained

roots and the financial industry in Pakistan is now ready to shift its focus to a
second generation of reforms. The second generation reforms will not only
help in achieving macroeconomic stability but also create an enabling
environment for sustainable economic growth. Institutional strengthening,
macroeconomic stability, protection of property rights, and legal and financial
infrastructure development should be the main pillars of the second generation
of reforms. The main ingredients of second generation of reforms include:

(i) Macroeconomic Stability

It can be thought that the banking system could easily be weakened
by high and volatile real interest rates, owing to inappropriate fiscal policies
that entail excessive borrowing from the commercial banks, inefficiencies in
the payment system that encourage fraud, and loss-incurring banks. In order
to maintain stability within the liberalized financial system, it is necessary to
ensure that the fiscal position should be sound, banks should be well
capitalized, and the payment systems should be modernized. To achieve these
objectives the authorities should ensure stable and enabling macroeconomic
conditions because it is inadequate to promote financial liberalization when
the structural and macroeconomic problems remain unresolved.

(ii) Improvement in Governance

An improvement in governance would ensure greater transparency
and accountability, a more secure and predictable environment for domestic
120 Muhammad Arshad Khan and Sajawal Khan

and foreign investment, and promote greater ownership of the reform

efforts. In Pakistan there is still a need to clarify rules related to governance.
Hence, attention should be paid to clarification and rules should be
conformed so that they are consistent with international standard.

(iii) Strengthen Institutional Capacity and Protection of Property Rights.

For economic stabilization and sustainable economic growth,
institutional strengthening and the risk taking ability of economic agents is
necessary. Macroeconomic stabilization requires strong institutional
coordination between the monetary and fiscal authorities. Strong institutions
and protection and simplification of property rights should be given an
important place in the second generation reform agenda. Furthermore, up-
gradation and the encouragement of institutions such as SMEs,
microfinance, consumer finance, housing finance and rural banking will
accelerate the momentum of the financial industry because of the access of
the vast majority of the population to financial services. Hence, there is an
urgent need to further develop and strengthen these institutions.

(iv) Streamline Venture Capital Funds and Private Equity Funds

Venture capital and private equity funds, private pension and
provident funds and insurance companies are the most effective means for
financing innovative firms in the economy. The authorities should
streamline these funds and encourage their growth.

(v) Strengthen the Legal and Financial Infrastructure

The accountability and enforcement of financial contracts requires
that we have a legal system that dispenses justice quickly and inexpensively.
But our legal procedure is too lengthy. There is a need to review banking
laws and procedures to make them simple and less abrupt. Hence, this area
needs special attention.

V. Conclusions

Financial restructuring is a continuous process not an event. Prior to

1990, the financial sector in Pakistan was characterized by weakness in
banking and corporate governance, weak accounting standards, lack of market
discipline, weak prudential regulations and poor legal infrastructure. These
problems increased the exposure of financial institutions to a variety of
external threats, including a decline in the values of assets, market contagion,
speculative attacks, exchange rate devaluation, and a reversal of capital flows.
Furthermore, capital flight and disrupted credit allocation further caused a
Financial Sector Restructuring in Pakistan 121

deterioration in the efficiency of the banking sector. In the background of the

arising situations of the financial sector in Pakistan, a number of restructuring
measures were undertaken since 1990 with a view to restore financial
discipline and improve the operational efficiency of the financial sector. The
financial sector restructuring program was instituted in 1990 and was
concluded in 2004. In response to financial restructuring measures, financial
discipline and operational efficiency shows significant improvement today as
compared to pre-1990. Pakistan has made considerable progress during the
past one and half decades in reforming its financial sector. Financial
restructuring and privatization have changed the landscape of the financial
industry in Pakistan. However, the secondary market is relatively thin and as
such the supply of corporate securities remains small but the change is more
fundamental in banking relative to equity markets. The development of the
capital market is related to a range of economic, financial, institutional and
legal factors that need to be addressed properly.

Furthermore, the legal infrastructure must be developed for financial

supervision, bankruptcy and foreclosure. Bank secrecy laws should be
improved to enhance transparency and a deposit insurance scheme is needed
to maintain confidence in the financial system. An early warning system and
prompt corrective actions are needed. The study further concludes that
without further improvement of corporate governance and expansion of the
investor's base, capital markets cannot be developed. Moreover, until the
equity markets are strengthened, the capital market cannot function well to
complement the banking sector. More openness, together with more
transparency and the disclosure of information, should contribute
significantly to the financial restructuring of the economy and integration
into the global economy. Although Pakistan restructured its financial sector
successfully within a very short period, the sustainability and performance of
financial sector reforms are required (Akhtar, 2007):

• Macroeconomic stability,
• A greater degree of consolidation should be necessary for strong and
robust banking,
• Prudent regulatory and supervisory framework,
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122 Muhammad Arshad Khan and Sajawal Khan

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The Lahore Journal of Economics
Special Edition (September 2007)

Pakistan’s External Trade: Does Exchange Rate Misalignment

Matter for Pakistan?

M. Ashraf Janjua*


This paper is primarily aimed at assessing the significance of the

exchange rate on Pakistan’s foreign trade. It estimates the Equilibrium Real
Effective Exchange Rate (ERER) and exchange rate misalignment for
Pakistan using annual data from FY78 to FY06. The Engle Granger co-
integration technique is used for the estimation of ERER depending upon
various macroeconomic fundamentals as recommended by Edwards (1994).
The results of the study are also used for the forecasting of ERER and
misalignment up to the year 2010. The results of the study reveal that
ERER is determined by variables such as: a) terms of trade, b) trade
openness, c) net capital inflows, d) relative productivity differential, e)
government consumption, and f) workers’ remittances.

The error correction term points to the gradual convergence of the

real exchange rate towards the long-run equilibrium level which suggests
that the prevailing Pak Rupee exchange rate has not deviated from the
ERER and captures economic fundamental trends. Moreover, Pakistan’s
foreign trade would depend significantly upon the state of economic
fundamentals in the future. Improved economic fundamentals are likely to
support trade besides paving the way for enhanced inflows of capital and
financial receipts.

I. Introduction

The economic literature recognizes that exchange rate policy

influences various parts of the balance of payments. It affects the balance of
trade of a country mainly through improving international competitiveness
which affects the supply and demand for exports and imports (i.e. the
elasticities of supply and demand for exports and imports). In fact, exchange
Dean, College of Business Management, Karachi, and Former Deputy Governor, State
Bank of Pakistan.
126 M. Ashraf Janjua

rate policy affects the international competitiveness of domestic products as:

a) changes in the cost of production may raise the domestic price level; b)
changes in domestic price may also affect production costs if changes in
wages are in line with the changes in cost of living when imports become
more expensive with depreciation; and c) if a large country depreciates its
currency, the exports from small countries to the concerned country may be
reduced. Keeping in view its significance, every government needs an
exchange rate policy and has to make a strategic choice between a fixed
exchange rate regime, a flexible exchange rate regime, or one of various in-
between options. Each policy has its own advantages and disadvantages, and
each country’s circumstances are different. Although many countries have
pegged their exchange rates with hard currencies, there is a clear trend
towards greater flexibility in exchange rate policy. Moreover, a central bank
that is independent of the government is committed to maintaining low
inflation and full employment does not finance budget deficits and often
prefers a flexible exchange rate.

Historically, Pakistan pursued a policy of export-led growth, with the

objective of achieving viability in her balance of payments. With a view to
achieving this objective, the country had to adopt various exchange rate
regimes at different times. A fixed exchange rate regime was followed from
1947 to 7th January, 1982. During the early 1980s, the dollar started
appreciating in terms of the major currencies and as the Rupee was linked
to the U.S. dollar, this affected the competitiveness of Pakistani products in
international markets. Thus, with a view to maintaining the competitiveness
of exports and thereby to bring a sustainable balance between the country's
current receipts and current payments, it was decided to adopt the managed
floating exchange rate system w.e.f. 8th January, 1982. Under this system the
value of the Pak-Rupee was reviewed daily with reference to a trade
weighted basket of currencies of the country's major trading
partners/competitors. Necessary adjustments in the value of the Pak-Rupee
were made as and when circumstances indicated a need for such an
adjustment, keeping in view the relative changes in exchange rates and the
prices of the country's major trading partners/competitors as well as major
macro-economic indicators of Pakistan. The managed float continued to
operate successfully till 21st July, 1998. In the wake of economic sanctions
by major donors and the restraining stance adopted by multilateral financial
institutions as a reaction to the nuclear tests on May 28, 1998, Pakistan had
to take a number of measures to face the challenge. As a part of this
strategy, the State Bank of Pakistan (SBP) introduced a New Exchange Rate
Mechanism (NERM) on 22nd July, 1998, replacing the managed-floating-
exchange-rate system. The underlying philosophy of the dual exchange rate
was to pass on the advantages of devaluation to exporters, expatriate workers
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? 127

wishing to remit money to Pakistan and to compress non-essential imports.

It was also intended to contain the cost of devaluation in terms of
containing price increases of essential imports and repayments of the
external debt thereby limiting the impact of inflation and the overall fiscal
deficit of the government. The adoption of NERM was tantamount to a
multiple currency practice. The multiple exchange rate system discriminated
among different exporters and importers and led to a misallocation of
resources with an adverse impact on output and growth. Further, under the
I.M.F's Articles of Agreement, a member is not allowed, except temporarily,
to engage in multiple currency practice. The two-tier exchange rate system
was replaced with a market- based unified exchange rate system w. e. f. May
19, 1999. Under the unified exchange rate system, a floating inter-bank rate
was applied to all foreign exchange receipts and payments both in the public
and private sectors. However, the State Bank could intervene in the market
for the sale and purchase of foreign exchange on its own account at rates
and timing of its choice. On 20th July 2000, Pakistan set the Pak rupee on a
free float.

Since the free float of the Pak rupee, monetary policy has played a
dominant role in stabilizing the exchange rate in Pakistan. Significant ups
and down in forex rates are now being monitored through effective
instruments of monetary policy. Similarly, whenever speculative activities are
observed in the market, they are tackled with proactive monetary policy
measures of the State Bank. The Bank uses the instrument of the discount
rate to control undue pressure on the exchange rate while Cash Reserve
Requirements (CRR) or mopping up of excessive liquidity through purchases
from the kerb market, to curb speculative activities in the forex market. The
recent level of the nominal exchange rate appears to be controversial from
the monetary policy angle. Although the SBP considers the current level of
the exchange rate suitable for foreign trade, the IMF and other institutions
have shown their concern recently over its suitability which is based on
continuous deterioration of Pakistan’s external trade, particularly the current

One viewpoint is that the appreciation of the Pak rupee is the result
of a host of other factors, thus it is difficult to assess the creditability of the
recent level of the nominal exchange rate from a monetary point of view.
The reason is that monetary policy simply helped exchange rate stabilization
at a specific level. It is, therefore, difficult to say that the recent level of the
exchange rate is close to the equilibrium level.

The prime objective of the current study is to evaluate the

suitability of existing exchange rate policy for Pakistan’s external trade. It
128 M. Ashraf Janjua

will particularly pinpoint the magnitude if the exchange rate has deviated
significantly from its equilibrium level. For this purpose, the paper is
organized in the following way. The second section is about the history of
exchange rate regimes and its significance for Pakistan’s external trade. The
third section discusses the methodology used for assessing the deviation of
the exchange rate from its equilibrium level. The fourth section pertains to
concluding remarks.

II. Exchange Rate Regimes and Pakistan Foreign Trade

Pakistan pursued different exchange rate regimes in its history

spreading over 60 years. Initially, the Pak rupee was pegged to the Pound
Sterling. The Pak rupee was then pegged to the US dollar in 1971 and the
new exchange rate parity was fixed at Rs.4.76 per US $. After the separation
of erstwhile East Pakistan (now Bangladesh) in December 1971, Pakistan had
problems in absorbing the surplus products which earlier used to be sent to
former East Pakistan. Large amounts of raw cotton piled up during fiscal
year 1971/72. Since its introduction on 15th January 1959, the Export Bonus
Scheme (EBS) had become increasingly complex with all the adverse
consequences of multiple exchange rates for resource allocation. Also,
Pakistan experienced a high rate of inflation during this period. These
events convinced policy makers to rationalize the exchange rate through
adjustment. As a result, the Rupee was depreciated on 11th May, 1972 and
the new exchange rate was set at Rs.11.00 per US Dollar.

Pakistan's Foreign Trade and Rupee/$ Parity

50,000 70
Million US $


30,000 40
20,000 30
0 0


Trade (LHS) Exchange rate

Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? 129

The new exchange rate was viewed by some people as excessive

devaluation of the Rupee39. However, when the US$ was devalued by 10% in
February 1973, the Pak Rupee, being linked with US$, automatically
appreciated by 10% and the new exchange rate was the Pak Rupee 9.90 per
US dollar. This exchange rate continued till 8th January 1982, when the
fixed exchange rate was discarded, and the State Bank of Pakistan adopted a
managed float based on a basket of 16 currencies of Pakistan’s trade

Following the worldwide trend of deregulation of economies and

exchange rates, Pakistan opted out of the fixed exchange rate regime and
floated the value of the rupee against a basket of sixteen currencies under
a managed exchange rate regime on 8th January 1982. As a result, the
value of the rupee depreciated quite significantly after the adoption of the
managed floating regime. During the 1990s, the value of the rupee was
generally set in line with the inflation differential. In other words, the
rupee had to be devalued to offset the adverse effect of domestic inflation
on the real exchange rate. For the last decade, however, exchange rate
depreciation has been undertaken more as a desperate attempt to control
the rising Current Account Deficit (CAD) than to follow the Purchasing
Power Parity (PPP) rule. The cumulative current account deficit during the
period 1992/98 stood at about US$23-30 billion which was financed by
the entire amount of US$11.0 billion of foreign currency deposits besides
government’s additional external borrowings. Accumulation of large short-
term liabilities in the absence of an equal rise in foreign exchange reserves
was bound to lead to a crisis in a period of economic or political
uncertainties. The economic crisis occurred when Pakistan exploded the
nuclear bomb on May 28, 1998.

During the fixed exchange rate regime from FY73-82, the actual
Real Effective Exchange Rate (REER) moved in tandem with the price
differential and the movement of the US Dollar vis-à-vis major currencies.
The Rupee regained competitiveness in real terms during 1976–79, because
of the continued lower inflation differential and US Dollar depreciation vis-
à-vis major currencies. During the early 1980s, the REER appreciated
substantially due to the appreciation of the US Dollar against major
currencies and higher domestic inflation as compared to its trading partners.
Keeping in view this sharp appreciation, Pakistan adopted the managed
floating exchange rate system on January 8, 1982. The period thereafter was

For details of discussion among the policy makers which led to new exchange rate,
please see Janjua, “The History of State Bank of Pakistan, Volume-III, (1977-88),” pp
409 – 413.
130 M. Ashraf Janjua

characterized by more frequent and small adjustments in the Rupee against

the US Dollar, keeping in view the relative changes in exchange rates and
the prices of the country's major trading partners/competitors as well as the
various macroeconomic indicators of Pakistan.

With the transformation of the economy from a semi-closed to a

more open or market-oriented economy in the beginning of the 1990s, the
exchange rate saw a much larger devaluation in nominal terms, which was
just offset by a higher level of inflation in Pakistan as compared to its
trading partners. The imposition of economic sanctions following the
nuclear tests in May 1998 created a crisis-like situation and the State Bank
of Pakistan introduced a number of measures including the implementation
of a two-tier exchange rate system40 among others, from 22nd July 1998, to
steer the economy out of the crisis. On May 19, 1999, the SBP moved from
multiple exchange rates to the dirty float by defending the exchange rate
within a narrow band up to 20th July 2000 by channeling the foreign
exchange from the kerb market to the inter-bank market through kerb
purchases. In July 2000, the SBP moved away from the managed exchange
rate to a floating exchange rate regime.

Trend in Nominal and Real Effective Exchange Rates


250 12
230 9
210 6
190 3
170 0

150 -3
130 -6
110 -9
90 -12
70 -15
50 -18
FY-7 9
FY-8 0

FY-8 2


FY-9 8

FY-0 0






The new mechanism was based on: a) official exchange rate, b) floating inter-bank exchange
rate, and c) composite rate.
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? 131

Bilateral RER (2000:100)

RS/yen RS/PSt

Initially, the rupee dollar parity witnessed a sharp nominal

depreciation of 18.5% during Fiscal Year 2001, which shows the market
correction of the cumulative overvaluation that took place during Fiscal Year
1999 and Fiscal Year 2000. In the new exchange rate regime, monetary
instruments act as a nominal anchor to curb the anticipated high volatility
of the exchange rate. This, coupled with the build-up of forex reserves, led
to stability in the nominal exchange rate after the sharp depreciation in
Fiscal Year 2001. The substantial surge in workers’ remittances in the inter-
bank market following the international crackdown on informal channels
after the September 11, 2001 incident reversed the downward trend in the
exchange rate. The excess liquidity in the foreign exchange market,
following the post September 11, 2001 surge in workers’ remittances in the
formal banking channel, induced the SBP to purchase US$ 8.2 billion from
October 2001 to March 2004 to preserve the competitiveness of exports
from abrupt exchange rate appreciation. The increased demand of foreign
exchange from importers dried up excess liquidity in the inter-bank market,
which not only prompted the SBP to scale down its purchases from the
inter-bank market; SBP also had to start providing market support by
financing lumpy oil payments. Interestingly, in real terms, the Rupee
continued to maintain the compositeness due to the fact that the basket of
currencies appreciated against the Dollar more than the Rupee and relatively
higher inflation compared to that of trading partners.
132 M. Ashraf Janjua

Exchange Rate
(Pak Rupee per US App(+)/
Date / Period Exchange Rate Regime
Dollar) Dep(-)
Prior to August,1955 3.31
8/1/1955 (i) Fixed Exchange Rate 4.76 -30.46
5/11/1972 from 14-8-1947 to 07-01-1982 11 -56.73
13-Feb-73 9.9 11.11
8-Jan-82 10.1 -1.98
1981-82 10.5535 -4.30
1982-83 12.7063 -16.94
1983-84 13.4838 -5.77
1984-85 15.1668 -11.10
1985-86 16.1391 -6.02
1986-87 17.1795 -6.06
1987-88 17.5994 -2.39
1988-89 19.2154 -8.41
1989-90 (ii) Managed Float 21.4453 -10.40
1990-91 from 8th Jan. 1982 to 21st July 1998 22.4228 -4.36
1991-92 24.8441 -9.75
1992-93 25.9598 -4.30
1993-94 30.1638 -13.94
1994-95 30.8507 -2.23
1995-96 33.5684 -8.10
1996-97 38.9936 -13.91
1997-98 43.1958 -9.73
1998-99 - (iii) Two tier Exchange Rate System 50.0546 46.7904 -13.70
(Multiple Exchang Rate)
from 22nd July 1998 to 18th May 1999
1999-00 - (iv) Dirty Float: SBP defending the 51.7709 -3.32
exchange rate within a narrow band
from 19th May 99 to 20th Jul 2000
2000-01 (v)from Managed Float to Floating 58.4378 -11.41
2001-02 Exchange Rate regime 61.42580 -4.86
2002-03 Since July 20, 2000 58.49950 5.00
2003-04 57.57450 1.61
2004-05 59.35760 -3.00
2005-06 59.85660 -0.83
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? 133

1) The two-tier exchange rate system was introduced on July 22, 1998.
The new mechanism was based on: a) official exchange rate, b)
floating inter-bank exchange rate, and c) composite rate.

2) The exchange rate system was unified on May 19, 1999.

Since the free float of the rupee, the monetary policy has played a
dominant role in stabilizing the exchange rate in Pakistan. Significant ups
and downs in forex rates are now being monitored through effective
instruments of monetary policy. Similarly, whenever speculative activities are
observed in the market, they are tackled with proactive monetary policy
measures taken by the State Bank. The Bank uses the instrument of
discount rate to control undue pressure on the exchange rate while the CRR
or mopping up of excessive liquidity through purchases from the kerb
market are used to curb speculative activities in the forex market.
According to the SBP, the following considerations are generally taken into
account while looking at the level of the exchange rate from the monetary
policy side:

1. The existing level of the exchange rate has helped improve the
build-up of forex reserves. There is a continuous increase in forex
reserves, which is also a positive sign for the economic stability of
the country.

2. The existing exchange rate level has sufficiently discouraged

speculative activities in the forex market.

3. The rate has also helped discourage inflows of foreign remittances

from illegitimate channels. Now there are less incentives for
remitters to transmit their money through Hundi or other illegal

4. The rate has helped strengthen the role of the inter-bank market.
The two forex markets are expected to integrate if the existing rate
prevails for a longer period.

5. The existing level of the exchange rate has smaller pass-through,

which is evident from the lower inflation rate.

6. The rate is also providing an incentive to capital inflows. Some

positive developments are also witnessed on the private foreign
investment front.
134 M. Ashraf Janjua

Like other economies, the September 11, 2001, incident had

significant consequences for the Pakistani economy. The process of
appreciation of Rupee-Dollar parity not only started but quickened primarily
during the month of October 2001 in the wake of increasing capital inflows
from the international community and donor agencies and easing of quota
restrictions imposed on some Pakistani exportables to the Euro zone and the
United States. The strengthening of the Rupee resulted from a variety of
factors, these included the lifting of US sanctions, easing of quota
restrictions by the European community, rescheduling of external debt, a
positive response by the IMF in terms of approval of credit lines, an increase
in foreign exchange reserves and diversion of investment funds from the
currency market to the stock market.

Pakistan's Exports and Rupee App/Dep

20,000 10
16,000 5
14,000 0
Million US$

In Percent
10,000 -5
6,000 -10
4,000 -15
0 -20
FY 9
FY 1

FY 5

FY 9

FY 3
FY 5

FY 9

FY 3
FY 5








App/Dep Exports

As regards Pakistan’s exports, it may be noted that Pakistan’s export

structure has a very narrow base, both in terms of products and markets,
and most of the exportable items are of low value addition. The composition
of exports mainly consists of textile manufactures and food items, largely
originating from the agricultural sector where the incidence of uncertainty
is quite high and the market is highly competitive. Although, the textile
sector constitutes over 65% of our total exports, its production and exports
have attained almost maximum capacity and there is a need to shift the
focus to other exportable items. The external shocks taking the form of
depressed demand and decreasing price of export products in the
international market have made the external sector most vulnerable. As for
the destination of Pakistan’s exports, about 70% of exports are directed to
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? 135

only 13 countries including the USA, UK, Hong Kong, Germany, Dubai,
France, Japan, South Korea and Canada, etc.

