IIUI/IIIE/SPRING2014/PZJ/IPE/11

Finance and Development

Fiscal Deficit and Public Debt:

Recently, fiscal deficit and public debt have been extensively debated in the developed and
developing countries. In the USA and Europe the problem of fiscal discipline has been
addressed through legislation. In case of developing countries the importance attached to
fiscal deficit is even greater. The World bank and IMF believe that fiscal deficit is the most
important policy variable that affect the whole economy, and therefore, the problem,
according to their viewpoint, is to be addressed through structural adjustment program. In
case of Pakistan, in the opinion of many economists, fiscal deficit is the primary cause of
major ills of the economy.
Should budget always be balanced, and what are the implications of increasing budget deficit
on an economy? According to some observers budget financed through deficit leads to
inflation. Domestic borrowing leads to a credit squeeze and the crowding out of private
investment and consumption. External borrowing leads to a current account deficit and
appreciation of a the real exchange rate and sometimes to a balance of payments crisis, or an
external debt crisis1. Other argued that there exist no negative relationship between budget
deficit and inflation or economic growth. According to Robert Eisner bigger deficits in the
USA have come with less inflation and smaller deficits with more inflation. The greater the
deficit, the greater was the next year’s increase in GNP; and less the deficit, the less was the
subsequent increase in GNP2.
After having reproduced divergent views on budget deficit and its possible implications, we
now consider the summary of fiscal policy statistics on Pakistan:

The salient features of public finance and fiscal deficit of Pakistan are summarized below:
 Total expenditure exceeds total revenue. No remarkable change is observed with
regard to curtailment in expenditure or generation of additional revenue.
 Current expenditure alone exceeds total revenue. Current expenditure is growing and
development expenditure is falling.
 Interest payments along with defence expenditure constitute more than half of annual
expenditure.

1 Easterly, W., Fiscal Deficits and Macroeconomic Performance in Developing Countries, World Bank,
Washington, 1993, p. 213.
2 Eisner R., Budget Deficit: Rhetoric and Reality, Journal of Economic Perspectives, Vol. 3, No.2, 1989, p.81-83

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  Main source of financing fiscal deficit has been non-bank borrowing. The financing of
deficit is more through internal resources than external resources.
 Fiscal deficit of the government of Pakistan has been around 8% of GDP during 1980s.
Fiscal policy has been identified by the World Bank and IMF as a critical “failure” in the
context of Pakistan, and as one of Pakistan’s key macroeconomic problems, threatening price
stability, balance of payments, constraining essential government investment in economic and
social infrastructure, and thereby endangering growth prospects 3 . Now let us consider the
summary picture of Pakistan’s key macroeconomic variable since 1980. The budget deficit as
a % of GDP is presented alongside other variables which it is supposed to affect:

Pakistan has experienced very high growth rates compared to other developing countries and
averaged well over 6.5% per annum in the 1980s. This is no mean achievement given the
huge budget deficit, which has averaged 7% in the same period. Similarly, an inflation of 7%
inflation over a decade is quite creditable. Moreover, with increasing budget deficit in early
1990s as high as 8% per annum in average, one would not have expected 13-30% growth in
the private sector over the same years. In line with Keynesian interpretation Akbar Zaidi
argues that higher public spending in Pakistan causes an increase in aggregate demand, and
subsequently growth, given the less than full capacity of the economy. If it is true that
Pakistan’s GDP is underreported by as much as 40% either due to informal economy or any
other reason, then the size of budget deficit as a percentage of true GDP would be much less
than the reported official figure of 8%.
According to Akbar Zaidi the real problem is not the level of reported budget deficit, but how
the public money is spent, and who is funding the government expenditure? It is the excessive
government spending, specifically for debt and defence service and not for development
expenditure, which is being financed through excessive taxation on consumption. The share
of development in total government spending, which was 40% in 1980 and 25% in 1990,
declined to 13% in 2000. Thus, a substantial increase in the share of interest payment has
come at the cost of development.

3World Bank, Changes in Trade and Domestic taxation for Reform of the Incentive Regime and Fiscal
Adjustment, Report 9828-Pak, Washington 1992, p. 2.

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Current Account and Public Debt:

By considering balance of payments one may ascertain that the trade balance has been
generally negative since 1970s, and the deficit in this account reached the level of 9.5 billion
US$ in 2006-07. Similarly, at the same time deficit in current account was 7.4 billion US$. In
terms of GDP the current account deficit was as high as 5.2%.