The structure of the country’s exports calls for a policy shift to

diversify exports across different products and also to move towards higher
value-added items. The objective of diversification and value addition can be
achieved through consistent and well-defined strategies. Due to limited
resources, a piece-meal strategy should be adopted to enhance the export
base. Initially, there is a need to explore the products in which the country
has a comparative advantage and certain low cost measures will help boost
the exports, thereby enhancing productivity. In spite of the fact that fruits,
vegetables and fish are produced in abundance in Pakistan, the processing
industry is not developed. One of the major reasons for Pakistan's poor
performance in this field is a lack of storage and canning facilities. Non-
traditional agro-based products such as fruits, vegetables, dairy products and
fish offer vast scope in augmenting domestic production and exports
through crop substitution, the introduction of modern technology for
storage, processing and packing, etc. The Export Promotion Bureau should
plan cold storage houses at different points in the fruit growing areas to
handle farm products for export purposes. These storage houses should also
serve as places where training for the packaging of fruits, vegetables and fish
for export should be imparted to the exporters.

The textile sector, which is the single largest contributor to the

nation’s export earnings, has remained concentrated in the relatively low
value-added segment of the market, which has retarded the realization of
Pakistan’s true potential in textile exports. Thus, the need is both to
diversify exports across different product categories and also to move to
higher value-added textile exports. The slowdown in exports from this sector
exerts a dampening effect on the overall export growth. For export
diversification through higher value added products, there is a need to
upgrade technology, which involves: 1) tailoring the existing technology and
processes to specific production requirements; 2) improving processes within
the existing technology design; 3) improving the quality of textile products.
Information Technology and other hi-tech sectors also require special
attention for development according to potential. Due to the economic
recession in major industrial economies and enhanced competition, the
country may also explore new markets for its products, particularly in the
Central Asian Republics, East Asian countries and the African region.

In a changing international environment, Pakistan also needs to

diversify exports towards its industrial base. This objective can be achieved
by attracting Foreign Development Investment (FDI) selectively in such
136 M. Ashraf Janjua

export-oriented industries that correspond to and utilize the dynamic

comparative advantage of the country. This will proactively create linkages
between domestic firms and Transnational Corporations (TNCs), enabling
local firms to tap the technological expertise of TNCs and move into
integrated international production systems, as indirect or direct exporters.

III. Exchange Rate Misalignment and Future Outlook

In 1994, John Williamson observed that he “cannot see how the

Fund could be expected to play a central role in the international monetary
system without the analytical capacity to judge whether exchange rates were
consistent with satisfactory macro-economic outcomes.” Propounding the
concept of the Fundamental Equilibrium Exchange Rate (FEER), he defined
it as the real effective exchange rate that is consistent with macro-economic
balance (which requires the simultaneous attainment of both the internal
and external balance).

To make the Real Effective Exchange Rate (REER) based assessments

comparable with other variants of equilibrium, the behavior of REER is
decomposed into permanent and temporary components and the movements
in each is explained in terms of certain determinants. Some studies try to
explain the REER appreciation / depreciation through certain identifiable
fundamental determinants and any movement in REER that remains
unexplained by the fundamentals is ascribed to cyclical / temporary shocks
(both internal and external) and interpreted as misalignment. Deviation of
the actual REER (based on observed inflation rates) from the equilibrium
REER (derived on the basis of fundamental determinants) – the sign of
misalignment – is not easy to identify. This is because there could be two
types of real exchange rate misalignment. Macroeconomic induced
misalignments occur mainly due to inconsistent macro polices (particularly
monetary policy). On the other hand, structural misalignment results when
changes in real determinants (such as technical progress and shifts in terms
of trade) alter the equilibrium REER, but the actual REER does not change
(Edwards, 1992). Sachs, Tornell and Velasco (1996) offered two reasons to
explain why the market agents also take into account the leading
information embodied in the REER.

a) Firstly, the higher the degree of appreciation of the REER and the
lower the extent to which tradables respond to REER depreciation,
the market receives the signal that a large REER depreciation may
be necessary to restore external balance, and accordingly initiates
action to ensure a sharp fall in the nominal exchange rate.
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? 137

b) Secondly, the more vulnerable an economy is to sudden and large

demand compression when demand management measures are
instituted to correct the external imbalance, the market perceives
that the authorities may prefer depreciation to recession and such
market perceptions often trigger the attack. Besides relating to the
construction of REER and fixing a benchmark equilibrium level,
several operational issues constrain any explicit policy
pronouncement on REER.

Misalignment generally refers to deviation of the actual exchange rate

from a path that is consistent with the economic fundamentals. Exact
identification of the path that could reflect economic fundamentals has,
however, proved elusive. The complexity of the issue has spawned an
enormous volume of literature, each trying to offer an alternative
approximation. For the purpose of identifying misalignment, various
determinants of the exchange rate have been used in the literature. The
earliest attempt on the subject dates back to 1945 when Ragnar Nurkse
defined the equilibrium exchange rate as one that could give rise to an
equilibrium in the balance of payments subject to:

1. the absence of any undue restrictions in trade flows,

2. the absence of special incentives to encourage inflow and measures

to discourage outflows, and

3. the absence of excessive unemployment.

The recent theoretical and empirical literature on the determinants of

the Equilibrium Real Exchange Rate (ERER) in developing countries include
Bartolini et al (1994), Edwards (1994), Elbadawi (1994), Guerguil and
Kaufman (1998) and Chinn (1998). Edwards (1994) constructed the ERER
based on a theoretical model that features a sustainable long-run equilibrium
in the nontraded goods and the external sector. The model recognizes the fact
that the short-term and long-term determinants of the ERER may differ, and
more specifically, only real factors determine the long-run behavior of the real
exchange rate whereas both nominal and real factors influence short-run
behavior. The model is very similar to Williamson's seminal work (Williamson
1985) except that it is constructed for a small, open economy, which is unable
to influence its terms of trade. The construction of the ex-post ERER involves
the estimation of the real exchange rate that preserves the internal and the
external equilibria.
138 M. Ashraf Janjua

Here, we applied the Johansen’s full-information maximum-likelihood

methodology of cointegrated systems (Johansen 1988) to estimate the ex-post
ERER for Pakistan as pinpointing the factors that resulted in the misalignment
of the real exchange rate in Pakistan, and could help investigating the aspects
of current account sustainability and the appropriateness of exchange rate
policies in Pakistan. The estimation procedure is very convenient since it
incorporates the cointegration relation to show how the "fundamentals"
influence the real exchange rate in the long run and derives the ERER as well
as the error correction mechanism to model the short-run adjustment process.
The explanatory variables used in the model capture fundamentals such as the
fiscal stance, degree of economic openness, international terms of trade, and
net capital flows.

The current study uses Engle Granger cointegration technique to

estimate the ERER, based on various macroeconomic fundamentals
suggested in the economic literature.

Empirical Framework

The methodology adopted in this paper has earlier been used by

Hyder, Zulfiqar and Adil Mahboob (2006). The study has updated the
estimates of their study and made forecasts41 of misalignment upto 2010.
The paper estimates the degree of real exchange rate misalignment based on
the model developed by Edwards (1988, 1989, 1994), Elbadawi (1994), and
Montiel (1997). The reduced form REER equation is given as follows:

lreer= f ( ltrop, ltot, lgovc, lrigdp, lremg, capinf, tfpd/t)

(-) (+/-) (+/-) (-) (+) (-) (+)

The variables included in the analysis are: the real effective exchange
rate index (reer), trade openness (trop), terms of trade (tot), real investment
to GDP ratio (rigdp), government consumption as % of GDP (govc), workers’
remittances as % of GDP (remg), long-term capital to gross domestic
product (capinf), and total factor productivity differentials (tfpd) or time
trend (t) representing the Harrod-Balassa Samuelson effect. All variables,
except capinf and tfpd, are expressed in natural logs. The signs for each
fundamental variable in determining the behavior of REER are explained

The forecasts are made under the assumption of the prevalence of a static environment in
Pakistan which is likely to remain unchanged up to 2010 and we do not foresee the reversal of
significant changes in the external economic front of the Pakistani economy during the period.
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? 139

• Trade openness depreciates REER because trade liberalization and

trade opening makes future consumption of importables very cheap
which in turn makes consumers substitute non-tradable for tradable

• The impact of terms of trade on REER is ambiguous and can take

either sign depending on the substitution and income effects.

• The impact of government consumption on REER depends not only

on the government inter-temporal budget constraints but also on the
composition of government consumption. If government consumption
contains a larger share of tradable goods, then the increase in
government consumption will worsen the current account, and thus
lead to a depreciation of REER.

• The sign of rigdp would be negative as the rise in rigdp means higher
spending on tradables (imported machinery and raw materials).

• The sign of workers’ remittances to GDP ratio on the real exchange

rate is positive which reflects that the rise in workers’ remittances to
GDP ratio, remg, leads to appreciation of the real exchange rate.

• The impact of net capital inflows on REER depends on the magnitude

of capital flows. The capital inflows over and above the current
account deficit will lead to appreciation of the REER while the capital
inflows matching or lower than the current account result in the
depreciation of the REER.

• The inclusion of the tfpd or time trend (t) in the REER equation
represents the well-known Balassa-Samuelson effect, which contends
that productivity improvements will be generally concentrated in the
tradable sector and thus lead to an appreciation of the REER.

The Engle-Granger two-step cointegration approach has been used

to estimate a single equation REER model for Pakistan. The coefficients
from the estimated models and sustainable values of the economic
fundamentals are then used to compute the ERER, while the misalignments
of the exchange rate are computed by taking the %age deviations of the
actual REER from the ERER. Annual data from Fiscal Year 1978 to Fiscal
Year 2006 have been used. The IMF trade-weighted REER index has been
used for Pakistan while the rest of the data are taken from the SBP’s
140 M. Ashraf Janjua

Statistical Bulletin, Economic Survey, and Economic Report of the

President on the US economy for the year 2006.

Results Interpretation

Firstly, the time series properties of data have been checked by

testing the stationarity of the fundamental variables. The augmented
Dickey-Fuller (ADF) criterion has been applied for unit root and the
results of the ADF test suggest that all the variables are integrated of
order one, i.e. I(1), which fulfills the criteria for estimating any long run

The Ordinary Least Square (OLS) has been applied for the estimation
of the results. The results are quite encouraging as coefficients and signs in
all regressions except rigdp coincide with the earlier empirical studies. In
the regression equation, five macroeconomic fundamentals [trade openness
(trop), current government consumption to GDP ratio (govc), net capital
inflows as % of GDP, real investment to real GDP ratio (rigdp), and total
factor productivity differential (tfpd)] determine the REER. Trop, and the
increase in govc and capinf caused depreciation in the REER while an
increase in rigdp leads to appreciation of the REER. The improvement in
tfpd leads to REER appreciation. The coefficient of tfpd is small in all three
regressions, which is in line with the recent empirical work. In Pakistan’s
case, workers’ remittances are an important source of foreign exchange
earnings and finance a large portion of trade and services deficits in the
current account balance.

Workers’ remittances turn out to be significant and have a positive

sign, which reflects that the increase in the remittance inflows cause
appreciation of the real exchange rate. Furthermore, the inclusion of the
relevant variable, remg, positively affects the overall performance of the
regression and causes tot (an important macroeconomic fundamental) to
significantly explain the real exchange rate. The positive sign of tot shows
that the improvement of tot leads to appreciation of the real exchange rate.
However, rigap becomes insignificant with the inclusion of remg and the
Wald Test supports the exclusion of rigdp.

The residuals generated from these regressions are tested for unit root to
establish a long-run cointegrating relationship. These residuals are
stationary, as reflected by the results of the unit root test reported,
confirming that the above regression is showing a long-run cointegrating
relationship between the REER and economic fundamentals.
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? 141

LRERR = 7.7 - 0.61* LTROP - 0.94* LGOVC + 0.17* LREMG-

(8.71) (-4.63) (-7.61) (5.91)

0.03*CAPINF1 + 0.34* LTOT + 0.03*TFPD (1)

(-3.34) (3.49) (5.73)

R2 = 0.96
Adj R2 = 0.94
S.E Regression = 0.07
D.W Statistics= 1.60

Following are the major results of the regression:

• As trade openness increases by one %age point of GDP, this leads to

real depreciation of 0.61% of the Pak rupee against the basket of

• An improvement in terms of trade by one percent causes 0.34% real

appreciation of the Pak rupee vis-à-vis the basket of currencies.

• An increase in government expenditure of one percentage point of

GDP is associated with 0.94% real of depreciation of the Pak rupee
against the basket of currencies.

• An increase in net capital inflows of one percentage point of GDP

causes 0.03% real depreciation of the REER.

• An increase in workers’ remittances of one percentage point of GDP

leads to a 0.17% real appreciation of the Pak rupee against the
basket of currencies.

• A one unit reduction in total factor productivity differential relative

to trading partners (i.e. US) causes a 0.03% real appreciation of the
Pak rupee against the basket of currencies.

The estimated regressions also satisfied the diagnostic tests.

142 M. Ashraf Janjua

Actual Vs Equilibrium Re al Effe ctive Exchnage Rate s (1992=100)










The above long-term relationships can be used to compute the
ERERs by evaluating these coefficients at sustainable values of
macroeconomic fundamentals. The rationale of using sustainable economic
fundamentals is to eliminate short run fluctuations in the explanatory
variables and only use long-term equilibrium values of the variables. The
Hodrick-Prescott (HP) filter is used to remove the short-term variations from
the explanatory variables.

The Figure (above) presents the actual REER and the ERER derived
by evaluating the coefficients at the HP filter series of economic
fundamentals. The estimated ERER reflects a divergence in both directions
from the actual REER in the first part of the sample while the behavior of
the actual REER remained close in the latter part of the sample. More
specifically, the rupee remained overvalued from 1978 to 1980 relative to
the ERER due to a lower price differential and real depreciation of the US
dollar against the major currencies. During the period 1981-86, the trend of
the actual REER and ERER reveals that the rupee remained undervalued due
to the real appreciation of the US dollar against hard currencies. This figure
also reflects that the actual REER appears to have been close to its estimated
equilibrium REER during the last five years. However, the spread between
the forecasts of the REER and ERER appears to have widened during the
period up to 2010 mainly on account of real appreciation of the Pak rupee
against trading partners and competitors currencies.
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? 143

Short-term dynamics of the REER are examined through the

estimation of error correction models (ECMs) which show that some of the
long-term fundamentals such as trop, capinf, and govc are statistically
significant and affect the short-run dynamics of the real exchange rate in the
same direction as the variables did in the case of the long run. The
estimated regressions also satisfied the post-diagnostic tests such as of no
autocorrelation, homoskedasticity, normality of the residuals and stability of

As described in the economic literature, macroeconomics policies such

as the exchange rate policy, fiscal policy and monetary policy may impact the
REER in the short run. We investigated the impact of macroeconomic polices
and found that excess domestic credit was insignificant while a rise in fiscal
deficit as a percentage of GDP and depreciation of the nominal exchange rate
(ndev) led to depreciation of the REER in the short run. Monetary policy is
statistically insignificant in all the short-run regressions which may reinforce
the established view that monetary policy in Pakistan was subservient to fiscal
policy. Since monetary policy remained subservient to fiscal policy due to the
heavy reliance of the government on financing the fiscal deficit from the
banking system, the direct impact of monetary policy in the short term is
statistically insignificant. The impact of net devaluation on the ERER turned
out to be negative as expected which indicates that nominal
devaluation/depreciation of the Pak Rupee against the US $ depreciates the
REER. As the coefficient of the error correction term is negative and has
absolute values smaller than one, this not only indicates the stability in the
long-term ERER but also reflects the gradual convergence of the exchange
rate towards long-run equilibrium.
144 M. Ashraf Janjua

We have also derived a misalignment of the exchange rate which is

percentage deviations of the actual REER from its equilibrium level. The
misalignment is based on the model of the ERER. Negative and positive
deviations reflect real appreciation/ depreciation of the actual REER from its
equilibrium level.

Misalignment (in percent)











The exchange rate misalignment ranged between -12.1% to 25.2%

with zero reversion mean during the year 1978 and 2006. Furthermore,
the actual REER in 2006 reflects an appreciation of the REER relative to
the ERER. This suggests that the current exchange rate is away from the

These results yield the following important policy implications for

exchange rate policy in Pakistan:

a) ERER is not fixed and is subject to variability as a result of changes

in economic fundamentals.

b) Fiscal policy is crucial to exchange rate stability in Pakistan.

Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? 145

c) The appreciation of the actual REER due to higher price differentials

relative to the ERER would lead to exchange rate misalignment.

d) A flexible exchange rate regime responds better in case of real

shocks more than other exchange rate regimes. This suggests that
the SBP should continue with its current stance of a flexible
exchange rate regime and intervene in the interbank market only to
smooth unwarranted movements in the exchange rate by keeping in
view the ERER and exchange rate misalignment.

To strengthen the viewpoint on exchange rate policy, bi-lateral

REER and ERRER has been computed for Yen and Pound Sterling. Both the
estimates of ERRER exhibit a completely different picture. The bi-lateral
REER and ERRER and computed misalignment against both the currencies
is given in the Appendix.

IV. Where do we go from here?

1. There has to be identification of and emphasis on the indicators of

fundamental equilibrium in the medium term.

2. Policy has to be a more flexible exchange rate to maintain a

competitive position in the world market.

3. Policy measures should be identified and if needed, should be

introduced immediately to correct any actual or even potential
misalignments of the exchange rate.

V. Policies and Ground Realities

Apart from a theoretical approach there is a need for greater (and

more intensive) coordination among the stakeholders: the SBP and the
government, the latter Comprising Finance, Commence, Export Promotion
Bureau, Board of Investment and Planning Commission.

Constraining policy hurdles should be removed at the macro and

micro level:

- Export industries

- Meeting the requirements of SMEs (fisheries, no bank credit, fishers,

do not have any collateral) – the case of tiles.
146 M. Ashraf Janjua

- Availability of specific facilities at the Federal, Provincial and Local

level. There is a need for improvement in the quality of imports: all
those factors which are related to productivity. It is not too early to
talk of a knowledge based economy – The role model is Singapore’s
medium and long term issues.

- The SBP should restrict its role to financial flows and price stability:
there should be adequate credit facilities to make full use of the
export potential.

- The government should provide incentives to help maintain


- Diversification of exports.

Concentration of exports in commodities: textiles, carpets, leather

products, sports goods, surgical instruments, rice etc. There is a need for
diversification towards services including I.T., dairy products, cottage
industry products, plants and machinery and jewelry.

We must also expand inter-regional trade with India, Bangladesh, Sri

Lanka, and China. With over 25% of our exports going to the U.S.A. we
have become extremely vulnerable. Any sanction could spell disaster for us.

VI. Concluding Remarks

1. Information about the causes of fluctuations in the real exchange

rate is important for central banks, as some fluctuations may require
immediate corrective actions by them while others may not require
this. It is essential to know what kind of movements in the real
exchange rate signal a loss in the external competitiveness of the
economy. If appreciation of the real exchange rate is due to an
improvement in the “fundamentals” such as an increase in the rate
of productivity growth in the tradable goods sector of an economy,
the central banks in this case need not take any corrective action.
However, if the real exchange rate deviates significantly from its
equilibrium level, also known as a “misalignment”, the competitive
stance of the Pak economy would be jeopardized and require
immediate “corrective action” by the SBP.

2. The real exchange rate responds to real as well as nominal

(monetary) variables. At any given moment, the real exchange rate
depends on economic fundamentals (e.g. tariffs, international prices,
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? 147

real interest rates, etc.) and aggregate macroeconomic pressures,

generated by an excess supply of money or a fiscal deficit or both.

3. In order to achieve sustainable macroeconomic equilibrium,

monetary and fiscal policies must be consistent with the chosen
nominal exchange rate regime. Further, the misalignments in the
real exchange rate can be used as a guideline for policy interventions
by the SBP.

4. Pakistan’s Balance of Payments (BoP) is characterized by persistent

large external financing needs with weak economic activity in the
country. This has cast doubt on the possibility of exchange rate
misalignment in Pakistan.

5. The CPI-based REER index suggests that the Pak. rupee has been
depreciating over the period of the study. However, the rate of real
depreciation of the Pak rupee was lower than the actual need which
is evident by the widening of Pakistan’s trade deficit. Moreover,
Pakistan’s export base remained stagnant and did show significant
diversification in the last decades, which is reflected in a constant
export market share and deteriorating trade balances.

6. There are some signs of external financial vulnerability and the

country’s real exchange rate appears to be somewhat overvalued, a
situation that could be best addressed through increased fiscal

7. The BOP statistics show that despite continued devaluation, the

Current Account Deficit (CAD) in Pakistan has deteriorated. This
does not necessarily mean that the exchange rate polices do not
work. The exchange rate policy in Pakistan failed due to a number of
factors. The most important reason is that devaluation was
accompanied by poor monetary management. In particular a
continued growth in money supply resulted in a high inflation rate
which neutralized the favorable affects of devaluation on the real
exchange rate and Pakistan could not achieve any competitive
advantage from devaluation. What really matters is to improve the
BOP position through adjustment in the real exchange rate. To
influence the real exchange rate through devaluation, Pakistan
should have adopted a tight monetary policy. Thus, except for the
intervention in the foreign exchange market the State Bank of
Pakistan should have held tight control on money supply.
148 M. Ashraf Janjua

8. In a changing international environment, Pakistan also needs to

diversify exports towards its industrial base. This objective can be
achieved by attracting FDI selectively into such export-oriented
industries that correspond to and utilize the dynamic comparative
advantages of the country. This will proactively create linkages
between domestic firms and Transnational Corporations (TNCs),
enabling local firms to tap the technological expertise of TNCs and
move into integrated international production systems, as indirect or
direct exporters.

9. The structure of the country’s exports suggests the need for a

policy shift, to diversify exports across different products and also
to move towards higher value-added items. The objective of
diversification and value addition can be achieved through
consistent and well-defined strategies. Due to limited resources, a
piece-meal strategy should be adopted to enhance the exports base.
Initially, there is a need to explore the products in which the
country has a comparative advantage and certain low cost measures
will help boost exports, thereby enhancing productivity. In spite of
the fact that fruits, vegetables and fish are produced in abundance
in Pakistan, the processing industry is not developed. One of the
major reasons for Pakistan's poor performance in this field is lack
of a storage and canning facility. Non-traditional agro-based
products like fruits, vegetables, dairy products and fish offer vast
scope to augment domestic production and exports through crop
substitution, the introduction of modern technology for storage,
processing and packing, etc. The Trade Development Authority of
Pakistan (TDAP), formerly the Export Promotion Bureau, should
plan cold storage houses at different points in the fruit growing
areas to handle farm products for export purposes. These storage
houses should also serve as places where training for the packaging
of fruits, vegetables and fish for export should be imparted to the

10. The variables such as trade openness, government consumption

and capital inflows lead to depreciation of the REER index, while
workers’ remittances, terms of trade, and total factor productivity
vis-à-vis trading partners lead to an appreciation of the REER
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? 149

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Institute for International Economics, Washington, DC.

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Rates”, in J. Williamson (ed.), Estimating Equilibrium Exchange
Rates, Institute for International Economics, Washington, DC.

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Application to Finland”, IMF Working Paper No: 97/109.

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the Real Exchange Rate in Chile”, IMF Working Paper No. 98/58.

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Exchange Rate and Exchange Rate Misalignment in Pakistan”, SBP
Working Paper Series, 2006.

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Economic Dynamics and Control, No. 12, pp. 231-254.
150 M. Ashraf Janjua

Johansen, S., 1991, “Estimation and Hypothesis Testing of Cointegration

Vectors in Gaussian Vector Autoregressive Models”, Econometrica,
Vol. 52, pp. 389-402.

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Null Hypothesis of Stationarity Against the Alternative of a Unit
Root: How Sure are We that Economic Time Series have a Unit
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Economic Literature 34, no. 2, pp. 647-668.

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Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? 151


Bilateral Misalignment

Bilateral Actual and Equilibrium RER vis a vis Pound Sterling








Misalignment (in percent)





-10.0 Appreciation




1978 1979
1979 1980
Actual BRER

1980 1981
1981 1982
1982 1983
1983 1984

Misalignment (in percent)


1984 1985
1985 1986
1986 1987
Bilateral Actual and Equilibrium RER vis a vis Yen

1987 1988
1988 1989
1989 1990
1990 1991
1991 1992
1992 1993
1993 1994
M. Ashraf Janjua

1994 1995
1995 1996
1996 1997
1997 1998
1998 1999

1999 2000

2000 2001

2001 2002

2002 2003

2003 2004

2004 2005

2005 2006

The Lahore Journal of Economics
Special Edition (September 2007)

Doha Round Baggage: Implications for Economic Reforms in

Pakistan and other Southern Countries

Naheed Zia Khan*

This study is based on the premise that agriculture remains the key
issue in all reform efforts of Pakistan and the Doha Round of trade talks has
strategic significance for the second round of the country’s farm sector
reforms. It is argued that although there are differences among the individual
developing countries, the majority have a comparative advantage in
agricultural production and removing farm sector export subsidies and trade-
distorting, domestic subsidies is their common concern. Evidence is provided
to support the view that the Uruguay Round negotiations on agricultural
subsidies are not a done deal, because although signed by the members, the
Agreement on Agriculture is not ‘ratified’ by the recent farm bills of the
developed countries which continue to defy economic logic and the WTO
(World Trade Organization). On the other hand, the evidence provided from
Pakistan shows that the governments of developing countries are not fighting
the farmers’ cause since they are poorly managing agricultural policy and
have been overly compliant with respect to the Uruguay Round ruling on
reducing farm subsidies and increasing trade liberalization. The analysis
shows that although the developed countries stand to gain far more from the
liberalization of trade in agricultural commodities than the developing
countries, the handful of farmers in developed countries are the stumbling
block to the regeneration of world trade. It is argued that to alleviate world
poverty, the developed countries need to demonstrate their willingness to
gradually remove both the absolute value of subsidies provided to their
farmers and the tariff and non-tariff barriers that protect agriculture.
Finally, the author maintains that at world trade forums, the developing
countries have exhibited poor representation due to lack of leadership.


The external sector is a fundamental policy concern of both the

first and second generation economic reforms in Pakistan. In an economic
Professor of Economics, Fatima Jinnah Women University, Rawalpindi.
154 Naheed Zia Khan

world dominated by trade, the rules of the World Trade Organization

(WTO) prevail. These rules are the outcome of the Uruguay Round (UR)
of trade talks. The UR began in 1986 and culminated in converting the
‘interim’ Secretariat of the General Agreement on Tariffs and Trade
(GATT) into the WTO. The UR was the eighth round of GATT and it
included agriculture and services in the trade talks for the first time.1
With 150 member countries in January 2007, the WTO enforces the
1993 UR agreement; the Agreement on Agriculture (AoA), the General
Agreement on Trade in Services (GATS), the agreement on Trade Related
Intellectual Property Rights (TRIPs) and Trade Related Investment
Measures (TRIMs). The members are required to abide by the WTO rules
which are prolific, running into thousands of pages. Following an aborted
attempt in Seattle in late 1999, the Ministerial Meeting of the WTO in
Doha, the capital city of Qatar, launched the next comprehensive round
of multilateral trade negotiations in November 2001. The Doha Round
aims at reducing tariffs, subsidies and other barriers to global commerce
in order to boost progress, apparently, in the underdeveloped parts of the
world. Like its predecessor, the UR, agricultural subsidies remain the
sticking point also in the Doha Round of trade talks, causing the
suspension of the process in July 2006, as the multilateral negotiation on
this thorny issue failed to reach agreement even after a five-year effort.

There is a broad range of issues that are of important concern for

economic reforms in developing countries such as Pakistan. One key issue
relates to the extent to which they have so far benefited from the UR
reforms, most notably the commitments to liberalize trade in agriculture.
In the wake of the break down of the trade talks in July 2006, this study
takes a hard look at developments in agricultural policies since the UR
agreement. The analysis is divided into four parts. Part 1 discusses the
importance of agriculture in Pakistan’s economy relative to the economies
of selected Asian and African countries. Part II presents the estimates,
found in the literature, of the welfare gains from removing trade barriers
globally. Pakistan’s performance in reforming its agricultural sector is also
discussed in this part. Part III analyzes the size and significance of the
developed countries’ farm subsidies in the Post-UR agreement period.
Finally, before presenting the conclusion of this study, Part IV discusses
the factors relating to agricultural subsidies hindering the reform efforts in
developing countries.

Part I

The earlier Rounds were Geneva 1947; Annecy 1948; Torquay 1950; Geneva 1956;
Dillon 1960-61; Kennedy 1964-67; and Tokyo 1973-79.
Implications for Economic Reforms in Pakistan and other Southern Countries 155

During the first reform period, Pakistan’s economic performance

compared favorably with most of its Asian counterparts. This is supported by
the last century’s scenario presented in Table-1. The figures listed in Tables-1
show that Pakistan fared well in comparison against the averages of low
income/ middle income countries and the world, and also with the individual
countries included in the list. However, many of its counterparts, both in Asia
and Africa, are much ahead on the literacy front where Pakistan lags behind
even the low income countries and markedly behind the middle income

Table-1: Economic and Social Indicators of Selected Developing

Countries (Asia and Africa)
Category National Income Social Indicators
(growth rate) 1999
1965-99 (% per annum)
GDP GDP Life Expectancy Adult Illiteracy
Per Capita (years) Rate (%)
1. Country
Bangladesh 3.8 1.3 61 59
Egypt 5.6 3.3 67 45
Kenya 4.7 1.2 48 29
India 4.6 2.4 63 44
Indonesia 6.9 4.8 66 5
Iran 1.7 -1.0 71 24
Malaysia 7.0 4.3 72 13
Mauritius 5.2 3.9 71 16
Oman 9.5 5.0 73 30
Pakistan 5.6 2.7 63 55
Singapore 8.3 6.3 78 8
South Africa 2.3 0.0 48 15
Sri Lanka 4.6 3.0 73 9
Thailand 7.3 5.1 69 5
2. Country Group
Low Income 4.1 1.8 59 39
Middle Income 4.2 2.4 70 15
3. World 3.3 1.6 66 n.a.

Source: World Bank (2001a).

156 Naheed Zia Khan

Pakistan’s economic performance is mainly dependent on the

performance of its agricultural sector, the lifeline of the country. Table-2
presents the contribution of Pakistan’s agricultural sector in its economy
relative to the developing countries included in the comparisons listed in
Table-1. All countries included in the list had overwhelmingly agrarian
economic structures about two generations ago. However, the drive for
modernization and industrialization which began in the later half of the 20th
century has varyingly affected different countries. The indicators listed in
Table-2 show the relative importance of agriculture in the countries’
economies during the part of the first reform period of the 20th century.

Table-2: Agriculture’s Contribution to the Internal and External Sectors

of the Economy
(Selected Developing Countries of Asia and Africa)
Country Agricultural internal Grain Agricultural external sector
sector shares and self- indicators
growth rate (%) sufficiency Merchandise Indices (1995-99)
Labor GDP Growth (%) exports Comparative Net
force 1999 rate 1995-99 (% share) advantage export
1990 1965-99 1995-99 indexž indexŸ
Bangladesh 66 25 2.1 88 11 1.07 -0.49
Egypt 39 17 2.8 110 15 1.45 -0.78
Kenya 19 23 3.4 85 64 6.06 0.46
India 69 28 2.8 99 20 1.88 0.28
Indonesia 56 19 3.8 89 17 1.56 0.20
Iran 26 21 4.5 130 6 0.70 -0.49
Malaysia 26 11 2.9 27 13 1.26 0.36
Mauritius 16 6 0.3 0 28 2.63 0.08
Oman 45 3 n.a. n.a. 5 0.44 -0.50
Pakistan 51 27 4.1 101 72 1.39 -0.33
Singapore 1 0.2 -1.5 0.00 4 -1.00 -1.00
South Africa 14 4 2.0 146 14 1.33 0.27
Sri Lanka 48 21 2.7 59 23 2.18 0.40
Thailand 64 11 3.9 142 23 2.15 0.45

Source: World Bank (2001a) and FAO (2001).

Agriculture’s share of the country’s exports relative to its share of global
merchandise exports.
Agricultural exports minus imports as a ratio of agricultural exports plus
Implications for Economic Reforms in Pakistan and other Southern Countries 157

The comparisons show that during the first reform period

agriculture played a very important role in Pakistan’s economy, both in the
internal and external sectors. Two of the three components of internal
balance are full employment and economic growth. It is normal for
agriculture’s contribution to production and employment to decline in
relative importance as an economy grows. However, the process is slow in
labor abundant countries such as Pakistan, starting from a low industrial
base and facing the acute shortage of both human and physical capital.
Table-2 suggests that for the upkeep of the internal balance of Pakistan’s
economy, agriculture appears to remain the most important sector also
during the second reform period; more than half of the country’s labor force
is still engaged in agriculture and the sector’s contribution to Gross
Domestic Product (GDP) is well above a quarter of the total.2 Thus,
agriculture remains the major source of Pakistan’s economic growth. More
importantly, the agricultural sector is also to be credited with achieving the
strategic target of grain self-sufficiency which must be maintained in the
future, as it is one of the prerequisites for sustainable development.

Although the history of Pakistan’s external balance happens to be a

sorry affair, agriculture has always provided it a saving grace through the
farm sector’s huge direct and indirect contribution to the country’s
merchandise export earnings.3 During the first reform period, a low
comparative advantage index of Pakistan in agriculture, relative to
Thailand, Sri Lanka and Kenya, must be adjusted for the huge share of its
textiles sector in export earnings which largely depends on the raw cotton
produced in the country.4 Another index, registered in the final column of
Table-2, accounts for the imports of agricultural products. It ranges
between -1 and +1, for net importers and exporters respectively. The sign
and the size of Pakistan’s index, -0.33, indicates that during the first
reform period the country has been fairly open in the domestic market to
competition from the rest of the world. The same cannot be maintained
for Iran and Oman whose economies are largely dependent on the

The agricultural share of labor force declined to 48.42 percent in 2002 (see, Pakistan
Economic Survey, 2002-03, Statistical Appendix, Table 12.11, p. 121).
The indirect contribution of agriculture to export earnings comes from the textile sector
which contributed about 60 percent of the export earnings during 1978-94. Pakistan is
the fifth largest cotton producer in the world and most of its textile export earnings
depend on the raw cotton produced in the country (see Khan, 1998).
The agricultural competitiveness listed in Table 2 is based on the computation of
Balassa’s index of ‘revealed’ comparative advantage, which is agriculture’s share of a
country’s export relative to agriculture’s share of global exports. The ratios necessarily
have a global average of unity (see Balassa, 1965).
158 Naheed Zia Khan

earnings from oil exports, while both Egypt and Singapore are now
considered overwhelmingly service economies.

Part II

Since 1945, multilateral trade has been a greater engine for

prosperity than any other form of international economic cooperation.
However, tensions in the world trading system began to arise in the early
1970s. A first attempt to shore up the system came with the Tokyo Round
of GATT talks which continued from 1973 to 1979. As mentioned earlier,
the UR was launched in 1986. It had 116 participants and it was originally
supposed to end in 1990 but did not, and lasted for eight years. The UR
began on a note of optimism with the exercise of opening markets
including the markets for agricultural commodities. However, seven years
later in 1993, the issue of the developed countries’ huge farm subsidies
brought the UR close to desperation. After a protracted feud between the
European Union (EU) and the United States (US), the UR ended
successfully in the formal signing of the trade agreements in April 1994.
The UR agreement was heralded as a watershed in the history of world
trade and was expected to lead to huge welfare gains around the world.
Table-3 lists the welfare gains, computed both for the developed and the
developing countries, from removing trade barriers globally, in the post-
UR world of 2005.

It is interesting to note in Table-3 that not only are the welfare

gains for the developed countries the largest in freeing international trade
in agriculture and food, it is the only sector where the potential gains
leave the current distribution of world income virtually unchanged
between the two country groups.5 All the more reason for developed
countries to seriously consider the opportunity cost of their huge farm

During the first reform period, Pakistan has overdone the fulfillment
of the UR commitments in freeing agricultural commodities trade. Table-4
shows that the divergence between the average unweighted applied and
bound tariff in agriculture has been widest in Pakistan amongst the four
major South Asian countries.

According to the World Bank’s estimates for 1997, the developing countries, with
almost 80% of the world population, subsisted on less than 20% of the world’s income
(See World Bank, 1998).
Implications for Economic Reforms in Pakistan and other Southern Countries 159

Table-3: Welfare Gains from Removing Trade Barriers in the Post-

Uruguay Round World of 2005
(1995 US$ billions)

Category Agriculture Other Textiles and Other Total

and food primary clothing manufactures
Total % Total % Total % Total % Total %
Developed 122.1 48.0 0.0 0.0 3.3 1.3 14.2 5.6 139.7 54.9
Developing 42.6 16.7 2.7 1.1 14.1 5.5 53.3 21.7 114.7 45.1
World 164.7 64.8 2.8 1.1 17.4 6.8 69.5 27.3 254.3 100
Source: Anderson et. al. (2001)
Table-4: Uruguay Round Commitments in Agriculture: South Asia

Average tariff rate (unweighted)

Country (2000)
Bound (%) Applied (%)
Bangladesh 188 25
India 124 19
Pakistan 197 24
Sri Lanka 50 27
Source: Athukorala (2000) and WTO (2001).
More importantly, even before the first reform package was
announced, Pakistan has been gradually removing input subsidies since the
early 1980s, which virtually ceased to exist by 2000. The input subsidies
were to be phased out and replaced by the output support price system
under the recommendations of the Pakistan Agricultural Prices Commission
(APCom), established in 1981. However, the support price policy scarcely
made the national exchequer dole out any funds to the country’s farmers,
particularly after signing the UR commitments. The scenario presented in
Table-5 supports the author’s position.
The figures in Table-5 show that the support prices of both rice and
cotton in Pakistan have been lower than the domestic market price in the
post-UR period. Although the government was not restricted by the UR
ruling of the WTO, it has never made any procurement of rice and cotton,
except in the first year of implementation, 1994-95, when a very small
160 Naheed Zia Khan

quantity of rice, .06% of total production, was procured. On the other

hand, the government has been procuring on average a little over 20% of
the total production of wheat annually, apparently going way beyond the
limits permitted by the UR commitments.6 However, the government’s
wheat procurement in Pakistan is for food security reasons and not to
support the wheat growers since the support price of wheat has been lower
than its market price till 1998-99; the former being only marginally higher
than the latter in 1999-2000. Such a small divergence does not warrant
procurement in widely prevalent and successful support price models.7

Table-5: Support Price, Market Price and Procurement of Major Crops

(Pakistan: 1994-00)

CategoryÉ Year
1994-95 1995-96 1996-97 1997-98 1998-99♠ 1999-00
1. Wheat
Support price 160 173 240 240 - 300
Market price 176 185 273 259 261 297
Procurement (a)Ø 3.74 3.45 2.72 3.98 4.07 8.55
Procurement (b)  22% 20% 16% 21% 23% 41%
2. RiceY
Support price 211 222 255 310 330 350
Market price 192 231 296 297 362 358
Procurement (a)▲ 21 0.12 - - - -
Procurement (b)   0.6% - - - - -
3. Cotton♣
Support price 423 423 540 540 - 825
Market price 794 739 840 808 876 580
Procurement (a) - - - - - -
Procurement (b)   - - - - - -

Source: APCom (2001) and Pakistan Economic Survey (2002-03).

Exactly 30 WTO members have commitments to reduce their trade distorting domestic
support in the amber box as measured by their AMS. Members without these commitments
have to keep within 5% of the value of production level, 10% in the case of developing
countries (for further clarification of this point, see Part II and footnote 15 of this study).
For example, the Common Agricultural Policy (CAP) of the EU has three interrelated
components: price support, import control and export subsidies. The EU determines
target prices for grains every year after intensive bargaining between the producing and
the consuming interests. A target price and an intervention price is derived. The latter is
set at 5-7 percent below the target price. When the market price in the Union falls to the
intervention price level, procurement begins. In this sense the intervention price of a
cereal represents the minimum support price for producers. In addition, for controlling
grain imports the EU employs an import tax, variable levy, designed to equalize the
import price with a decreed domestic price (see Kreinin, 1995, P. 186-7).
Implications for Economic Reforms in Pakistan and other Southern Countries 161

All prices are in rupees per 40 kg.
Procurement in million tonnes.

Procurement in million tonnes
Procurement as percentage of total production.

No support price was announced for 1998-99 wheat crop.

In all fairness, the figures listed in Table-5 show that APCom has
been tinkering rather than fine tuning while calculating the support price
mark up. The official publications do provide the elaborate goals of the
support price, but the information on its mechanism and implementation is
very general and extremely vague. Also, empirical evidence shows that there
has been a huge transfer of welfare gains from producers to the consumers
(Ashfaq et. al. 2001; Niaz 1995). It may therefore be concluded that even
during the first reform period, agricultural policies have been penalizing
rather than rewarding the farmers in Pakistan.

Part III

The shortcomings of reform efforts by developing countries such as

Pakistan are often escalated in a world of unequal trade partners, as the
huge agricultural subsidies received by the developed countries’ farmers
encourage overproduction and distort trade by making farm goods artificially
cheap internationally.

Farm protection is ubiquitous in developed countries. It has a

formidable history which dates back to the Corn Laws that had protected
British Farmers from imports of foreign grain for 200 years.8 After an ugly
struggle, the British Parliament eventually voted for reform in 1846.
Powerful countries have found a pretext in every age to protect their
farmers. In 19th century Europe, the pretext was unfair competition from
cheap American and Australian imports. In the 1930s it was farm poverty.
After the Second World War it was food security and later on it became
preservation of the rural character.9 With advancements in communication
technology, the issue of farm support has now become a potent emotional
and political force the world over. In the EU and US, the farm lobbies wield
influence out of all proportions to the share of the farm sector in these
countries’ GDP and the labor force.

Adam Smith devoted Chapter 5 of Book IV to subsidies, called “bounties” in his time.
Although he discussed bounties in the context of foreign trade, the main issues are the
same (see Smith, 1776, pp. 398-408).
See, ‘A Survey of Agriculture’, The Economist, December 12, 1992.
162 Naheed Zia Khan

Before exploring the implications of the size and significance of

agricultural subsidies of developed countries, it will be helpful to have an
overall idea of the players’ stakes in the international market for agricultural
products. Table-6 presents the share of leading exporters of agricultural
products in the world receipts from agricultural exports between 1980-
2002. The most significant development to be noted is that the US share
declined by about 3% in 10 years to 1990, and the EU share increased
markedly during the same period. This may be explained by Greece,
Portugal and Spain, all having a comparative advantage in agriculture,
joining the EU, then the European Community.10

Table-6: International Trade in Agricultural Products: Leading

Exporters (1980-2002)
World export of agricultural products
Country/Group (% share in total export receipts)
1980 1990 2000 2002
EU15 32.8 42.4 39.6 40.1
US 17.0 14.3 12.9 11.8
Canada 5.0 5.4 6.3 5.6
Brazil 3.4 2.4 2.8 3.3
China 1.5 2.4 3.0 3.2
Australia 3.3 2.8 3.0 2.9
Argentina 1.9 1.8 2.2 2.2
Thailand 1.2 1.9 2.2 2.0
Indonesia 1.6 1.0 1.4 1.5
Malaysia 2.0 1.8 1.5 1.5
New Zealand 1.3 1.4 1.4 1.4
Russia” - - 1.4 1.3
Chile 0.4 0.7 1.2 1.2
India 1.0 0.8 1.2 1.1
Source: WTO (2003)
Russian Federation.

This observation provides food for thought for why after 1990 the US became
interested in the expansion of NAFTA. Also, on the issue of farm subsidies the two
powers, EU and the US, were likely to make or break the UR negotiations. Each insisted
that an unsatisfactory deal will be rejected, even if that means no deal at all (see “GATT:
The Eleventh Hour” The Economist, December 4, 1993).
Implications for Economic Reforms in Pakistan and other Southern Countries 163

Agricultural policies pursued by developed countries cause major

distortions which seriously hinder market access for developing countries.
Progress made in reducing protection in developed countries has remained
unsatisfactory to the extent that the Doha Round, launched in November
2001, was suspended in July 2006, after negotiators failed to reach an
accord on agricultural subsidies and market access. The subject continued to
lead to dispute and controversy even in the March 2-4, 2007, ‘mini-
ministerial’ meeting in Kenya. Figures listed in Tables 7-9 provide a
backdrop to understanding the Doha Round stalemate.

Table-7: Agricultural Support in OECD Countries

Agricultural Support Estimates 1986-88 2001-03

Total support (US$ b) 303.720 324.053
Producer Support 241.077 238.310
General Services Support 40.946 57.849
Fiscal Transfers to Consumers 21.697 27.894
Support per farmer (US$ thousands) 10 11
Support per hectare (US$) 183 182

Source: OECD, Agricultural Policies in OECD Countries, 2003.