Balance of Payments (millions US$)

76-77 80-81 87-88 94-95 01-02 02-03 03-04 04-05 05-06 06-07
Export 1132 2799 4362 7759 9140 10889 12396 14401 16388 17119
Import -2418 -5563 -6919 -10296 -9434 -11333 -13604 -18753 -24624 -26614
Trade -1286 -2764 -2557 -2537 -294 -444 -1208 -4352 -8236 -9495
Balance
Services -356 -515 -1381 -2384 -2617 -2128 -3594 -5841 -7302 -7968
(Net)
Transfers 590 2242 2256 2437 4249 5737 6116 8440 9914 10102
(Workers (578) (2116) (20139 (1866) (2389) (4237) (3871) (4168) (4600) (5494)
Remittance)
Current -1052 -1037 -1682 -2484 1338 3165 1314 -1753 -5624 -7361
Account
Balance
Long-Term 743 1072 1572 2797 1280 1035 -201 2562 6017 10006
Capital
Private 161 261 330 1725 1911 -177 225 691 1221 4153
Public 582 811 1242 1072 33 1457 810 -892 1341 1864
Basic -309 35 -110 313 2618 4200 1113 809 393 2645
Balance
Errors & 57 -25 -30 -75 961 909 -137 -854 36 507
Omissions
Required -252 10 -140 238 3579 5109 976 -45 429 3152
Official
Finance
Changes in 252 -45 140 -238 -2792 -5209 -826 -372 -818 -4303
Reserves
- = increase
Sources: Zaidi, 2008, Table 9.1; GOP, Economic Survey 2007-2008, Ministry of Finance, Islamabad, Table 8.2

Current account deficit has to be financed through increased capital import. Only in 2006-07
10006 billions US$ were imported to finance current account deficit. During the year 2007-
2008 more than 6 billion US$ were taken out of reserves to finance the deficit.

Domestic and Foreign Debt:

According to the report of the committee for Debt Reduction and Management Strategy
(DRMS) in 2001 “Pakistan’s public debt has reached alarming proportion. The downward
rigidity of budgetary expenditure and lack of buoyancy in revenues have generated
persistently large fiscal deficits over the last two decades. This has resulted in the
accumulation of public debt at a fast rate”4. In the understanding of DRMS, the debt crisis
was triggered by the un-sustainability of the level of deficits in the fiscal and current account
and the pattern of their financing in the 1990s5. Data on public debt (including domestic and
foreign debt) is given in the following table:

4 GOP, A Debt Reduction and Management Strategy, Islamabad, 2001, p. v.

5 Ibid, p. xv.

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Total debt rose to more than 100% of GDP in 1998-99 having about 60% share of external
debt. Both of key foreign debt ratios, namely external debt service as % of export earning and
foreign exchange earning, rose to 55% and 35%, respectively. Until the huge debt
rescheduling in 2002, most indicators regarding debt as % of total revenue, tax revenue and
current expenditure, were not particularly impressive. In 2000 Pakistan’s public debt to
revenue ratio was 610%, almost double of India’s (385%), three times Mexico’s (220%), and
ten times Chile’s (60%)6. The reasons why the debt burden increased so sharply during 1996-
99 and culminated into debt crisis, was because growth rates had fallen in the 1990s and so
had revenues. In the 1980s, there was real revenue growth of 8.2% per annum while it was
only 3.9% per annum in the 1996-99 period, implying that not only was debt increasing, but it
was becoming even more difficult to service the debt. Additionally, the real crunch came
when interest rates jumped from negligible levels since the mid of 1980s to substantially high
real interest rates in the 1996-99 period:

6 Ibid, p. xiii.

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Interest rates increased due to financial liberalization, a hallmark of so called stabilization
policy of the Word Bank and IMF. Particularly, foreign debt crisis was triggered by the un-
sustainability of the level of current account deficit (CAD) in the balance of payments of
Pakistan. The CAD during the 990s was on average 4.8% of GDP, increasing further to 6% if
one includes the balances of foreign currency accounts. Foreign exchange earnings (including
exports and remittances) had fallen during 1996-99. Additionally, depreciation of Pakistani
Rupee made it more expensive to service foreign debt:

It was the 1996-99 period again, in which there was further deterioration in the external debt
situation. The real interest rate on external debt rose while real growth in foreign exchange
earning turned negative. Pakistan was paying back in terms of interest alone, much more than
it actually borrowed. Net addition to total debt outstanding in the period 1990-2000 was
15451 billion US$ while in the same period the total amount repaid as interest and principal
was 36611 billion US$:

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One would have expected that such huge amounts of inflows would have benefited the
country in terms of growth and raising living standard of the people. However, in case of
Pakistan, foreign capital inflows have been substantially used to finance consumption.
A growing debt that must be financed by increasing interest payments, is unfair to present and
future generations. Peoples are better off, if government improve the quality of the life of
present and future generations by investing in social goods like health, education and
infrastructure. However, if deficit grow due to massive increases in military spending and
large tax cuts, then the burden of debt on present and future generations must not be fair.
Due to debt rescheduling worth 12.5 billion US$, debt write-offs and the creation of sufficient
fiscal space Pakistan was able to manage a growth rate of about 6% per annum in average in
the recent past. However, the basic issue of foreign aid and development needs to be resolved
in terms of maintaining higher growth and reducing absolute poverty in Pakistan.