It is observed that, in nominal terms, the OECD countries together
pay more subsidies to their farmers in the post-UR period. More
importantly, although the producer support shows an overall decline, rather
than decreasing, the support per farmer has increased. This trend, especially
when compared with marginally reduced support per hectare, suggests that
the progress of developed countries in reducing farm subsidies scarcely goes
beyond a cosmetic exercise.

Table-8: Agricultural Support in OECD Countries: Relative Shares

Region/Country Percentage Share in Total OECD Support

1986-88 2001-03
EU 37 36
United States 24 29
Japan 20 17
Korea 5 6
Others 14 12
Total 100 100
Source: OECD, Agricultural Policies in OECD Countries, 2003.
164 Naheed Zia Khan

Figures listed in Table-8 and Table-9 provide a closer insight into

the implications of OECD farm subsidies for the reform efforts of
developing countries.

Table-9: Size of Agricultural Support in Major Developed Countries:


Region/country Support Estimates

Total Producer Averages
support support Per farmer Per hectare
US$ b US$ (000) US$
OECD 324.053 238.310 11 182
EU 114.720 102.708 15 670
United States 95.128 44.239 19 112
Japan 56.489 5.359 23 9828
Others 57.716 86.004 - -

Source: OECD, Agricultural Policies in OECD Countries, 2004.

Table-8 provides information on the relative share of agricultural

support provided by member countries of the OECD. The figures show that
the EU’s share of the agricultural dole out is largest, followed by the US and
Japan. Moreover, per farmer support, listed in Table-9, of the EU, US and
Japan happens to be much above the OECD average. Japan appears to be
contributing most in this scenario, followed by the US. However, the
relative significance of Japanese and American farm subsidies needs to be
considered taking account of the much larger relative size of the farm sector
of the latter with a comparative advantage in agriculture in addition to
technological competitive advantage, particularly when compared with the
developing countries. Japanese farm subsidies, though contributing to global
inefficiency, do not hurt farmers elsewhere as the country is not listed in
the league of leading agricultural exporters (See Table-6).11

From the viewpoint of global efficiency, the scenario presented in

Tables 7-9 is bad enough, but the worst part, particularly in the context
of the argument of this study, is that rather than falling, as was required

Most of the Japanese farm subsidies go to the rice growers for ensuring self-
sufficiency in rice production. Rice is the staple food grain in Japan. For Japan, rice is a
near-sacred product, deeply embedded in history, culture, economics, politics, and
symbolism. For the Japanese the rice is the Christmas tree and rice producing land is
reverently called our holy land (see Blaker, 1999).
Implications for Economic Reforms in Pakistan and other Southern Countries 165

under the UR obligations, the developed countries’ farm subsidies have

been increasing. The available estimates show that in 2001, the US had
increased its subsidy to 21% of the gross farm receipts, while the EU was
contributing 35% of gross receipts of its farmers (OECD 2002).12 Finally,
in May 2002, the US passed legislation to further increase the amount the
government pays to farmers. The new Farm Act provides an additional $83
billion in subsidies above the existing program during the next decade.13

These developments are in gross violation of the AoA which

established commitments at the UR to limit and reduce baseline domestic
support, as measured by the Aggregate Measure of Support (AMS). This was
the most innovative element of the AoA because trade distortions arising
from domestic support policies were for the first time formally recognized
(Schluep and Gorter 2001). A key aspect of the reductions commitments in
the domestic support was the distinction between domestic policies that
distort trade and those that do not. This makes it possible to focus on trade
distorting policies, negotiate reductions in their magnitude and provide an
incentive for governments to re-instrument their domestic policies towards
non-distorting measures (Schmitz and Vercammen 1995). However, most
countries could circumvent their AMS commitments because of an
extremely high base period upon which commitments were made and
because of the sector-wide nature of the support commitments (OECD
2000). Hence, the AMS has been the least binding element of the AoA
commitments for most countries. Moreover, the establishment of the blue
box and green box which were both exempted from reduction requirements
further weakened the domestic support element of the Agreement.14 Total
support provided by amber policies on production was measured by the
AMS, which countries agreed to reduce by 20 percent in the 1995-2000
implementation period (OECD 1999).
Also see “The Doha squabble,” The Economist, March 27th 2003.
See “Why U.S. Farm Subsidies Are Bad for the World” Philadelphia Inquirer, May 6,
In WTO terminology, “boxes” which are given the colors of traffic lights in general
identify subsidies: green (permitted), amber (slow down — i.e. be reduced), and red
(forbidden). The AoA has no red box, although domestic support exceeding the reduction
commitment levels in the amber box is prohibited; and there is a blue box for subsidies
that are tied to programs that limit production. Amber box policies include transfers from
consumers such as administered price supports but also taxpayer-funded subsidies for
both inputs and output. The accounting method is either government expenditures or
price gaps using the “equivalent method of support” (EMS) measure. Green box policies
include decoupled payments (that purportedly do not affect production decisions) and
policies to correct for market failures such as environmental programs, research, food
aid, and crop insurance and income safety net programs. This class of policies is
generally taxpayer funded that does not involve transfers from consumers.
166 Naheed Zia Khan

As mentioned above, the AoA sought to define, quantify and reduce

trade distorting policies. It included three areas, namely, import access,
export subsidies and domestic support. However, the figures listed in Table
7-9 suggest that the AoA cannot be rated as a success because, despite
support reduction commitments, the absolute size of the developed
countries’ subsidies has in fact increased over the implementation period.15

Part IV

The Cancún Ministerial Meeting in September 2003 was the

second disappointment for the WTO in four years. Before the Doha Round
was launched in November 2001, its meeting in Seattle in December 1999
broke down, largely because of the undue pressure exerted by the
developed countries on extraneous issues. The trade round stagnated for
22 months between the meetings in Doha and Cancún. After a long
stalemate, and at the behest of many developing countries, the US and the
EU drew up a framework in August 2003 for freeing farm trade. Though
it involved some reform, the plan was much less ambitious than the Doha
Round had implied. Export subsidies, for example, were not to be
eliminated after all.16 Angered by this lack of ambition, a new block of
developing countries emerged just before the Cancún meeting to
denounce the EU/US framework as far too timid. Led by Brazil, China and
India, this so-called G22 became a powerful voice at the Cancún
Ministerial Meeting in September 2003.17

Given the analysis in Part III, developing countries were

understandably dissatisfied at Cancún with the commitment of developed
countries to agricultural reforms. Many demanded concessions on
agriculture from the US and the EU before talks could move forward, and
consequently refused to negotiate. Although it spanned diverse interests -
India, for instance, is terrified of lowering tariffs on farm goods, while
Brazil, a huge and competitive exporter, wants free trade as fast as
possible-the G22 stood together and managed to effectively block the
consensus required to do anything in the WTO. The Group’s initiative
ought to be viewed in the light that farm trade is not some peripheral

The European Union, Japan and the United States account for over 85 percent of total
domestic support under the AMS [see, OECD 2002].
For a better insight into the plan, see “More fudge than breakthrough,” The Economist,
June 26th 2003.
The Group included Argentina, Bolivia, Brazil, Chile, China, Columbia, Costa Rica,
Cuba, Ecuador, Egypt, Guatemala, India, Indonesia, Mexico, Nigeria, Pakistan,
Paraguay, Peru, Philippines, South Africa, Thailand, Venezuela (see “The WTO under
fire,” The Economist September 18th, 2003).
Implications for Economic Reforms in Pakistan and other Southern Countries 167

issue. It is central to the whole round. Being a development round, Doha

Round was launched with much fanfare. Many developing countries felt
they had a raw deal from the UR. They were dragged reluctantly into yet
another set of trade negotiations largely by the promise of freer trade in
farm goods.

A group of four West African countries-Benin, Burkina Faso, Chad

and Mali-managed to have cotton included as an explicit item on the
Cancún agenda. Their grievances were simple and justified. West African
cotton farmers are being crushed by the $3 billion-plus a year subsidy that
US squanders on its 25,000 cotton farmers, helping to make it the world’s
biggest exporter, depressing prices and wrecking the global market.18 With
low labor costs and small manageable plots, farmers in West and Central
Africa are among the lowest-cost producers of cotton in the world. The
International Cotton Advisory Committee puts the cost of producing a
pound of cotton in Burkina Faso at 21 US cents compared to 73 cents in
the US itself. However, state subsidies guarantee a minimum price to US
farmers, regardless of what happens to world prices. US farmers also
receive additional payments to augment their incomes to a target price
level. As a result, they continued to expand cotton production, by 42 %
between 1998 and 2001, oblivious to almost five years of depressed world
prices. In 2002, partly due to the continuous flooding of the market by
US cotton, world cotton prices fell to 42 cents per pound, far below the
long-term average of 72 cents. During the 2001/02 season, the US
government paid more to its cotton farmers in support than the value of
the harvested crop, $3.9 billion in subsidies for a crop valued at
$3 billion. These subsidies were responsible for 65 per cent of the $300
million loss in potential revenue in all of Sub-Saharan Africa in 2002.
Benin, Burkina Faso, Mali, Cameroon and Côte d'Ivoire were hit hardest.
According to another estimate, the US spends $10.7 million per day
subsidizing its cotton farmers, which is three times the total aid given to
Sub-Saharan Africa (UNDP 2003). As mentioned earlier, in May 2002, the
US passed legislation to further increase the amount that the government
pays farmers. The new Farm Act provides an additional $83 billion in farm
expenditure, above the $100 billion spent on existing programs. Cotton
growers, mainly comprising corporate agricultural companies, are expected
to receive an additional $2.5 billion over a decade.19 This has inflamed an

See “The WTO under fire,” The Economist, September 18, 2003.
See, August 7, 2003.
168 Naheed Zia Khan

already raging controversy around agricultural subsidies and has stirred

anger in developing countries.20

The EU is no less harmful. Its farm reforms may be radical by the

organization's undemanding standards but will not be enough to satisfy the
rest of the world. For example, even though its production costs are more
than double to that of Asian and Latin American countries having a natural
comparative advantage, the EU is now the second largest sugar exporter
from being a net importer 30 years ago. The EU spends about $3.3 billion
annually in supports on sugar exports, and in mid-2002 was paying its
producers a guaranteed price three times that was being offered on the
world market. Due to EU subsidies, prices on the world sugar market have
fallen by 17%.21 However, the sugar subsidy is only the tip of the iceberg.
The annual dairy subsidy in the EU is $913 per cow, which is almost double
the per capita income of Sub-Saharan Africa at $490 and 114 times the
annual per capita aid given by the EU to this region. It gets worse when it
comes to Japan, where each cow gets $2,700 to chew each year, a figure
that is more than five times the per capita income of sub-Saharan Africa
(UNDP 2003).


Being a developing open economy, the success of Pakistan’s

agricultural reform efforts is conditional on the international market
situation. Agriculture stands out as the most distorted part of the world
economy. The most damaging feature of the Common Agricultural Policy
(CAP) of the EU and of the US Farm Support Program is that agricultural
subsidies are tied to production, with surpluses dumped on world markets
via the payment of export subsidies. The sufferers are mainly developing
countries, many of whose economies depend heavily on agriculture. For
most developing countries, phasing out all farm-export subsidies is the
biggest single objective of the Doha round.

Indeed, Brazil has lodged a legal challenge against the US at the WTO, charging that it
is in breach of the “peace clause” of the Organization's AoA. The clause, ironically
introduced at the insistence of the US and EU during the UR trade negotiations, protects
a country from challenge to its subsidy regimes as long as it does not raise them beyond
levels set in 1992. No African or Asian nation has yet filed a legal suit at the WTO
against the developed countries’ farm subsidies. Many are cash-strapped, dependent on
aid and debt relief from the very countries they would be challenging. Many are also
wary of the potential for retaliatory action.
See, August 7, 2003.
Implications for Economic Reforms in Pakistan and other Southern Countries 169

Ironically, the rules prohibiting subsidies were supported and

organized within the WTO by the same countries that are violating the UR
ruling on farm subsidies. Much of the blame lies with the AoA itself. In
theory, the Agreement requires all member countries to reduce subsidies
that hinder trade, but numerous loopholes and rules, the ‘peace clause’ for
example, are weighted in favor of the more dominant members of the
WTO, allowing them to avoid reducing agricultural subsidies and continue
raising them in some cases.

Lower tariff barriers and a big cut in the developed countries

subsidies have strategic significance for the developing world as a whole. An
estimated 96% of the world’s farmers live in developing countries, with
some 2.5 billion people depending on agriculture for a livelihood. Over the
years, unfavorable trade terms have been a major factor in the erosion of the
market share of developing nations. According to the WTO, the share of the
South in world agricultural exports fell from 40% in 1961 to 35% in 2002.22
The huge subsidies of developed countries depress farm prices and place the
farmers of developing countries at a big disadvantage. US taxpayers, along
with their European counterparts, bear a direct responsibility for poverty in
the world.

Finally, can any of the failures outlined in this study be effectively

addressed and the Doha Round revived? Presently, there is little room for
optimism in that the North lacks a holistic and farsighted approach to the
interdependence and complimentarity of the world economy, while the
South appears to be as divided and disorganized as ever. The G22, for
instance, left Cancún determined to stick together and fight another day.
Since after, quite a few member countries of the G22 alliance have been
negotiating free trade agreements with the US. Their commitment to the
free trade of farm goods and their interests in pursuing the strong market
access commitments, requiring free trade agreements with the US, do not
appear to be in harmony with each other. This leads to the final concluding
remarks that in the previous rounds of the GATT and WTO, the
negotiations by the developing countries have amply exhibited the
unfortunate lack of leadership. Cancún provided some short-lived hope, as
the subsequent developments suggest that it too has failed to pass the time

22, August 7, 2003.
170 Naheed Zia Khan


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The Lahore Journal of Economics
Special Edition (September 2007)

Economic Effects of the Recently Signed Pak-China Free

Trade Agreement

Samina Shabir* and Reema Kazmi**


Factor endowments and cross country differences create regional

disparities among states. The disparity in sizes between the Chinese and
Pakistani economies can lead to the creation of trade patterns that can
positively or negatively impact the latter’s economy. The present paper
attempts to analyze the pros and cons of forming a Free Trade Agreement
(FTA) with China given the size, structure and trade patterns of Pakistan’s
existing economy. It also deals with the crucial questions of: Can the
formation of an FTA with China benefit Pakistan? Will trade liberalization
under an FTA with a neighboring country like China spur Pakistan’s trade
and growth? Looking at trends and trade patterns of Pakistan, the
potential of Pakistan’s existing economy is analyzed to enhance
interregional trade and export diversification by further deepening
cooperation with China. In the light of this analysis, the paper also
outlines a number of recommendations to extract the maximum benefit for
Pakistan’s economy from this recently signed FTA with an old economic
partner, China.

I. Introduction

Free trade or globalization is a hotly debated phenomenon in the

global village of today’s economic system. If the economic prosperity and
growth of all the nations of the world could be brought at par with each
other by the free flow of goods and services, regardless of borders, under
the free trade banner, then it is a scenario for which every one of us should
strive for. However, according to skeptics, this concept of Free Trade is
nothing but a mirage. The observed reality is that the World Trade
Organization (WTO) which is the international flag bearer of free trade has
so far not been successful in bringing about trade liberalization around the
globe. There is a perception that the WTO seems to be biased toward
Debt Office, Ministry of Finance Government of Pakistan, Islamabad.
Debt Office, Ministry of Finance, Government of Pakistan, Islamabad.
174 Samina Shabir and Reema Kazmi

industrialized and already developed countries, safeguarding and advancing

their interests, thus further worsening the lot of the world’s poor. This
failure or loss of credibility of the WTO has led developing countries to
fend for their own interests in this increasingly integrated but regionalized
world. Bilateral trading arrangements, although less preferred to multilateral
ones, are one of the instruments employed by various countries, both
developed and developing, to secure their export markets and to guarantee
their trading activities in the future.

Free Trade Agreements (FTAs) are a common type of bilateral

arrangement between two or more countries. FTAs facilitate the free flow of
trade and investment and bring about closer economic integration between
the binding parties by eliminating tariff/restrictions on each other’s
commodities. More than 60% of global trade, at the moment, is being
channeled through bilateral and regional trading arrangements. At present,
almost 300 such arrangements exist globally. The purpose of these FTAs is
not only to serve the economic needs of two countries, but to also
accommodate political motivations, or in other words, legitimatize trade
between two coalition allies (the recent US – Panama FTA is an example). A
host of industrialized countries have already established bilateral
arrangements (e.g., EU, NAFTA etc.), mostly among themselves. With the
realization of the growing importance of FTAs, some developing countries
have also entered into these arrangements. The recently signed Pakistan -
China FTA is a move in the same direction. With the growing importance of
emerging economies in South and East Asia, Asia Pacific and South America,
Pakistan is aiming at strengthening its trading relations with the economies
of those regions. With the growing importance attached to China as the
fourth largest economy of the world as well as an immediate neighbor of
Pakistan, it is about time for Pakistan to think about strengthening its
economic ties, apart from their already strong strategic and military
relations. It was with this enthusiasm and aim in mind that Pakistan laid the
foundation for an FTA arrangement with China in July, 2006.

China being the fourth largest economy of the world, with a trade
surplus of $30 billion and foreign exchange reserve of $1 trillion, has
strategically moved from being a centrally planned to a market based
economy. At the end of 2006, China's global trade exceeded $1.758 trillion.
Pakistan in comparison, is an emerging economy with nominal GDP of
$128.5 billion, a trade deficit of $8.51 and foreign exchange reserves in
excess of $13 billion. Given the disparity in the sizes and economies of these
two countries, entering into an FTA arrangement at this point in time can
lead to some very crucial implications for both the countries, especially for
Pakistan. Thus, this paper attempts to explore the implications of the FTA
Economic Effects of the Recently Signed Pak-China Free Trade Agreement 175

between China and Pakistan on Pakistan’s economy. A case in point is the

textile sector of Pakistan which is an important contributor to the country’s
overall exports, while China is also very competitive in this sector - leading
to a clash in interests. Therefore, it is imperative to analyze the implications
of the FTA for various sectors of Pakistan’s economy. Likewise, a huge
historic trade deficit with China makes it necessary to see the impact of this
FTA on trade with China and Pakistan in general. A number of Chinese
firms were operating in Pakistan, even before the establishment of the FTA,
so now this also requires us to explore the investment scenario in Pakistan.
This study analyzes all these impacts in detail.

The objective of the present paper is to examine the impact of the

recently signed Pak-China Free Trade Agreement (FTA) on Pakistan’s
economy. The paper has been structured as follows: Section II deals with
Pakistan-China trade and economic ties; Section III looks at the already
signed FTA of Pakistan and China with various other countries; Section IV
analyzes the economic impact of FTA on Pakistan’s economy in detail and
Section V presents the conclusions of the paper.

II. Pakistan China Trade and Economic Relations

The year 2006 marks the completion of 55 years of cordial relations

between Pakistan and China. Over all these years, the two countries have
been able to evolve a cooperative relationship at multiple levels, especially in
the political, defense and diplomatic arenas. However, Pakistan and China
have not been able to make substantial progress in their economic relations
until recently.

At the dawn of the 21st century and with the implementation of the
WTO regime just around the corner, both the countries realized the
missing economic dimension in their evolving strategic relationship. The
two countries thus acknowledged the fact that in order to sustain a
comprehensive cooperative relationship, substantive economic collaboration,
in line with the level of political and strategic coordination, was imperative.
Economic cooperation would not only consolidate the comprehensive
bilateral relations between the two countries, but also help in achieving
common aspirations for development, peace and stability in the region. In
the last few years or so, the two governments have convened a number of
high-level conferences/forums, inaugurated by their respective leadership in
Pakistan and China, to promote economic cooperation thereby exhibiting
interest, resolve and patronage to the private sector business community of
the two countries. Pakistan and China have now successfully created a clear
and shared vision of the direction of their economic relations. However, the
176 Samina Shabir and Reema Kazmi

results of this evolving economic cooperation would only be realized after

the upcoming implementation of the agreements reached at various levels
on trade and investment.

Since the early 1950s, Pakistan and China have entered into trade
relations; however, the first formal Trade Agreement was signed in January
1963. Later, in October 1982, the two countries established the Pakistan-
China Joint Committee on the Economy, Trade and Technology. Trade
between China and Pakistan had generally been conducted under the 1963
Trade Agreement, according to which both countries had granted MFN
status to each other. Pakistan had, at that time, multi-modal trade with
China i.e. barter trade and cash trade. However, at present trade with China
is conducted almost entirely on a cash basis in convertible currency.
Recently, the economic relationship between China and Pakistan has come
to the forefront. Now the question arises as to why this sudden interest in
trade between the two countries has suddenly been ignited. Amongst other
reasons, one is that the Chinese government has persuaded its state-
controlled enterprises to import Pakistani products in order to improve the
trade balance and make more project-specific investments. The private
sector’s engagement, which would be the main engine for growth in
bilateral economic relations in the future, is still at a low level. On the
other hand, compliance with the WTO regime is imminent and thus
countries are on the look out for the consolidation of ties with their most
dependable trading partner. In the case of Pakistan, that dependable trading
partner as well as a neighbor is China. Thirdly, logistically an all-reaching
trading agreement with a neighborly state like China is economically
rational and cost effective. Thus, with the rest of the world already well on
its way towards economic integration with like minded allies, Pakistan has
also started to follow this well treaded path.

Traditionally, throughout its trade relations with China, Pakistan

has had a chronic trade deficit. This is primarily because China is
competing in almost all the major sectors of Pakistan’s potential export
areas, which happen to be very limited. Secondly, the Pakistani business
community remained content with their established export destinations
i.e., the US and the Western Europe, and hardly made serious efforts to
either diversify the export base or to explore other areas and regions for
enhancing the volume of their exports. This fixation with Western markets
and non-innovative export approach has consistently undermined the
country’s export potential. Third, though it was feared initially that cheap
Chinese products could take over the Pakistani market, this trend abated
once people realized that they were of low quality, with almost no
guarantee by the company. This was true for both small items, such as
Economic Effects of the Recently Signed Pak-China Free Trade Agreement 177

shoes, as well as bigger items, such as locomotives. Fourth, Chinese

brands were not as famous as the western ones, so competition usually
went against China. Fifth, despite being neighbors, there was a lack of
effective means of communication between Pakistan and China. The
Karakorum Highway, which opened in 1978, could not be used to
increase the volume of trade in any substantial manner. In addition, an
underdeveloped shipping industry in Pakistan further limited the trade
routes and discouraged the growth in trade volume. Sixth, Pakistan’s
cotton based industry is the main pillar of its exports. Since China itself is
a major textile manufacturer, the trade volume could not be raised.

As a result of this renewed interest in trade relations, on May 12

2001, Pakistan and China signed six agreements and one Memorandum of
Understanding (MoU). At that time, Chinese financial assistance for the
agreed projects was estimated to be worth over one billion dollars. This
signing of agreements can be termed as the first round of a substantive
initiative for expanding economic cooperation. The agreements signed
included: Economic and Technical Cooperation, Tourism Cooperation, Lease
Agreement on Saindak Copper-Gold Project, Supply of Locomotives to
Pakistan Railways, Supply of Passenger Coaches to Pakistan Railways, White
Oil Pipeline and MoU between China’s ZTE and Pakistan
Telecommunications Co. Ltd. Under the Agreement on Economic and
Technical Cooperation, the Chinese government agreed to provide a grant
of 50 million Yuan for the promotion of economic and technical
cooperation between the two countries.

China, meanwhile, also reiterated support for a project which is very

close to the Pakistani people’s hearts. Thus, almost a year later, on March
22, 2002, General Musharraf and the Chinese Vice Premier, Wu Bang Guo,
attended the ground-breaking ceremony of the Gwader sea-port. Phase one
of Gwader port was successfully completed in April 2005, and work on the
second phase is in progress.

In the following years, there has been a regular exchange of high-

level visits between the two countries and each visit added new dimensions
and areas for economic cooperation. For example, President Musharraf’s visit
in November 2003 resulted in the signing of a Joint Declaration on
Direction of Bilateral Relations. It was in fact a road-map determining the
direction and scope of overall Pak-China bilateral relations in the future.

In December 2004, Pakistan and China again signed seven

agreements in trade, communication and the energy sector and drew up a
framework for greater cooperation. These agreements envisaged an increase
178 Samina Shabir and Reema Kazmi

in bilateral trade, further movement on the preferential trade agreement,

the setting up of joint agro-based industries and increased Chinese
investment in Pakistan. Pakistan announced Free Market Economy (FME)
status for China. Also, China committed to provide $150 million for the
Chashma Nuclear Power Plant (Phase II). It was part of the preferential
buyers’ credit of $500 million to be provided by the Chinese government
for investment through Chinese companies. China’s investment in Pakistan
at present stands at US $4 billion plus, and at least 114 Chinese projects are
underway. The Chinese side also agreed that the Joint Economic
Commission should soon review Pakistan’s proposal to set up a Pakistan-
China Joint Investment Company and the establishment of a Joint
Infrastructure Development Fund for investment in Pakistan.

The Chinese Prime Minister’s April 2005 visit was considered a

landmark visit in which the two sides signed 21 agreements and MoUs on
cooperation in economic matters, defense, energy, infrastructure, the social
sector, health, education, higher education, housing and other areas. The
two sides also signed a Treaty of Friendship, Cooperation and Good
Neighborly Relations. Under the agreement on Early Harvest Program
(EHP), which became operational on January 1, 2006, China has reduced
tariffs to zero on 767 items. This was the first step towards establishing a
free trade area between the two countries. It is envisaged that by the year
2008, Pakistan and China would be fully able to implement the FTA,
covering 90% of the commodities. The remaining 10% would remain on the
sensitive list of commodities and tariffs might be removed, or at least toned
down, during the second round of FTA negotiations scheduled to be held in
2011 and be implemented in 2012. During the recent visit of the Chinese
President to Pakistan in November 2006, the two countries signed 18
agreements, including a free trade pact/agreement, which they hope will
boost trade from $ 4.26 billion last year to $ 15 billion within the next five
years. The two sides have also signed a pact on a five-year plan to set up a
comprehensive framework for boosting economic ties. Pakistan provides the
shortest possible route, from Gwader through the Karakorum Highway, to
the Western regions of China, which are undergoing a huge economic
transformation. This route is secure, short and can serve as an alternative to
the sea route that passes through the Straits of Malacca. Both countries have
been focusing on trade interaction through this route.
Economic Effects of the Recently Signed Pak-China Free Trade Agreement 179

As a result of the concerted efforts and determination to enhance

economic cooperation between both sides, trade between the two countries
has been registering constant growth: from $1.07 billion in 1997, to $3
billion in 2004, to $4.26 billion in 2005, and the estimated trade volume in
2006 is at $5 billion. Therefore, in a short span of eight years, the trade
volume between China and Pakistan has increased by around $3.2 billion –
not a paltry amount by any standards. Although the current trade balance is
still heavily in favor of China, the opportunities for Pakistani exports to
China are growing. According to the Chinese Customs Authority, “Pakistan's
export to China showed an upward trend, registering an increase of about
39.2% in 2005. The exports amounted to $832 million from January to
December 2005, whereas it was at $594 million in the same period during
the previous year (January-December 2004). Therefore, the increase in
Pakistan’s exports to China in a period of one year has amounted to about $
238 million.” It is expected that if Pakistan’s economy continues to achieve
its current growth rate, bilateral trade would touch around US$ 8 billion by

During the President of Pakistan’s recent visit, the two sides inked
13 agreements and one MoU, aimed at boosting bilateral economic
cooperation while covering a wide range of issues, including trade and
economic cooperation as well as cooperation on energy, transportation,
agriculture, health, population, seismology and meteorology. A feasibility
study is also being conducted to make Pakistan China’s “trade and energy
corridor.” Thereby, upgradation of economic cooperation has become an
integral part of the overall Pakistan-China strategic cooperation. The
institutionalization of economic relations through the above-mentioned visits
have laid the foundation and set the direction of the cooperative
relationship of Pakistan-China.

Although the two-way trade has increased, the volume of trade is

still low. Traditionally, the trade balance has always been titled in favor of
China, except for a short while in 1952, owing to China’s involvement in
the Korean War. For decades China’s constant increase in exports to
Pakistan resulted in a persistent and growing trade imbalance. The main
items of Pakistan’s imports from China are machinery and parts, iron and
steel manufactures, sugar, chemical materials, chemical elements and
medical and pharmaceutical products. The main items of Pakistan’s exports
to China are cotton fabrics, cotton yarn, petroleum and its products, fish
and its preparations, leather, fruits and vegetables. Unfortunately, the mix of
Pakistan’s products exported to China is very narrow. Almost around 80 %
of its exports consist of cotton yarn and fabric.
180 Samina Shabir and Reema Kazmi

Pakistan’s exports to China lack diversity and both countries are

competitors in the textile sector. Diversification of exports from Pakistan
into non-traditional items will help minimize the trade imbalance. Another
important factor in trade deficit with China is the growing exports of
Chinese products to Pakistan. Since these are more economical, businessmen
are inclined to buy more from China. Pakistan therefore, should be looking
at China not simply as an export market but as a primary source for the
import of capital goods and industrial raw material.

The two countries signed a Preferential Trade Arrangement (PTA) in

November 2003, which has been operational since January 1, 2004. Pakistan
and China instituted a Joint Study Group to negotiate a Free Trade
Agreement between the two countries and have simultaneously negotiated
an Early Harvest Programme (EHP), which became operational on January 1,

According to Pakistan’s Ministry of Commerce, Pakistan has given

market access on 118 tariff lines of organic chemicals and 268 tariff lines of
machinery – 386 tariff lines in total. Except 30 tariff lines, 13 relating to
organic chemicals and 17 relating to machinery, all the other tariff lines
have an MFN rate of 5%. As per the agreed timeframe of the elimination of
tariffs, Pakistan was required to reduce the tariff only on 30 tariff lines by
January 1, 2006. The tariff on the rest of the tariff lines i.e. 356 tariff lines
was reduced to zero on January 1, 2007 i.e. no immediate revenue
implications. Similarly, China has brought to zero all tariffs on 767 items.

Pakistan-China Investment Relations

Pakistan and China on February 12, 1989 signed a Bilateral

Investment Treaty (BIT) that encourages the promotion of bilateral
investment both in China and Pakistan, and covers all kinds of investments,
protects investors and investments of both the countries against
discrimination and expropriation, seeks fair and equitable treatment and
provides a dispute resolution mechanism.

The overall Foreign Direct Investment (FDI) in Pakistan has risen by

over 600% in the last five years. However, the Chinese share in the overall FDI
is still very low. Pakistan has been able to introduce and implement investor
friendly policies as a result of which FDI has increased. Pakistan’s investment
policy is very liberal which makes available all economic sectors for FDI. It
provides equal treatment to local and foreign investors and allows 100% equity
to foreign investors with no government sanction required. Full remittance of
profits, capital, dividends, royalties, technical and franchise fees is allowed.
Economic Effects of the Recently Signed Pak-China Free Trade Agreement 181

Complete legal cover is provided through Foreign Private Investment

(Promotion & Protection) Act 1976, Protection of Economic Reforms Act
1992, and Foreign Currency Accounts (Protection) Ordinance 2001.

Similarly, the Chinese government encourages foreign investment in

the Chinese market, and has continuously liberalized and expanded the
fields for investment. In recent years, China has further liberalized the
restrictions imposed on the proportion of foreign equity in investment
projects and opened new sectors to foreign investment. The newly–opened
sectors include telecommunications, urban water supply and drainage,
construction and the operation of gas and heat distribution networks, which
were all previously prohibited from any foreign investment. China has also
opened such service sectors as banking, insurance, distribution, trading
rights, tourism, telecommunications, transportation, accounting, auditing
and legal services. Also, there are a number of laws protecting the interests
of foreign investors as well.

III Pakistan & China FTAs with other Countries:

Both Pakistan and China are fully aware of the pitfalls of

regionalization as well as isolation. Thus, keeping in mind the current global
scenario they have signed various FTAs mostly with other emerging
economies and nearby states.

Chinese FTA with ASEAN

The conceptualization of the Chinese FTA with ASEAN, known as

CAFTA can be traced back to as early as 1995 when Thailand for the first
time proposed a special economic zone, similar to an FTA with China’s
southern provinces. Later, the Asian Financial Crisis in 1997 and the U.S-led
NATO bombing of China’s embassy in Belgrade in 1999 led to discussions of
the formation of an FTA from academic circles to the high policy-making
level. Decision making by Chinese leadership to strengthen cooperation with
ASEAN finally led to the Chinese tentative proposal of setting up an FTA
with ASEAN in Singapore in 2000, and later a formal proposal in Brunei in
2001. It was on December 2, 2004 that China signed a free trade agreement
with ASEAN. Being the first ever signed FTA by China, it caught the world’s
attention. The Chinese academia proposed a move beyond traditional modes
of trade and tariff reduction to include cooperation in services (including
financial, science and technology, including IT) electricity, agriculture, tourism
and transportation (including air transport), non-traditional security and cross
border crime (such as drug trafficking) and regional cooperation (such as GMS
182 Samina Shabir and Reema Kazmi

cooperation and building China’s Southwest International Corridor through


In the view of some Chinese strategists, an FTA with Japan and

Korea first would have better served the Chinese side because stronger
economic complementarities would make them better partners than ASEAN.
Fewer opportunities for domestic industries and more pressure will exist as a
result of cooperation with ASEAN countries. Moreover, making further
concessions to ASEAN as through CAFTA would increase the huge trade
deficit with ASEAN which stood at $1.3 billion in 1993, $1.64 billion in
1998, $2.7 billion in 1999 and $4.8 billion in 2000. However, despite these
realities China did not have the confidence to open its market to economies
that are bigger and far more advanced than its own. If China would have
engaged in an FTA arrangement with Japan and Korea, thus reducing its
current average tariff of 14% to the levels of Korea and Japan with the given
huge bilateral trade volumes, the fear was that the final outcome would
have been damaging. Moreover, the rise in the trade deficit because of
Chinese agricultural products not finding better access into Japanese and
Korean markets would not have been fairly compensated. Since by 2015,
China will be able to achieve full trade and investment liberalization it was
better for it to choose ASEAN as a partner for an FTA. In addition to
traditional areas of trade and investment, China’s FTA with ASEAN is more
than just an economic deal to cover political and security issues as well.
Using this new regionalism as a precautionary measure to dilute potential
U.S unilateralism in the region shows that CAFTA was both strategically as
well as economically motivated.

According to analyst John Bishop (June 1, 2005) the CAFTA which

was to be concluded by the end of June 2005 and implemented in 2010 will
have significant implications for both China and ASEAN nations. China will
benefit from improved trading access to the ASEAN customer base of 410
million people and increased imports of much needed raw material and
food. But this will lead to the export of low value agricultural products to
China from ASEAN while ASEAN will absorb higher value manufactured
products from China leading to higher trade deficits for ASEAN nations.

Chinese FTA with Chile

The China- Chile FTA was signed on November 18, 2005 in Pusan.
Since January 2005, five rounds of negotiations on market access, rules of
origin, technical barriers to trade, SPS remedy, dispute settlement
mechanism, and related legal and technical issues have already taken place.
Economic Effects of the Recently Signed Pak-China Free Trade Agreement 183

The China–Chile FTA will further deepen the partnership and the
trade liberalization process will help unleash the potential of bilateral
economic and trade cooperation and intends to set a new example in South-
South cooperation. According to the Ministry of Commerce China, after
going through the respective internal approval procedures, the China-Chile
FTA will start comprehensive tariff concessions in the latter half of 2006.
On the Chilean side, the import tariff rate of 74% of the tariff lines will be
lowered to zero immediately after the Agreement takes effect, while on the
Chinese side, 63% of the import tariff lines will have zero rate within 2
years; the remaining import tariff lines of both parties will be zero rated in
5 to 10 years after the Agreement becomes effective. Each party may keep
only 3% of the tariff lines as exceptions with tariff rates unchanged. This
means that in 10 years after the start of the tariff concession process, the
import tariffs on 97% of the tariff lines of both sides will be zero.
Furthermore, the Agreement provides that the two parties may accelerate
the tariff concession upon consensus through consultation. In addition to
the liberalization of trade in goods, the Agreement also states the two sides
will strengthen cooperation in such areas as economic matters, small and
medium sized enterprises, culture, education, science and technology,
environmental protection, labor and social security, IPR protection,
investment promotion, mining and industry1.

The establishment of the China-Chile FTA has been seen as a milestone

in the history of the China-Chile relationship, as Chile has always been an
important trading partner of China in Latin America. The bilateral trade
between the two countries has reached a level of US 5.4 billion during the
period 2002-04, with a 22% annual average growth rate of Chinese exports to
Chile and 42% of imports. Chile’s imports from China comprise such products
as light industrial products, electromechanical products and plastic products
and Chile’s exports to China are composed of such products as copper, fish
powder, fruit and wine. The two economies have been strongly complementary
to each other in industrial structure and import and export commodity mix.2

Pakistan - SAFTA3

The Agreement on the South Asian Free Trade Area is an agreement

reached at the 12th South Asian Association for Regional Cooperation
(SAARC) summit at Islamabad, Pakistan on January 6, 2004. It created a

The Economic and Commercial Counselor’s office of the Embassy of People’s
Republic of China, Nov. 18, 2005.
184 Samina Shabir and Reema Kazmi

framework for the creation of a free trade zone covering 1.4 billion people
in India, Pakistan, Nepal, Sri Lanka, Bangladesh, Bhutan and the Maldives.
The seven foreign ministers of the region signed a framework agreement on
SAFTA with zero customs duty on the trade of practically all products in the
region by the end of 2012. The SAARC Preferential Trading Arrangement
(SAPTA), with concessional duties on sub-continent trade, went into force
on January 1, 1996. The new agreement i.e. SAFTA, came into being on
January 1, 2006 and will be operational following the ratification of the
agreement by the seven governments. SAFTA requires the developing
countries in South Asia, that is, India, Pakistan and Sri Lanka, to bring their
duties down to 20% in the first phase of the two year period ending in
2007. In the final five year phase ending 2012, the 20% duty will be
reduced to zero in a series of annual cuts. The least developed country
group in South Asia consisting of Nepal, Bhutan, Bangladesh and Maldives,
gets an additional three years to reach zero duty.

Pakistan - Sri Lanka FTA (PSLFTA):

The Pakistan – Sri Lanka FTA was signed on July, 2002 and came
into effect in June 2005. Immediately after the FTA became operational,
Pakistan offered 206 items duty-free while Sri Lanka offered 106 items duty
free, hence giving a special and differential treatment to Sri Lanka. Sri
Lanka has been given a five year time period to phase out tariffs as
compared to three years given to Pakistan. The Sri Lankan negative list
consists of 697 items as compared to 540 items in Pakistan’s negative list.

Items in the zero duty list of Pakistan (subject to application of the

mutually agreed rules of origin) include frozen fish, vegetables, spices,
fruits/juices, polymers of vinyl chloride in primary forms, natural rubber
(excluding latex), raw silk, tanned/crust skins, wool, some varieties of paper
and board, carpet and floor covering, non-alloy aluminum, iron and steel
products and toys/dolls.

Sri Lanka’s no-duty items under the FTA include chickpeas, dates,
oranges, benzene, toluene, apparel and clothing accessories, ballbearing,
penicillin/streptomycin/tetracycline and their derivatives and vacuum flasks
(excluding glass inners).

Export markets for certain products are crucial for both Sri Lanka
and Pakistan despite the fact that Pakistan and Sri Lanka have not been
major trading partners over the years. For example, in order to benefit from
duty free access of tea, Sri Lanka needs to create a strong marketing
Economic Effects of the Recently Signed Pak-China Free Trade Agreement 185

campaign to change the preference of the Pakistani consumers to bulk tea

from CTS tea of which Kenya is a major producer.

Currently, trade between India and Pakistan takes place mostly via
Singapore or Dubai. If Sri Lanka can promote Indo-Pakistan trade by
encouraging Pakistani investors to open operations in Sri Lanka in order to
trade with India using the ISLBFTA and vice versa, then Sri Lanka can
gradually acquire hub status in South Asia.4

IV. Analysis and implications of Pakistan-China FTA

The military and strategic relationship between China and Pakistan has
always been strong. However, economic relations between the two countries
have, unfortunately, not been as robust (as illustrated in Section 2). Bilateral
trade, mutual investment (direct/portfolio or both), joint ventures and
aid/loans represent components of the economy which, although they have
been previously coordinated upon by the two economies, the scope for
cooperation in these fields remain untapped.

Fig-1 Pakistan's Total Trade Volume with China ($


4. 4.2
3. 3.
2 1.
1. 1.0 0.97 1.0
199 199 199 200 200 200 200 200 200

Source: IPCS Special Report 30, September 2006

China’s trade has mostly been concentrated in markets of developed

countries such as ASEAN, JAPAN and the US. However, its trade with East
Asian and South East Asian neighbors has also been considerable in volume.
China’s exports to its six East Asian neighbors was $124.2 billion and $
168.8 billion worth of goods in 2003 and 2004 as compared to the rest of
Asia (minus Japan and the Middle East) where it exported goods worth $28.6
billion and $40.4 billion in the same time period. This includes many other

Kalegama, S., “Sri Lanka's Free Trade Agreement with Pakistan”, Economic Watch.
186 Samina Shabir and Reema Kazmi

countries besides those of South Asia. So what share does Pakistan constitute
and what is the importance of Pakistan as a market destination for China? As
Table-1 shows, until 2000 China’s share in Pakistan’s external trade was less
than 6% whereas it crossed the mark of 10% after 2003. Moreover, before
Chinese trade agreements came into force with India, Pakistan’s share was
only 20-25% on an average in terms of Chinese trade with South Asia,
which has further declined at even the South Asia level.

Table-1: China’s Total Trade Volume with Pakistan and Other Countries
($ billion)

Year 1997 1998 1999 2000 2001 2002 2003 2004 2005
Pakistan 1.07 0.915 0.971 1.09 1.30 1.80 2.43 3.1 4.26
(20.21)* (18.74) (17.21) (18.88) (19.93) (19.47) (23.38) (27.90) (34.98)
India 1.83 1.92 1.98 2.77 3.60 4.94 7.6 13.6 18.73
SAARC 3.9 3.89 4.15 5.35 6.43 8.31
ASEAN 25.06 23.66 27.20 38.55 41.80 54.76 78.2 105.9 120
Japan 60.81 58.02 66.16 83.20 87.88 101.97 130 167.9 200
USA 49.03 54.99 61.49 83.30 80.61 97.31 126 169.4 211.63

Source: IPCS, Special Report 30

* Figures in brackets refer to the total external trade volume of Pakistan in

billion dollars.

Table-2 gives us China’s exports to and imports from Pakistan over

the span of the last fifteen years. This has been done to analyze the
burgeoning trade deficit of Pakistan between the two trading partners. Over
the years, bilateral trade with China has been on a very small scale. The
share of Pakistan’s exports to China in total exports was only in the range of
1-1.5% until the mid 90s. The table further shows that although the trade
volume between the two countries has started to improve, it still remains in
the range of 2-3% up to 2005-06. On the other hand, imports from China
have always been substantial over the period under consideration. During
the decade of the 90s, imports from China have fluctuated between 4-5%,
and thereafter have steadily increased to 9.47% during 2005-06. The trade
balance with China has always been negative for all time periods starting
from the 1990s till 2005-06. However, it is important to note here that
during the Korean War of the 60’s, Pakistan’s trade deficit actually
registered a surplus with China.
Economic Effects of the Recently Signed Pak-China Free Trade Agreement 187

Table-2: China’s Export to and Import from Pakistan ($ million)

Years Exports Imports Trade Share of Share of Share of trade

balance Exports to Imports from deficit with
China in total China in total China in total
exports Imports trade deficit
1990-91 60.83 386.12 -325.29 0.99 5.07 21.86
1991-92 55.47 399.77 -344.31 0.80 4.32 14.66
1992-93 41.60 420.96 -379.36 0.61 4.23 12.13
1993-94 53.67 439.00 -385.33 0.79 5.13 21.88
1994-95 90.63 458.03 -367.40 1.11 4.41 16.28
1995-96 145.82 546.17 -400.35 1.67 4.63 12.92
1996-97 103.38 542.91 -439.53 1.24 4.56 12.30
1997-98 160.99 510.37 -349.39 1.87 5.04 23.45
1998-99 159.71 416.47 -256.76 2.05 4.42 15.53
1999-00 180.35 471.62 -291.26 2.10 4.57 16.74
2000-01 304.14 525.14 -221.00 3.31 4.89 14.47
2001-02 229.06 574.94 -345.88 2.51 5.56 28.70
2002-03 244.57 838.42 -593.85 2.19 6.86 56.02
2003-04 288.11 1153.69 -865.57 2.34 7.40 26.40
2004-05 354.24 1842.91 -1488.67 2.46 8.95 23.98
2005-06 463.99 2706.32 -2242.33 2.82 9.47 18.51

Source: Pakistan Economic Survey, 2005-06

Amongst others, one of the reasons for the huge deficit between
China and Pakistan can be attributed to the fact that Pakistan’s exports have
been highly concentrated in the markets of few a countries e.g., USA, Japan,
Germany, Hong Kong, Dubai and Saudi Arabia. These countries alone
account for almost 50% of Pakistan’s total exports. In addition, Pakistan’s
exports are also excessively concentrated in a few items such as cotton,
leather, rice, synthetic textiles, sporting goods, etc. Pakistan’s exports to
China mainly consist of cotton textile material, leather, chromium, mineral
and crude oil, and aquatic products. The exports of these products have
been very small as shown by the share of Pakistan’s exports to China in total
188 Samina Shabir and Reema Kazmi

Fig-2 Pakistan's Merchandize Trade with China 1990-2006

1990-91 1992-93 1994-95 1996-97 1998-99 2000-01 2002-03 2004-05

Total Trade Exports Imports Trade Balance

Source: Pakistan Economic Survey, 2005-06

On the import side, Pakistan’s imports are mainly concentrated in

the markets of a few countries, as 40% of imports continue to come from
the USA, Japan, Saudi Arabia, Germany, U.K and Malaysia. Like exports,
imports are also concentrated in a few products such as petroleum and
petroleum products, machinery, chemicals, transport equipment, edible oil,
iron and steel, fertilizers and tea. This concentration of imports has
remained unchanged over the last one decade or so. Machinery, petroleum
and petroleum products and chemicals alone account for almost 53% of
these imports. Over the years, this composition of imports has not witnessed
any remarkable change. Among consumer and capital goods, the share of
raw material for consumer goods in total imports has been high while that
for capital goods has declined. However, the share of capital goods has
shown an increase, thereby representing an increase in investment in the
country. The declining share of consumer goods, on the other hand,
represents an increase in domestic production.

The share of the trade deficit with China in the total trade deficit
shows that although Pakistan’s exports to China have been very
insignificant, the same is not true for imports from China. Pakistan
mainly imports high tech products, chemicals, plastic products and house
hold appliances, chemical materials, machinery, medicine, minerals, light
industry products, native produce and animal byproduct from China.
Economic Effects of the Recently Signed Pak-China Free Trade Agreement 189

Under the recently signed Pakistan-China FTA, both countries have

committed themselves to reducing or eliminating tariffs on all products in
two phases starting from July 1, 2007. The first phase covers trade in goods
and investment while the negotiations in the second phase i.e., trade in
services will be held in mid 2007. An Early Harvest Programme (EHP) which
has been operative since 1st January 2006 has been merged into this newly
signed bilateral FTA. Under the EHP, China has brought to zero all tariffs
on 767 items. For Pakistan, the overall package includes duty free access on
industrial alcohol, cotton fabrics, bed-linen and other home textiles, marble
and other tiles, leather articles, sports goods, mangoes, citrus fruit and
other fruits and vegetables, iron and steel products and engineering goods.
A 50% tariff reduction on fish, dairy sector products, frozen orange juice,
plastic products, rubber products, leather products, knitwear, and woven
garments will also be enjoyed by Pakistan under the FTA. China can get
increased market access mainly on machinery, organic and inorganic
chemicals, fruits and vegetables, medicaments and other raw materials for
various industries including that of the engineering sector, intermediary
goods for engineering sectors, etc.

During Phase I, within five years of the agreement coming into

force, both parties will reduce tariffs on 85% of the products based on
different extents of tariff reduction and at least 36% of the products will be
tariff free within the first three years. China will mainly reduce tariff on
livestock, aquatic products, vegetables, mineral products and textiles,
whereas Pakistan will reduce tariffs generally on beef, mutton, chemicals and
machinery products. Phase II will start in the sixth year of implementation
of the agreement. Further reduction of the tariffs on various products will
be based on the review of the implementation of the agreement. In terms of
tariff lines and trade volumes, the intention of both countries is to eliminate
tariffs on no less than 90% of the products, within a reasonable period of

In the preceding paragraphs we have already established the fact

that Pakistan’s exports to China are negligible as compared to its imports
from there. This raises the concern that granting additional market access
to China, through a reduction of tariffs under the FTA arrangement,
might lead to harming Pakistan’s economy rather than being beneficial
e.g., Pakistan has agreed to reduce tariffs mainly on machinery, organic,
and inorganic chemicals, fruits and vegetables, medicaments and other
raw materials for various industries including that of the engineering
sector, intermediary goods for engineering sectors, etc. Given the current
export structure of Pakistan’s economy, it becomes imperative to analyze
the prospective impact of this FTA on Pakistan’s economy.
190 Samina Shabir and Reema Kazmi

Presently Pakistani markets are heavily flooded with cheap Chinese

smuggled goods – a major part of the illegal trade in the country. A legal
channel for the trade of these commodities, even in the absence of an FTA,
can make Pakistan’s trade volume double with China. Since smuggling
normally takes place to save on custom duties/tariffs, the implementation of
the FTA makes such activities useless or non-profitable since tariffs/duties
saved by the smugglers have largely been removed under the FTA. Legal
documentation of these commodities will have a positive impact on
Pakistan’s economy. Although the goods being shipped from China to
Pakistan and vice versa will be duty free, they will still be registered thus
enabling the government to collect revenue in the form of income/sales tax
on them. As we see an influx of cheap Chinese products enter Pakistan
under the FTA, this can be good for Pakistan’s economy in the sense that
documentation leading to subsequent tax generation will increase CBR
collection for the country.

Besides the aforementioned products, there are other specific

products in which China is more competitive than Pakistan. The
procurement of many of these products is vital for the Pakistani economy
as well e.g., textile, cotton yarn and garments represent a major share of
Pakistan’s total exports. Opening the Chinese economy to these sectors
would obviously mean a replacement of domestic production by cheap
imports from China. Since Pakistan is in the initial stages of development,
it is trying to expand its industrial base through the expansion in its
production of semi-finished and finished products. Therefore,
strengthening its engineering sector, auto sub-sector, consumer durables
mainly domestic appliances needs at least at this point in time some
protection in order for the booming trend in the economy to be

One of the most frequent and recurrent concerns regarding any

FTA is that the impending FTA, allowing for an influx of various goods,
might stifle the indigenous industry of the less developed country or the
country having a smaller economy. In the case of Pakistan – China FTA
similar reservations have been expressed by various strata of the society
especially industrialists, small business operators as well as academia of the
country. Pakistan being a smaller economy as compared to China is
compelled to look out for its local industries. Since the removal of duty
on almost 90% of tradable products between the two countries could have
spelt disaster for the textiles, garments, and engineering industries, which
although booming at present are still in their infancy and thus are in not
a position to face a deluge of cheap Chinese goods. Realizing the dangers
associated with the implementation of an FTA, both the countries have
Economic Effects of the Recently Signed Pak-China Free Trade Agreement 191

agreed to induct a separate clause in the agreement to abolish this

concern once and for all. Article 25, a part of the newly signed
agreement, related with both dumping and countervailing duties, states
specifically that no dumping will be tolerated and thus steps to stop this
practice have been finalized.

The following sectors of the economy have been provided protection

by Pakistan under the FTA.

Cotton Yarn, Textile and Garment Sectors

Cotton yarn is subject to a tariff of 5% which will remain at 5%

during the first phase of the Pak-China FTA. The duty on textiles and
garments, which is 25%, would be reduced to 20% in 5 years. The polyester
sector, including fabrics and garments, have been put in the No Concession
List and no duty reduction will take place in the first five years.

Textile Sector

The share of the textile industry in the economy along with its
contribution to exports, employment, foreign exchange earnings, investment
and value added makes it the single largest manufacturing sector of Pakistan.
It contributes around 8.5% to GDP, employs 38% of the total
manufacturing labor force, and contributes between 60-70% to total
merchandise exports. Indeed, with exports reaching about $8.6 billion in
2004-05, Pakistan is one of the largest textile exporters in the world. The
variety of products ranging from cotton yarn to knitwear, garment made-ups
and bedwear are the most important export products with an export value
of about $1.35 billion each. Knitwear, ready made garments and cotton yarn
also have important shares in total exports. Overall, the US and the EU are
Pakistan’s largest trading partners accounting for 25% and 20% shares of
Pakistani exports respectively. Other major importers include China, the
UAE and Saudi Arabia. The textile trade is classified into two broad
categories i.e. textiles which include yarn, fabric and made-ups, and clothing
which represents ready-made garments. 5

Economic Survey of Pakistan 2005-06, Manufacturing, Mining and Investment Policies
(Ch: 3).
192 Samina Shabir and Reema Kazmi

Fig-3 Composition of Pakistan

Textile Exports 2004-05
Art Silk
Tents & Syntax, 268
Canvas, 61 Other
textile, 137
Towels, 462 Raw Cotton,

Madeups Yam, 983

Fabrics, 1924
1467 Ready Made

Source: Pakistan Economic Survey, 2005-06

Ready Made Garments Sector

Pakistan, with total exports of around US$ 1 billion, has a meager

share of 1% in the global apparel market. The apparel export product mix
from Pakistan is heavily tilted towards men's wear and knitted garments.

The major thrust of garments and made-ups exports from Pakistan is

towards the USA market. The European Union is the second largest market
for garment manufacturers from Pakistan. The major markets that Pakistani
manufactures have so far not been able to explore are the Japanese, Far East
and Middle East markets. These markets demand high product standards
and in return offer higher unit price realizations. The shift towards newer
product and non-traditional markets can only be brought about by more
emphasis on synthetic garments, and the development of a marketing and
research infrastructure for the industry.

The production of garments and made-ups in Pakistan is

concentrated mainly in Lahore, Faisalabad and Karachi. These three clusters
have their own specialties. Faisalabad caters more to home textiles, Lahore is
the home of knitwear and Karachi lives up to its reputation of being “mini
Pakistan,” having established itself both in the knit as well as the woven side
of the industry.
Economic Effects of the Recently Signed Pak-China Free Trade Agreement 193

Engineering Sector

In the steel sector, the prime quality goals are subject to a 10% duty
which will be reduced to 5% in 5 years and secondary goods subject to duty
of 20% would be reduced to 16% in 5 years.

The engineering sector accounts for a 63% share in world trade. To

achieve any significant share of the world trade in engineering goods and
services, Pakistan will have to do many things which include improving
universities, polytechnics and factories for the kind of manufacturing
prowess and design capabilities required by the world market, which now
stands spoilt for choices. In this context, an important step has been taken
by the restructuring of the Engineering Development Board.

In Pakistan, large-scale manufacturing companies in the engineering

sector lack export strategies as well as export development. While Japan,
Korea and Malaysia rely on their large-scale companies to spearhead the
export push, in Pakistan this is being conveniently left to the SME sector.
The government needs to look at this deficiency and bring the strength of
the large scale manufacturing sector into play for a quantum jump in the
export of engineering goods and services.

Auto Sub-Sector

Vehicles in CBU, SKD and CKD condition and auto parts classified
under any of the headings of Pakistan Customs Tariff have been protected
and no duty reduction has been committed to for the first five years.

The auto industry is considered globally as the mother of all

industries. The automobile industry has the largest segment in world trade.
The annual size of automotive exports has grown over $600 billion, which
accounts for about 10% of world exports. In today’s fast globalizing world,
changing models, improving fuel efficiency, cutting costs and enhancing
user comfort without compromising on quality are the most important
challenges of the industry. The auto industry in Pakistan is growing fast and
may soon begin to achieve economies of scale. This mechanical revolution
has been aided in part by sound macro-economic policies pursued during
the last seven years. Furthermore, the e-pass scheme for electronic goods,
unchanged auto policy over the last few years, liberal adjustment of the tax
regime to lower duties on raw materials and intermediate products have also
helped in the rapid expansion of the auto sector. The tremendous rise in
automobile demand has resulted in increased production, giving a healthy
impetus to industrial output and generating over 150,000 direct
194 Samina Shabir and Reema Kazmi

employment opportunities besides contributing tax revenue to the national


Since 2001-02, the automobile market has been growing rapidly by

over 40% per annum and if an average annual growth of 30% per annum
is maintained, Pakistan’s market will cross the milestone of 500,000 units
by the year 2010. Long-term investment friendly policies of the
government and up-gradation of production facilities are considered as a
pre-requisite by experts to achieve the automobile vision 2010 of 500,000

Consumer Durables- Domestic Appliances

All domestic appliances have either been completely protected or the

duty will be reduced from 25% to 20% and 20% to 16% in 5 years.

Riding high on rapidly growing demand, the home appliance

industry in Pakistan is expected to double its capacity of producing TVs,
refrigerators and deep freezers by 2009. Refrigerators lead the figure of the
current year with 569,756 units. The production of TVs, refrigerators and
deep freezers amounted to 372,192, 233,000 and 120,000 respectively in
2000-01. The production of these items has almost doubled in a short span
of three years. If this trend continues, the home appliance industry would
double its production and will increase its contribution to GDP, and
accordingly contribute revenue to the national exchequer. An added benefit
is the increase in direct jobs in the industry and the vendor industry.

Fig-4 CAGR Growth in Selected Markets from 2003-07

Cellular 93.87

Motor 26.70%

Cars 20.80

Van 12.50%

Refrigirator 10.90%
TV 7.50

0.00 20.00 40.00 60.00 80.00 100.00

Source: PRSP II
Economic Effects of the Recently Signed Pak-China Free Trade Agreement 195

The pace of growth in demand for home appliances is the direct

result of the banks and leasing companies’ policy of consumer financing
packages together with the relaxation through and e-pass schemes. Many
dealers have initiated their own schemes of easy installments thus further
escalating demand.

The following sectors have also been protected by Pakistan in the


ƒ Food basket
ƒ Cigarettes
ƒ Locally manufactured inorganic and organic chemicals
ƒ Plastic products
ƒ Edible products e.g., Edible oils
ƒ Paper and paper board
ƒ Engineering goods

In order to boost trade ties between China and Pakistan, duties/tariffs on

items of mutual interest have been reduced drastically. In some cases it has
been decided that the duties be completely written off over a period of 5
years. The table given below shows the three stages of tariff reduction to be
implemented under the FTA for both Pakistan and China.

In the case of exports, as we have shown in Table-2, Pakistan’s

exports to China are a very small proportion of the country’s total
exports. If Pakistan can increase its exports to China through increased
market access for commodities which were earlier under the high tariff
lines, then it will be highly beneficial for Pakistan’s economy. As shown
in Table-3 certain export items e.g., leather articles, cotton fabrics, bed
linen and home textiles, marble and other tiles, sports goods, citrus fruits
(kinoo, lemon, lime) and other citrus fruits will be rendered tariff free in
three stages. However, we are well aware of the fact that the composition
of Pakistan’s exports to China are primary in nature as they consist of
cotton, textile material, leather, chromium, mineral and crude oil, and
aquatic products etc.
196 Samina Shabir and Reema Kazmi

Table-3: Tariff Structure

Products MFN Tariff Tariff for Pakistan

of China On 1/1/2006 On 1/1/2007 On 1/1/2008

Cotton fabrics 10-14 5 0 -

Bed-linen & home 14 5 0 -
Synthetic yarn 10 5 0 0
Polyester fabrics 10-15 5 0 0
Polyester yarn 5 0 0 0
Indentured industrial 4 10 5 0
Dentured industrial 30 10 5 0
Leather articles 10 5 0 -
Marble & other tiles 24 10 5 0
Table ware 18 10 5 0
Sports goods 14 5 0 0
Mangoes 15 5 0 0
Citrus fruits (kinoo, 12 5 0 0
lemon, lime etc.)
Other citrus fruits 30 10 5 0

Source: Ministry of Commerce, Government of Pakistan

Furthermore, increased exports of these products because of

enhanced market freedom can lead to increased revenue generation but will
not necessarily diversify Pakistan’s exports and will also not strengthen the
industrial base of the country. However, all is not lost; it must be
remembered that since Pakistan’s exports are highly concentrated in cotton,
leather, rice, synthetic textile and sport goods - a one billion consumer
market of China will be advantageous for Pakistan and can diversify
Pakistan’s exports in terms of destination.

China being an emerging economy is trying to raise the living

standard of its rural populace. Thus, it offers huge potential for Pakistani
exporters, especially in areas of agricultural, aquatic and leather products.
According to the Chinese Feasibility Study on FTA, “The Pakistani
Economic Effects of the Recently Signed Pak-China Free Trade Agreement 197

commodities that have the greatest potential to be exported to China are

tropical fruits. These fruits are widely planted in Pakistan, and China has
already finished quarantine and inspection on Pakistani mangoes and citrus.
After zero tariffs are levied, in North-west China, Pakistani fruits will enjoy
certain advantages in both quality and price compared with the fruits grown
in Southern China. Pakistan is also rich in fishery resources. With the
adjustment of polices on fishery industry and the improvement of
technology, the potential of Pakistan’s fishery industry will be unleashed.
After the zero tariff policy is adopted, Pakistan will see a rise in its exports
to China.”

These opportunities show that Pakistan can divert its exports from
the markets of various other countries that have put high tariffs barriers on
Pakistani imports and allow them to flow towards the Chinese borders under
the guise of the newly formulated FTA. These advancements under the FTA
will not only increase the trade volume with China but will also guarantee
exposure to Pakistani products in the world’s second largest economy,
thereby making Pakistan a force to be reckoned with in the region.

In addition to market access, the FTA also covers clauses related to

investments, including its promotion and protection, its treatment,
expropriation, compensation for damages and losses and dispute settlement.
The historic ties of investment between China and Pakistan have already
been covered in detail in Section 2 of the paper.

Bilateral trade between China and Pakistan in recent years has made
considerable progress, - increasing with an annual average rate of 30% in
the past 5 years and exceeding $4.2 billion in 2005. In the first 9 months of
2006, Sino-Pakistan trade amounted to $3.75 billion, thus, making China
the third biggest trading partner of Pakistan.

Over the course of the last six decades, China and Pakistan have
witnessed a steady growth in mutual investments, however the scale of
investment is still relatively small. According to statistics released by the
Board of Investment, out of a total FDI of $1524 million that was invested
in Pakistan during 2004-05, the Chinese share was only $ 443,763. Chinese
investment in Pakistan at the moment is concentrated mainly in Gwader
port construction, exploration of coal and other resources, nuclear power
stations, hydroelectric power stations, ship-building, machinery,
infrastructure, construction, agriculture and manufacturing.
198 Samina Shabir and Reema Kazmi

Table- 4: Mutual Investment between China and Pakistan

Pakistan’s Investment in China (10,000 $)

2003 2004 By 2004
Number of Projects 19 21 96
Contractual Value 1949 3210 7148
Actual Investment 343 454 1700
China’s Investment in Pakistan (10,000 $)
Number of Projects 4 3 34
Contractual Value 930 7344 10411

Source: Chinese Feasibility Study on Free Trade Agreement (March 15,


Chinese private as well as public sector corporations are launching

big budget projects, especially in the manufacturing and construction
sectors, all over the country. Some of the major Chinese companies
operating in Pakistan are Heirs, ZTE, Howai Technologies, China National
Petroleum Corporation, China State Construction Engineering Corporation,
Dong Fang Electric Corporation, CMEs, China Ocean Shipping Corporation
and Air China. The successful implementation by various Chinese joint
ventures will encourage more Chinese as well as other foreign investment to
step into Pakistan.

The signing of the FTA is projected to be beneficial for both the

countries. If Pakistan is going to benefit from increased investment flows
to the country, Pakistan is an important market for China to engage in
the project contracting business in South Asia. In recent years, the average
value of signed contracts of labor services amounted to about US$ 500
million per year. By the end of Sept. 2006, the total value of contracted
engineering and labor service cooperation projects of China in Pakistan
amounted to US$ 8.64 billion and the turnover was US$ 7.2 billion. By
September 2006, the agreed investment of China in Pakistan was US$ 110
million and the actual investment of Pakistan in China was more than
US$20 million.
Economic Effects of the Recently Signed Pak-China Free Trade Agreement 199

Fig-5 Sector-wise Chinese Investment 2004-05 ($)

521 Transport
Others, 76194
Communications (Motorcycles


Source: Pakistan Board of Investment

As shown above, Chinese investment in Pakistan is substantial,

covering IT and telecom, oil and gas, power generation, engineering,
automobiles, infrastructure and mining sectors. Yet Pakistan‘s investment in
China is not on the same scale. During 2004, Chinese firms were involved
in investment in Pakistan for a contractual value of approximately $ 10,411
compared to Pakistani investment of only $1700 million. Signing of an FTA
provides safeguards for the promotion of investment between the two
countries but given the existing investment volume and investment friendly
opportunities offered by the Government of Pakistan, China will be in a
better position to utilize the benefits being offered, in lieu of yields
including profits/dividend/capital gains as compared to Pakistani firms
operating in China.. However, they can positively contribute to the
development of Pakistan by generating new employment opportunities,
transfer of technology, exposure to new products and markets; but it should
be kept in mind that the primary aim of any multinational is to maximize
profits and there are pros and cons associated with allowance of these
investments to enter an economy.

V. Conclusion

Pakistan’s FTA with China is another strategic link in the chain

which Pakistan initiated in order to negotiate bilateral and regional
preferential/free trade agreements. Pakistan aims to seek enhanced market
access, by addressing tariff/non-tariff barriers, facilitating and further
200 Samina Shabir and Reema Kazmi

promoting trade, improving investment and economic development,

augmenting comparative value of its exports and build added capacity in
specified targeted areas through technical cooperation and collaboration
through entering into such an arrangement.

The present paper undertakes a general analysis of the implications

of the Pak-China FTA. The inferences drawn from the present analysis is
that although Pakistan’s economy is much smaller than that of China’s in
terms of GDP, trade, reserves etc., yet the FTA offers a huge potential for
Pakistan’s economy. Pakistan can change the trend of its chronic trade
deficit with China by utilizing the increased market access given by China.
Pakistan can also reduce its overall trade deficit by diverting its exports from
traditional destinations to the new one billion consumer base of China; but
for that Pakistan has to make its exports more competitive, more diversified
and much better in quality. Increased investment flows will enhance the
capacity of the existing industries, will help in technology transfer, and
generate employment opportunities for the local population, thereby
positively contributing to the economy of Pakistan. However, the Pakistani
side would be less able to enjoy the concessions given by China for
investment opportunities because the volume of investment to China from
Pakistan is negligible. Nonetheless, we should not look at the FTA from this
perspective, that if there are only positive implications for Pakistan, then
why has China entered into such a deal? We know from the facts and
figures that economy-wise China is already far along the road to
development, and for big and developed economies, political and security
matters much more than economic considerations in making such decisions
of mutual cooperation. Pakistan’s strategic geographical location makes it a
valuable ally which can act as a trade corridor for countries such as China.
Economic Effects of the Recently Signed Pak-China Free Trade Agreement 201


Ceylon Chamber of Commerce, “Sri Lanka – Pakistan Free Trade


China Study Center, Institute of Strategic Studies. “Area Brief on China


China Daily, “ASEAN-China FTA Benefits Both Sides”, April 3 2002.

Chinese Feasibility Study on Free Trade Agreement, Online Search, March

15, 2005.

Economic and Commercial Counsellor’s Office of the Embassy of the

People’s Republic of China in the Republic of Croatia., “China and
Chile Signed FTA Agreement”, November 18 2005.

Government of Pakistan. “Five Year Development Program on Trade and

Economic Cooperation between Pakistan and China”, Economic
Affairs Division.

Government of Pakistan, “Pakistan – China Free Trade Agreement”,

Economic Affairs Division.

Government of Pakistan, Economic Affairs Division. Poverty Reduction

Strategy Paper (PRSP) II 2007.

Hong, H., 2004, “ASEAN and China Sign “Dirty” FTA”, Taipei Times, Dec. 18.

IPCS, Special Report 30, September 2006.

Kalegama, S., “Sri Lanka's Free Trade Agreement with Pakistan”, Economic

Kumar, A., 2006, “China-Pakistan Economic Relations”, Institute of Peace

and Conflict Studies, special report 30.

Lijun, S., 2003, “China-ASEAN Free Trade Area: Origins, Development and
Strategic Motivations”, ISEAS Working Paper, International Politics
& Security Issues Series No. 1.
202 Samina Shabir and Reema Kazmi

Nag, B., 2005, “Trade Cooperation and Performance in East and South Asia:
Towards a Future Integration”, South Pacific Development Journal,
Vol. 12, No. 1, pp. 1-29.

Pakistan Economic Survey, various editions.

People’s Daily Online, “China Established Nine FTAs in Past Five Years”,
February 9 2006.

People’s Daily Online, “Sino-Pakistan Trade on Upward Trend”, August 13


Philippine Daily Inquirer, “China-ASEAN FTA to Boost Regional

Integration”, June 1 2005.

Website of General Administration of Customs China.

Website of Pakistan Board of Investment.

The Lahore Journal of Economics
Special Edition (September 2007)

Determinants of Female Labor Force Participation in Pakistan

An Empirical Analysis of PSLM (2004-05) Micro Data

Mehak Ejaz∗


This paper seeks to identify the major determinants of female labor

force participation in Pakistan, specifically with reference to rural and
urban areas. Limited dependent variable techniques (Logit and Probit) are
utilized to determine the factors affecting female labor force participation.
This analysis uses data taken from the PSLM (Pakistan Social and Living
Standards Measurement Survey, 2004-05) which measure individual and
household characteristics of females between the ages of 15-49. Empirical
results suggest that age, educational attainment and marital status have
significant and positive effects on female labor force participation (FLFP).
When women belong to the nuclear family and have access to vehicles, they
are more likely are they to participate in economic activities, whereas a
large number of children and the availability of home appliances reduces
the probability of FLFP. The results imply that reducing the child care
burden on females and facilitating educational attainment would lead to a
higher labor force participation rate for females in Pakistan.

I. Introduction

The economically active population, or labor force, is a group of

people who produce goods and services to meet the requirements of society.
Pakistan has a relatively low labor force69 participation rate owing to the
lower percentage of women in the work force. Therefore this is a major
issue concerning the development of Pakistan.

According to the Labor Force Survey, the female labor participation

rate in 2004-05 was only 14.6%. According to the Economic Survey, the

The author is a Research Associate at the Centre for Research, Lahore School of
Economics, Lahore.
In Pakistan, the labor force is defined as all persons ten years of age and above who are
working or looking for work for cash or kind, one week prior to the date of enumeration.
204 Mehak Ejaz

female labor force participation rate has shown a considerable rise of 8%,
over the past three decades. However, as compared to other South Asian
countries, the LFP is still very low.70

Labor Force Participation Rates, 1973 - 2006

Percentage of Participation























Male Total Female

There are several explanations for the low rate of female labor
participation in Pakistan. A few of these reasons are the early age marriages,
the strong negative social and cultural influences on the free movement of
women and the absence of an organized labor market. This paper is an
attempt to highlight the major factors that hinder women from joining the
labor force in Pakistan.

Earlier studies have emphasized the decision making aspect in

Pakistan though the focus on determinants is somewhat lacking. The main
sources of labor force and employment statistics are the Population Census
and Labor Force Survey, conducted by Federal Bureau of Statistics on an
annual basis.

The situation of women in Pakistan varies according to their

geographical location and class. Women who belong to urban areas and the
upper strata of society are in a better condition as they have greater
opportunities for higher education and seeking professional work. Almost
75% of the female population belong to rural areas, and suffer from poor
health issues, mainly due to constant motherhood. All Pakistani women

According to the World Bank Report of 2002 the labor force participation rate was
42% in Bangladesh, 32% in India and Bhutan, 41% in Nepal and 37% in Sri Lanka.
Determinants of Female Labor Force Participation in Pakistan 205

remain structurally disadvantaged as a result of legal, social and cultural


On the basis of this background, women's economic activities and

the determinants regarding paid employment are examined by analyzing
different factors pertaining to the household.

According to our knowledge, there is no specific study to date that

has incorporated the socioeconomic and cultural issues as well as
household related factors. This study explores the causal factors,
determinants and issues that are major hurdles for women’s participation
in the labor force and hence, the economic development of Pakistan. After
the analysis on HIES (1999) data, no empirical study has analyzed such a
large number of observations. In this study, the total number of
observations is 115,077, of which 72,099 come from rural areas and the
rest of the 42,978 observations pertain to the urban areas of Pakistan. We
believe that this study will prove to be a contribution towards the existing

The paper is divided into six sections. The next section presents a
comprehensive literature review which highlights the main ideas, theory,
findings and shortcomings of the relevant work conducted in this field. The
third section provides the theoretical framework, based on which the
methodology is developed. A detailed discussion of the Probit and Logit
models is also included in this section. The fourth section explains the data
source and the description of relevant variables, while empirical results and
the findings of the study are discussed in the fifth section. This section also
includes a brief comparison of the FLFP rates of Pakistan, India and
Bangladesh. Section six concludes the paper, and deals with some policy

II. Review of Literature

Over the years, many researchers have dealt with the issue of
female labor force participation. Estimating the labor supply curve and
determinants of productivity has been a common topic of interest among
many economists and sociologists. This section attempts to review the
literature pertaining to the labor supply theory, as well as issues regarding
female labor force participation.71

The literature entails cases both within and outside Pakistan.
206 Mehak Ejaz

Berndt (1990) states that the labor force participation rate of

women varies by age and has considerably increased for all age groups
during the past three decades. He extends the neoclassical labor supply
framework to encompass the household, while addressing issues such as the
discouraged worker hypothesis, and the male chauvinist model. He points
out that most first generation studies show that female labor supply is more
responsive to changes in wage rates and property income, as compared to
male labor supply. The second generation of studies points out that the
elasticity of these estimates is greater.72 Nakamura and Nakamura (1979)
contradict some of these results. They find the female labor supply to be
unresponsive to changes in wage rates. Hausman (1981) implies that
progressive income taxes reduce a wife’s labor supply by decreasing the net
after tax wage. Mroz (1987) essentially follows up on the Nakamura and
Nakamura study relating to the responsiveness of female labor supply. He
notes the large diversity of reported estimates of female labor supply
responses to variations in wage rates and income. He concludes that the
estimated uncompensated wage effect is positive but rather small. Moreover,
he finds the income effect to be negative and fairly small. These results
suggest that the modest sensitivity of married women’s labor supply is not
very different from the labor supply of prime aged married males. The
backward bending labor supply curve in essence holds true for females as
well as males.73 Hence the results are consistent with the view that a
woman’s preference for work is an unobserved omitted variable that affects
her current as well as previous labor market participation. Robinson and
Tomes (1985) also support the conclusions of Nakamura and Nakamura
(1981), as they conduct their study on Canadian women. The estimates
obtained in this study are larger than those of the Nakamuras, suggesting
that the income elasticity of demand for leisure is greater relative to the
substitution effect for women, than that for men. These results indicate that
the contrasting patterns of female and male labor supply curves correspond
to the differential responsiveness of male and female participation to
opportunities, rather than the hours worked.

A major factor that reduces the female labor force participation

rate relates to the fact that women essentially tend to concentrate more on
providing services to the household after they get married. This is a crucial
issue and has been dealt with by various researchers worldwide. Bradbury
and Katz (2005), identify a recent decline in female labor force
participation, specifically among well educated women with children. He

Heckman, Killingsworth and Macurdy(1981).
Nakamura and Nakamura (1981)
Determinants of Female Labor Force Participation in Pakistan 207

finds that unobserved and unpredictable factors contribute towards a decline

in the participation of women.

Dynamic, lifetime models of labor supply have also been of

considerable debate in the economic literature. In such models, economic
agents act in a way as to consider the future consequences of their present
actions. Mincer (1962) attempted to reinterpret the static analyses of labor
supply to include lifetime variables.74 He finds that family income has no
effect on the wife’s demand for leisure. His results also indicate that the
number of children have a significant effect on a female’s lifetime labor
supply curve. Moreover, he concluded that the probability of labor force
participation is inversely related to lifetime wealth measures.

Duleep and Sanders (1994) present similar results and examine

the current labor supply of 25-44 year old married women in the United
States. They are further classified into native-born whites, Asian
immigrants, Hispanic immigrants, and European immigrants. The results
of this study show that the employment rates of women are inversely
proportional to the number of children and age of the youngest child,
when no account of past work is taken. There are significant differences
across the groups of women whereby native born white women are less
responsive to the number of children and age of the youngest child.
However, when women are classified according to whether they worked in
1979, the number of children does not seem to be associated with the
propensity to start or continue working.

Heckman (1974) presents an interesting analysis of the value a

woman places on her time (asking wage or shadow price of time). The
results indicate that the estimated effect of one child less than six raises the
asking wage by 15%. Increases in net assets, the husband’s wage rate and
woman’s education has a positive effect on the asking wage.

Several studies have been conducted on the situation of Pakistani

women, and factors affecting their participation rate have been analyzed.
Shah (1986) analyzed the changing role of women in Pakistan between 1951
and 1981. He concluded that the labor force participation decision of
women is inversely related to the socio-economic status of the family. Shah
et al (1976) examined some of the socio-economic and demographic factors
that determine the labor force participation decision of women in Pakistan.
They attempt to analyze results for all the four provinces of Pakistan. Their

Variables such as consumption, leisure, work at home, wages, budget constraints and
time were translated into lifetime variables.
208 Mehak Ejaz

results show that labor force participation has a significant and inverse
relationship with the nuclear family, as well as the child-woman ratio
However, a positive relationship has been found with marital status,
dependency ratio and literacy rates. The positive relationship with marital
status however, is in contrast to most of the earlier studies. Rashid et al
(1989) present a case study of Pakistan in which they attempt to analyze the
demographic and socio economic factors affecting the labor supply of
women. The results show that LFP is positively related to increases in
expected earnings, wages and level of education. An interesting observation
by these researchers is the fact that the presence of a male figure in the
household reduces the likelihood of female participation in the labor force.
However, the presence of other females in the house increases the
probability that a woman will work.

Ibraz (1993) confines his study to the rural areas of Pakistan, and
observes that various cultural issues such as the observation of purdah in
an Islamic society restrains a woman from active participation in the labor

Naqvi and Shahnaz (2002) have conducted a similar study of

Pakistan and have identified the household related factors that lead to
women’s participation in economic activities. The innovative aspect of the
paper is that it relates women’s decision to participate in economic activities
with their empowerment. The empirical findings of this paper suggest that
the economic participation of women is significantly influenced by factors
such as age, education and marital status.

It can be inferred from the literature that various economic as well

as sociological factors have a profound effect on the labor force participation
decision of women. However, it is felt that some important factors have
been neglected in these studies, especially those relating to household
issues. This study, therefore, attempts to identify and present a
comprehensive analysis of all such factors.

It is expected that this study will contribute to the economic

literature in a significant way by improving upon the previous studies and
also identifying the factors affecting LFP in Pakistan.
Determinants of Female Labor Force Participation in Pakistan 209

III. Theoretical Framework and Methodology

The Probit and Logit Models

Economists frequently encounter the research problem whereby the

dependent variable of the structural model is not directly observed. The
actual value observed may be dependent on the values of other variables or
alternatively may observe a variable that takes on values related to the
underlying unobserved dependent variables. For these models, ordinary least
squares or standard economic estimators are not appropriate, because of the
limited or qualitative nature of the observed dependent variable.

General equation

Υ i = f ( Χ 1 ....... Χ i )

where, Yi denotes female labor force participation (FLFP). Χ 1 ......Χ n

represent various determining factors leading to female participating in the
labor force.

* k
y i = β 0 + ∑ β j χ ij + ε i
j =1

where y i* is not observed. It is a latent variable. What we observe is a

dummy variable yi defined by

yi = 1 if y i* > 0

=0 otherwise

y is equal to 1 if the female participates in economic activity and equal to

zero if she does not. β is a row vector of parameters and ε i is normally
distributed with mean 0.

The probit and logit models differ in the specification of the

distribution of the error term u in the equation75, such that the former
assumes that errors are normally distributed and the latter assumes that
errors follow the logistic distribution.

Maddala (2001), Gujrati (1995)and Berndt (1991)
210 Mehak Ejaz

Data Source

The study is based on cross-sectional data from the Pakistan

Social and Living Standards Measurement (PSLM) Survey - HIES (2004-
05), concentrating on the sample of women aged 15-49. The total
number of households were 73,42976 of which 115,077 observations
pertain to females aged 15-49. These observations are used in the
empirical analysis.

Given that the logistic postulates:

Prob [female in work force] =
1 + e −z

Z = β0 + β1Χ1 + β2 Χ2 + .......... . + βk Χk

Each β i is shown to be:

∂ log(oddsratio ) 77
= - βi 78
∂χ i

For continuous variables, it is possible to compute the change in probability

when the variable, Χ j is increased by one unit. This change can be
calculated using:

∂P B j e −z
∂X j [
1 + e −z ]

Usman Sikander (Research Officer, Lahore School of Economics) helped in processing
the micro level data
77 −z
Odds ratio =P [female in work force]/ P [female not in work force] = e
β i provides a measure of change in the logarithm of the odds ratio of the chance of the
female working to not working.
Determinants of Female Labor Force Participation in Pakistan 211

The following is the list of variables used in the estimation of the


Notation and description of variables in the econometric model

Dependent variable Labor force participation (LFP) = 1 if women

worked/looking for work
= 0 otherwise

Independent variables

Age Age of the female respondent

Marital Marital status (dummy variable)

1 = unmarried; 0 = married women
(Unmarried includes single, divorced and widowed

School Years of schooling

H-Income Head’s income

Children No. of children

Infants No. of children younger than 5 years

W-people No. of working people in the family

F-size Size of family (No. of family members including


F-type Type of family (dummy variable)

1= nuclear family, 0 = otherwise

Location Rural/Urban (dummy variable)

1= urban, 0 = rural

Asset-agric Ownership of agricultural land

Tech Weighted index of appliances

Cycle Own cycle =1, 0 = otherwise

212 Mehak Ejaz

IV. Empirical Results

Table-1: Labor Force Participation of Female

Frequency Percent
Rural Urban Total Rural Urban Total
0.00 59243 39033 98276 82.2% 90.8% 85.4%
1.00 12856 3945 16801 17.8% 9.2% 14.6%
Total 72099 42978 115077 100.0% 100.0% 100.0%

Table-2: Results of Overall Pakistan79

Variable Description Probit Logit

Coefficients Marginal Coefficients Marginal
Effects Effects
Constant -1.878* -0.349 -3.266* -0.322
Age of the female 0.017* 0.003 0.031* 0.003
Married=1,Otherwise0 -0.214* -0.040 -0.425* -0.042
Years of Schooling 0.022* 0.004 0.046* 0.005
No. of working people in family 0.511* 0.095 0.994* 0.098
Family Size -0.134* -0.025 -0.289* -0.029
Nuclear=1,Otherwise 0 0.097* 0.018 0.219* 0.022
if own Car, Motorcycle, 0.072* 0.013 0.119* 0.012
Cycle=1,Otherwise 0
Weighted index of home -0.235* -0.044 -0.428* -0.042
If Female head=1, Otherwise 0 0.497* 0.092 0.971* 0.096
Infant+ children per female 0.365* 0.068 0.754* 0.074
Infant+ children per female sqr -0.044* -0.008 -0.089* -0.009
No. of observations 115077 115077
R2 0.2259 0.2361
Scaled R2 0.1687 0.1773
Fraction of Correct Predictions 0.8719 0.8735
*, **, *** presents significance at 1%, 5%, and 10% level respectively

Sayed Kalim Hayder (Senior Research Fellow) helped in the econometric results
Determinants of Female Labor Force Participation in Pakistan 213

Table-3: Results of Urban Areas

Variable Description Probit Logit

Coefficients Marginal Coefficients Marginal
Effects Effects
Constant -1.878* -0.340 -3.266* -0.31
Age of the female 0.017* 0.004 0.031* 0.00
Married=1,Otherwise0 -0.214* -0.062 -0.425* -0.06
Years of Schooling 0.022* 0.007 0.046* 0.01
No. of working people 0.511* 0.079 0.994* 0.08
in family
Family size -0.134* -0.022 -0.289* -0.02
Nuclear=1,Otherwise 0 0.097* 0.028 0.219* 0.03
If own car, Motorcycle, 0.072* 0.088 0.119* 0.08
cycle=1,Otherwise 0
Weighted index of home -0.235* -0.021 -0.428* -0.02
If female 0.497* 0.075 0.971* 0.07
head=1,Otherwise 0
Infant+ children per 0.365* 0.056 0.754* 0.06
Infant+ children per -0.044* -0.007 -0.089*
female sqr
No. of observations 42978 42978
R 2.13E-01 0.2188
Scaled R 1.62E-01 0.1637
Fraction of Correct 9.14E-01 0.9153

*, **, *** presents significance at 1%, 5%, and 10% level respectively
214 Mehak Ejaz

Table-4: Results of Rural Areas

Variable Description Probit Logit

Coefficients Marginal Coefficients Marginal
Effects Effects
Constant -1.756* -0.376 -3.039 -0.352
Age of the female 0.013* 0.003 0.024 0.003
Married=1,Otherwise0 -0.138* -0.030 -0.275 -0.032
Years of Schooling 0.014* 0.003 0.032 0.004
No. of working people 0.483* 0.103 0.923 0.107
in family
Family size -0.123* -0.026 -0.258 -0.030
Nuclear=1,Otherwise 0 0.097* 0.021 0.223 0.026
Own Agricultural asset 0.003* 0.001 0.004 0.000
Ownership of cattle 0.001* 0.000 0.002 0.000
If own Car, Motorcycle, 0.099* 0.021 0.163 0.019
Cycle=1,Otherwise 0
Weighted Index of home -0.206* -0.044 -0.367 -0.043
If female 0.481* 0.103 0.955 0.111
head=1,otherwise 0
Infant+ children per 0.341* 0.073 0.687 0.080
Infant+ children per -0.041* -0.009 -0.081 -0.009
female squared
No. of observations 72099 72099
R 0.2302 0.2413
Scaled R 0.1782 0.1875
Fraction of Correct 0.8489 0.8506

*, **, *** presents significance at 1%, 5%, and 10% level respectively
Determinants of Female Labor Force Participation in Pakistan 215

V. Empirical Findings

The empirical model highlights the major determinants of female

labor force participation (LFP) in Pakistan. Further, in order to give due
consideration to regional heterogeneity, the model is estimated for the rural
and urban areas as well. A number of potential variables are included in the
model on the basis of theoretical models that have been discussed in detail
in the section on the literature review. In order to improve the model
specification, region specific variables relating to the rural and urban areas
are incorporated.

Estimated parameters and mean probability derivatives of the Probit

and Logit model for the overall model are reported in Table-2.2. The
probability derivatives indicate the change in probability on account of a
one-unit change in the given independent variable after holding all the
remaining variables constant at their mean.

Female characteristics such as age, marital status, years of schooling,

and household characteristics such as the number of working people in the
family, nuclear/extended family, ownership of vehicle, female headed
household, family size, and availability of home appliances are the significant
determinants of female labor force participation in Pakistan. The sample
consists of females of the age cohort 15-49 years. The coefficient of age for
the Probit and Logit model reflects that with an increase in age, there is a
greater likelihood that a female will enter the labor market.

The dummy variable that takes the value of 1 for married and 0
otherwise proves that the significance of marital status affects the LFP. The
results indicate that if a woman is married, there is less probability that she
will enter the labor force. In Pakistan, married women are less likely to be
involved in income generating activities due to their preferences for
household activities. Education is also a very important factor in
determining the probability that a female would enter the labor force, since
education plays an important role in deciding whether to work or not by
enhancing job prospects. Empirical studies found that for women, greater
educational attainment leads to greater participation in the labor force, but
also increases the productivity. As the years of schooling increase, the
probability of women’s participation in the labor force also increases. Its
coefficient is statistically significant. The results suggest that a female that is
educated, unmarried and between the ages of 15 and 49 would have the
greatest chance of being part of the labor force. In order to understand the
participation decisions of women, household characteristics of the female are
also included in the model.
216 Mehak Ejaz

The socioeconomic status of the household plays a very important

role in the labor force participation decision of women. It is a general
perception that women usually enter into the work force due to financial
constraints faced by the household.

Working people in the family also influence female labor force

participation positively. This measures the earning capacity of the household
as well as outward orientation of the family. As the number of working
people increases in a household, members encourage their women to
participate in economic activity as well. The greater the number of working
people in the family, the higher would be the probability of women
participating in the workforce. The demonstration effect may also be one of
the reasons for a positive relationship between working people in the family
and LFP of females. It is reasonable to infer that owing to the lower income
of other family members, a female would move towards the labor market
because of financial needs.

A negative association is found between family size and LFP which

indicates that a unit increase in family size would decrease the log odd value
by 0.134, signifying a lower incidence of women in the workforce. The
existence of patriarchal relations also plays a vital role in hindering the
activity of women, as they are dependent on their husband’s or father’s
decisions. The greater the number of people in a household would lead to a
higher workload for the female members, as they would be involved in
household activities such as fetching water, doing the laundry, preparing
food, and looking after the family members.

Another household characteristic, “type of family”, also affects the

female employment rate. This determinant is used as a dummy variable that
takes the value of 1 for a nuclear family and 0 for an extended family. Since
the extended family system still exists in Pakistani culture, it is imperative to
incorporate this phenomenon by including two categories of families
(extended or nuclear). It has been observed from the results that a woman
living in a nuclear family is less restricted and more independent in decision
making as compared to women living in joint or extended families. The
coefficient of this variable is significant and positive which indicates that a
woman is more likely to participate in the labor force, perhaps due to fewer
dependent family members in a nuclear family.
It is interesting to note that the provision of any kind of vehicle
such as motorcycle, cycle or car increases the probability of women entering
the labor force. The more you facilitate the women with a conveyance, the
more she would feel secure while traveling from home to workplace. Hence,
Determinants of Female Labor Force Participation in Pakistan 217

ownership of a vehicle by the household has a significant effect on women’s

decision to participate in the labor force. The availability of home appliances
such as a refrigerator, air conditioner, television, VCD/VCR/CD player, and
computer has a negative impact on women to work. The impact of this
variable can be explained by the financial status as well as the value placed
on leisure. The availability of such goods implies higher earnings of the
household, which may lead to a greater preference for leisure.

If a household is headed by a female, other female members of the

family may feel more empowered. Being a head of the family, she would
encourage female participation in an economic activity. Realizing the
responsibilities, she could be more likely to join the labor force depending
upon the financial needs of her family. There is a positive relationship
between female headed households and LFP.

The proxy variable for the number of dependents is defined as the

number of infants (children from age 0-5) and number of children (from 6-
10 years of age) per female80. It is introduced to find out the impact of
dependent children on female participation. With the increase in the
number of infants and children, a female is encouraged to participate in the
labor force. However, the square of this variable has a negative impact on
the probabilities of female labor force participation. The results indicate that
for a small number of infants and children per female, the participation rate
increases as the number gets larger but increases at a decreasing rate.

Probit and Logit models estimated for urban regions have been quite
similar to the results for Pakistan overall. However, an additional variable,
technical education, defined as females having degrees in medicine,
engineering, computer science, agriculture or M.Phil/Ph.D, has a positive
and significant impact on women participating in the labor force in urban
areas, mainly due to the fact that women living in urban areas are more
likely to obtain technical education. Technical education is not found to be
significant in overall Pakistan and its rural areas, whereas it has a significant
effect on the urban areas.
In a similar manner, sector specific variables such as ownership of
agricultural land and cattle are introduced in the model for rural areas. Both
the variables are found to have a positive impact on LFP. The ownership of
agricultural land and cattle reflects their assets as well as a source of income.
Earnings from agricultural land and cattle add to the household income, and

As PLSM is unable to provide information on the infant or children of a specific
female, therefore, this variable is a proxy of the number of infant and children per female
in the household
218 Mehak Ejaz

the duty of looking after these assets is usually assigned to women. In this
way, women are involved in the income generating process of the
household. They also serve as a helping hand during the cutting and
harvesting period, and are paid for these activities. This maximizes the
probability of females working in the labor force. Ownership of agricultural
land and cattle are therefore highly significant variables and has a positive
impact on the rural female participation rate. These variables, however, turn
out to be less significant in the case of overall and urban areas of Pakistan.

Why is the Female Labor Force Participation Rate Lower in Pakistan?

It is interesting to note that despite the same social and economic

background, Pakistan, India and Bangladesh exhibit varying levels of female
labor force participation rates. The FLFP for India and Bangladesh is more
than twice that of Pakistan. It is rather surprising that in spite of being a
conservative Muslim nation, Bangladesh has the highest level of FLFP in the

One critical factor according to the Human Development for South

Asia (2003) Report is the inclusion of data on casual workers. According to
this report, India and Bangladesh are the only South Asian countries that
include data on casual workers. Informal wage employment is estimated to
account for 30-40% of informal employment in the non agricultural sector.
Hence, it may be inferred that the reported levels of FLFP for India and
Bangladesh are high due to this factor.

One major determinant of FLFP is the literacy rate.81 Interestingly,

however, the female literacy rate of Bangladesh is lowest in the region. A
trivial conclusion can therefore be that the female labor force participation
is not strictly dependent on the female literacy rate. Hence it is important
to analyze other factors that may account for the differing levels of FLFP.

Bangladesh is a poor country, and has suffered major political and

economic turmoil since the time of its independence. The level of poverty is
considerably higher in this region. Women belonging to the poorer
households are more likely to engage in economic activity particularly in
Bangladesh. Bangladesh has 15% households that are headed by women,
compared to 10% in Pakistan and 9.1% in India. It is evident from our
empirical findings that FLFP is positively related to the incidence of female

Female literacy rate: India 48.3%, Pakistan 35.2% and Bangladesh 31.8%. UNESCO
Determinants of Female Labor Force Participation in Pakistan 219

headed households. Hence, the greater FLFP in Bangladesh probably owes a

lot to the greater number of households headed by females.

The most important factor that accounts for high FLFP in

Bangladesh may relate to the success of micro credit finance in the country.
The outstanding success of the Grameen Bank has made it possible for many
women, specifically in the rural areas, to earn a fair share of income. They
use this income primarily for expenditure on food, clothes, health and the
education of their children. Unfortunately, micro credit finance schemes
have not been as successful in Pakistan as in Bangladesh. One factor
responsible for this failure may be due to the non availability of donors, and
the high default rate on the part of borrowers. Moreover, unlike
Bangladesh, women may have shown less interest towards the micro credit
schemes in Pakistan.

The fertility rate is inversely proportional to FLFP. Over the years

fertility rates have considerably decreased in India and Bangladesh. However,
the fertility rate for Pakistan is still very high. Hence this might be a vital
factor that accounts for the disparity between the FLFP in India, Bangladesh
and Pakistan.

VI. Conclusion and Policy Implications

The paper has identified and analyzed the major determinants of

female labor force participation in Pakistan with special reference to rural
and urban areas. For this purpose, data on women (aged 15-49), from the
PSLM Survey (2004-2005), has been analyzed using the Probit and Logit
regression models. The empirical results of the study suggest that for
women, higher educational attainment leads to greater participation in the
labor force. The results suggest that there is a greater probability that a
woman with the characteristics of being educated and unmarried would be a
part of the labor force. On the basis of the empirical results, it has been
observed that if a woman belongs to a nuclear family, has access to a
vehicle, and has fewer children, then she is more likely to participate in the
labor force. On the other hand, if the family size is large and she belongs to
an extended family, she would be less likely to enter into the labor force. If
the number of infants and children per female is small, female participation
increases, whereas with a large number of children the probability of
participating in the work force decreases. Moreover, the availability of home
appliances reduces the probability of female participation in the labor force.
220 Mehak Ejaz

In light of the findings of this study, the following are some

suggestions and policy implications to improve the social status of rural and
urban female regarding the labor force participation:

Reviewing the facts stated in the data regarding the proportion of

females participating in the labor market with respect to education level, it
has been surprisingly observed that 70% of our female labor force is
illiterate, they have never attended school and of the remaining 30%, 11%
have completed education up to matric, 9% primary, 3% higher education
and 7% up to graduation. It is an alarming situation and the need of the
hour is to analyze the factors as to why female education is minimal.
Education plays a vital role in the development of societies and only
educated females can understand their rights since education empowers a
woman to make decisions regarding labor force participation.

As compared to urban areas, there are limited opportunities for

education in rural areas. In rural areas women mostly work in the fields.

Women should also be encouraged to obtain technical education. In

this regard certain programmes should be initiated so that they can
contribute towards development.

The proper utilization of human and financial resources is lacking in

our society. The solution to the problem lies in spreading awareness among
the parents and husbands of females. The entry of females in the labor
market fundamentally changes the status of females in their families as well
as in society.
Determinants of Female Labor Force Participation in Pakistan 221


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224 Mehak Ejaz


Overall Pakistan
Table 2.1: Descriptive Statistics

Number of Observations: 115077

Mean Std Deviation Minimum Maximum
Age 28.164 9.727 15 49
Marital 0.665 0.472 0 1
School 3.165 4.470 0 19
W_People 2.015 1.419 0 15
F_Size 8.105 3.843 1 54
F_Type 0.629 0.483 0 1
Vehic 0.837 0.931 0 2
Tech 0.709 0.859 0 4
F_Head 0.066 0.249 0 1
INF_F 1.101 1.182 0 10
INF_F2 2.608 5.347 0 100
Table-2.2: Correlation Matrix

Age Marital School W_People F_Size F_Type Vehic Tech F_Head INF_F INF_F2
Age 1.000
Marital 0.572 1.000
School -0.230 -0.310 1.000
W_People -0.067 -0.056 -0.054 1.000
F_Size -0.083 -0.039 -0.059 0.470 1.000
F_Type 0.096 -0.017 0.009 -0.288 -0.390 1.000
Vehic -0.012 -0.043 0.138 0.109 0.101 -0.039 1.000
Tech -0.011 -0.112 0.549 -0.048 0.052 -0.050 0.216 1.000
F_Head 0.010 -0.095 0.049 -0.166 -0.111 -0.265 -0.066 0.044 1.000
INF_F 0.156 0.373 -0.237 -0.146 0.086 0.134 -0.076 -0.190 -0.054 1.000
INF_F2 0.134 0.273 -0.168 -0.151 -0.005 0.166 -0.063 -0.144 -0.038 0.917 1.000
Determinants of Female Labor Force Participation in Pakistan
226 Mehak Ejaz


Table-3.1: Descriptive Statistics(Urban)

Number of Observations: 42978

Mean Std Dev Minimum Maximum
Age 28.038 9.778 15 49
Marital 0.602 0.489 0 1
School 5.600 5.007 0 19
W_People 1.942 1.279 0 12
F_Size 7.926 3.545 1 36
F_Type 0.650 0.477 0 1
Vehic 0.005 0.072 0 1
Tech 1.190 0.957 0 3.6
F_Head 0.070 0.256 0 1
INF_F 0.908 1.093 0 10
INF_F2 2.019 4.639 0 100
Table-3.2: Correlation Matrix (Urban)

Age Marital School W_People F_Size F_Type T_EDU Tech F_HEAD INF_F INF_F2
Age 1.000
Marital 0.621 1.000
School -0.250 -0.297 1.000
W_People -0.079 -0.064 -0.059 1.000
F_Size -0.102 -0.033 -0.114 0.519 1.000
F_Type 0.082 -0.018 0.013 -0.307 -0.384 1.000
T_EDU 0.006 -0.015 0.153 -0.002 -0.023 -0.003 1.000
Tech 0.014 -0.072 0.500 -0.038 0.001 -0.053 0.093 1.000
F_Head 0.008 -0.113 0.032 -0.109 -0.104 -0.276 0.005 0.017 1.000
INF_F 0.136 0.392 -0.242 -0.142 0.092 0.099 -0.022 -0.197 -0.076 1.000
INF_F2 0.116 0.285 -0.180 -0.150 -0.004 0.139 -0.014 -0.157 -0.054 0.910 1.000
Determinants of Female Labor Force Participation in Pakistan
228 Mehak Ejaz

Table-4.1: Descriptive Statistics

Number of Observations: 72099

Mean Std Dev Minimum Maximum
Age 28.238 9.697 15.000 49.000
Marital 0.703 0.457 0.000 1.000
School 1.714 3.362 0.000 19.000
W_People 2.059 1.495 0.000 15.000
F_Size 8.212 4.006 1.000 54.000
F_Type 0.617 0.486 0.000 1.000
Asset_AG 3.441 18.464 0.000 825.000
Cattle 11.148 1740.926 0.000 411212.0
Vehic 0.776 0.938 0.000 2.000
Tech 0.422 0.641 0.000 3.600
F_Head 0.064 0.244 0.000 1.000
INF_F 1.216 1.217 0.000 9.000
INF_F2 2.958 5.700 0.000 81.000
Table-4.2: Correlation Matrix (Rural)

Age Marital School W_People F_Size F_Type Asset _AG Cattle Vehic Tech F_Head INF_F INF_F2
Age 1.000
Marital 0.545 1.000
School -0.257 -0.303 1.000
W_People -0.062 -0.060 -0.030 1.000
F_Size -0.073 -0.049 0.000 0.447 1.000
F_Type 0.104 -0.011 -0.021 -0.278 -0.393 1.000
Asset_AG 0.001 -0.005 0.027 0.007 0.060 -0.029 1.000
Cattle -0.001 0.003 -0.003 0.007 0.005 -0.003 0.000 1.000
Vehic -0.016 -0.043 0.117 0.126 0.102 -0.046 0.031 -0.004 1.000
Tech -0.027 -0.080 0.382 -0.034 0.138 -0.091 0.080 -0.003 0.204 1.000
F_Head 0.011 -0.082 0.065 -0.197 -0.114 -0.259 -0.028 -0.002 -0.074 0.068 1.000
INF_F 0.168 0.351 -0.186 -0.157 0.078 0.161 -0.017 0.010 -0.061 -0.124 -0.041 1.000
Determinants of Female Labor Force Participation in Pakistan

INF_F2 0.144 0.260 -0.134 -0.157 -0.010 0.185 -0.016 0.009 -0.051 -0.102 -0.030 0.921 1.000
230 Mehak Ejaz

Pakistan (Probit)
Dependent variable: LFP
Number of observations = 115077 Scaled R-squared = .168659
Number of positive obs. = 16801 LR (zero slopes) = 19060.7 [.000]
Mean of dep. var. = .145998 Schwarz B.I.C. = 38377.5
Sum of squared residuals = 11136.7 Log likelihood = -38307.6
R-squared = .225859
Fraction of Correct Predictions = 0.871929

Parameter Coefficients S. Error t-statistic P-value

C -1.878 0.0265 -70.96 [.000]
Age 0.017 0.0006 26.29 [.000]
Marital -0.214 0.0150 -14.29 [.000]
School 0.022 0.0015 14.75 [.000]
W_People 0.511 0.0044 116.06 [.000]
F_Size -0.134 0.0021 -65.33 [.000]
F_Type 0.097 0.0128 7.54 [.000]
Vehic 0.072 0.0055 13.04 [.000]
Tech -0.235 0.0082 -28.66 [.000]
F_Head 0.497 0.0221 22.49 [.000]
INF_F 0.365 0.0123 29.74 [.000]
INF_F2 -0.044 0.0025 -17.26 [.000]


β (C) = Estimated logistic coefficient of each variable (it can be interpreted

as the changein the log odds associated with a one-unit change in the
independent variable)
S.E = Standard error of estimates
Sig = Significance value or p value {this value is compared with the
significance level( α ) to determine whether each independent variable is
significant or not in the model. If the significance (p) value of a variable is
less than the designated value of α (1% or 5% or 10%), the corresponding
variable is significant}
R I = partial correlation associated with the explanatory variable I, its value
represents how much each variable contributes in this model.
Determinants of Female Labor Force Participation in Pakistan 231

PAKISTAN (logit)
Dependent variable: LFP

Number of observations = 115077 Scaled R-squared = .177273

Number of positive obs. = 16801 LR (zero slopes) = 20014.6 [.000]
Mean of dep. Var. = .145998 Schwarz B.I.C. = 37900.6
Sum of squared residuals = 10972.2 Log likelihood = -37830.7
R-squared = .236099
Number of Choices = 230154
Fraction of Correct Predictions = 0.873511

Parameter Coefficients S. Error t-statistic P-value

C-1 -3.2658 0.0507 -64.45 [.000]
Age-1 0.0309 0.0012 26.37 [.000]
Marital-1 -0.4253 0.0279 -15.26 [.000]
School-1 0.0462 0.0027 16.80 [.000]
W_People-1 0.9936 0.0089 112.12 [.000]
F_Size-1 -0.2892 0.0043 -67.13 [.000]
F_Type-1 0.2193 0.0242 9.05 [.000]
Vehic-1 0.1191 0.0102 11.67 [.000]
Tech-1 -0.4283 0.0157 -27.25 [.000]
F_Head-1 0.9708 0.0402 24.13 [.000]
INF_F-1 0.7535 0.0231 32.58 [.000]
INF_F2-1 -0.0892 0.0048 -18.46 [.000]
232 Mehak Ejaz

Urban (Probit)

Dependent variable: LFP

Number of observations = 42978 Scaled R-squared = .162052

Number of positive obs. = 3945 LR (zero slopes) = 6601.35 [.000]
Mean of dep. Var. = .091791 Schwarz B.I.C. = 9943.07
Sum of squared residuals = 2819.15 Log likelihood = -9879.06
R-squared = .213285
Fraction of Correct Predictions = 0.913630

Parameter Coefficients S. Error t-statistic P-value

C -2.7199 0.0575 -47.32 [.000]
Age 0.0321 0.0013 24.54 [.000]
Marital -0.4953 0.0292 -16.98 [.000]
School 0.0574 0.0024 23.54 [.000]
W_People 0.6358 0.0099 64.53 [.000]
F_Size -0.1777 0.0046 -38.85 [.000]
F_Type 0.2203 0.0250 8.80 [.000]
T_EDU 0.7066 0.0984 7.18 [.000]
Tech -0.1717 0.0126 -13.58 [.000]
F_Head 0.6031 0.0380 15.86 [.000]
INF_F 0.4451 0.0257 17.30 [.000]
INF_F2 -0.0551 0.0058 -9.48 [.000]
Determinants of Female Labor Force Participation in Pakistan 233

Urban (logit)

Dependent variable: LFP

Number of observations = 42978 Scaled R-squared = .163745

Number of positive obs. = 3945 LR (zero slopes) = 6666.41 [.000]
Mean of dep. Var. = .091791 Schwarz B.I.C. = 9910.55
Sum of squared residuals = 2798.93 Log likelihood = -9846.53
R-squared = .218812
Number of Choices = 85956
Fraction of Correct Predictions = 0.915282

Parameter Coefficients S. Error t-statistic P-value

C-1 -4.8093 0.1135 -42.37 [.000]
Age-1 0.0606 0.0025 24.35 [.000]
Marital-1 -0.9739 0.0561 -17.35 [.000]
School-1 0.1143 0.0048 23.90 [.000]
W_People-1 1.2245 0.0196 62.35 [.000]
F_Size-1 -0.3779 0.0097 -39.04 [.000]
F_Type-1 0.4096 0.0485 8.45 [.000]
T_EDU-1 1.2477 0.1705 7.32 [.000]
Tech-1 -0.3332 0.0247 -13.51 [.000]
F_Head-1 1.1017 0.0709 15.54 [.000]
INF_F-1 0.9284 0.0511 18.16 [.000]
INF_F2-1 -0.1156 0.0120 -9.66 [.000]
234 Mehak Ejaz

Rural (probit)

Dependent variable: LFP

Number of observations = 72099 Scaled R-squared = .178171

Number of positive obs. = 12856 LR (zero slopes) = 12765.2 [.000]
Mean of dep. Var. = .178310 Schwarz B.I.C. = 27497.3
Sum of squared residuals = 8155.51 Log likelihood = -27419.0
R-squared = .230158
Fraction of Correct Predictions = 0.848888

Parameter Coefficient S. Error t-statistic P-value

C -1.7562 0.0308 -57.01 [.000]
Age 0.0130 0.0007 17.40 [.000]
Marital -0.1380 0.0179 -7.70 [.000]
School 0.0138 0.0021 6.56 [.000]
W_People 0.4832 0.0050 96.07 [.000]
F_Size -0.1230 0.0024 -52.35 [.000]
F_Type 0.0974 0.0154 6.33 [.000]
Asset_AG 0.0027 0.0003 8.91 [.000]
Cattle 0.0010 0.0002 4.88 [.000]
Vehic 0.0992 0.0065 15.24 [.000]
Tech -0.2062 0.0120 -17.25 [.000]
F_Head 0.4812 0.0279 17.27 [.000]
INF_F 0.3410 0.0143 23.77 [.000]
INF_F2 -0.0407 0.0029 -14.03 [.000]
Determinants of Female Labor Force Participation in Pakistan 235

Rural (logit)

Dependent variable: LFP

Number of observations = 72099 Scaled R-squared = .187476

Number of positive obs. = 12856 LR (zero slopes) = 13427.2 [.000]
Mean of dep. Var. = .178310 Schwarz B.I.C. = 27166.3
Sum of squared residuals = 8025.56 Log likelihood = -27088.0
R-squared = .241346
Number of Choices = 144198
Fraction of Correct Predictions = 0.850636

Parameter Coefficients S. Error t-statistic P-value

C-1 -3.0386 0.0580 -52.37 [.000]
Age-1 0.0236 0.0013 17.50 [.000]
Marital-1 -0.2754 0.0328 -8.40 [.000]
School-1 0.0321 0.0039 8.28 [.000]
W_People-1 0.9234 0.0100 92.35 [.000]
F_Size-1 -0.2584 0.0048 -53.74 [.000]
F_Type-1 0.2234 0.0286 7.82 [.000]
Asset_AG-1 0.0041 0.0005 7.43 [.000]
Cattle-1 0.0016 0.0007 2.23 [.026]
Vehic-1 0.1632 0.0118 13.81 [.000]
Tech-1 -0.3675 0.0226 -16.24 [.000]
F_Head-1 0.9549 0.0502 19.03 [.000]
INF_F-1 0.6873 0.0264 26.02 [.000]
INF_F-21 -0.0807 0.0054 -15.04 [.000]
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major economic facts, issues and policies.

The Lahore School was granted a Charter in January, 1997 by an Act of

the Provincial Assembly of the Punjab: The Lahore School of Economics
Act 1997 (Act II of 1997). The Charter vests the powers of an
independent degree granting institution to The Lahore School.

The Lahore School has both undergraduate and graduate programs in

economics, business information systems and finance. Its postgraduate
program leading to the MPhil and PhD degree is administered through
the Lahore School’s Centre for Advanced Research in Economics and
Business (CAREB). The student body and faculty comprise both national
and expatriate Pakistanis and The Lahore School encourages expatriate
Pakistanis to join as students or as faculty.

The Lahore School’s publication program comprises The Lahore Journal

of Economics (a bi-annual publication), a Seminar Paper Series and a
Text Book Series. The Program encourages both in-house and external

For further information, please call (Pakistan 92-42-) 5714936 or visit the
Web page:

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