By Shahid Sattar
The economy is headed towards a deep recession. Only a well-targeted fiscal stimulus can avert the incoming crisis. Petroleum prices have increased once again, and further hikes in electricity tariffs are on the table.
The exchange rate continues to face upward pressures, largely due to the release of pent-up demand as import restrictions are withdrawn amid a limited supply of foreign exchange. At the same time, the rise in international fuel prices is expected to continue over the course of this year.
While global food prices have come down from their 2022 peak, they remain elevated at around 2021-levels. All these factors have a high pass-through to inflation, and it is safe to say that inflation is likely to increase further in the near term.
The policy rate, the primary tool to curb inflation, is already at a high of 23 percent, and monetary policy is largely constrained.
The effectiveness of interest rates hikes is also highly questionable at this point since inflation is entirely supply driven, while the mechanism that connects interest rates to inflation is on the demand side. And demand is difficult to curb further since it is already low and relatively inelastic because a large part of household consumption expenditures—especially for the lowest income groups—is being spent on foodstuffs and energy costs, both of which are very basic necessities.
Production in the textiles sector has been down by over 30 percent since March, production capacity in the automobile sector has remained highly underutilized, and business leaders are now warning that over 50 percent of industry across the country is headed towards closure. This has further implications for upstream and downstream sectors such as retail and domestic manufacturing of intermediate inputs, respectively.
Not only are we faced with an increase in prices and erosion of real wages, but also massive joblessness that is placing unbearable pressures on lower- and middle-income groups.
This puts our already struggling economy in an extremely grim position. Amid an already weak and persistently weakening demand, large-scale closure of industry and massive joblessness, and a looming crisis in the financial sector, Pakistan is undoubtedly headed towards a deep recession that will take years to come out of and will cause unimaginable pain and human suffering.
However, there is still time to avert the incoming crisis. The economy needs a stimulus and needs it fast. Yes, fiscal policy is constrained by the IMF SBA, but not to the extent that we have been made to believe. The agreement only prohibits unbudgeted and untargeted subsidies. This means that any stimulating measure will need to be accompanied by a revenue increasing or expenditure decreasing measure.
Since taxes have already been increased considerably in the FY24 budget, revenue increasing measures will only increase the tax burden on already unfairly and highly burdened classes and create further incentives for tax avoidance unless they are imposed on untaxed segments.
The alternative to this is an expenditure decreasing measure, where fiscal space for the stimulus is made by decreasing the government’s current expenditures. The latter is preferable.
The stimulus must also be targeted. The optimal audience is industry—ideally less protected and export-oriented sectors. This will achieve several objectives. First, it will allow firms to resume production, which will address joblessness in both the targeted sectors as well as in upstream and downstream sectors, thus averting the loss of wages.
Second, it will stimulate export creation and relieve pressures on the exchange rate, thereby providing some relief in terms of inflation pass-through. If the stimulus is carefully designed, it will also facilitate the economic adjustment away from protected industries towards productive export sectors reducing the costs of deeper structural reform.
Finally, export earnings will also push up real wages through second- and higher-order effects, providing further relief from inflation.
The final question is of the mode of stimulus. This can take multiple forms such as direct transfers or concessional financing to firms. However, these will have unintended consequences such as an increase in inflation through money supply and are also made complicated by the government’s commitments to the IMF.
The best way to stimulate industry is through the provision of competitive input prices. As we have already argued, exports are collapsing under the power sector’s burden and this effect is spreading to other sectors as well. Provision of cost-of-service tariffs to B3 and B4 export-oriented consumers, that excludes economic inefficiencies like stranded costs, cross-subsidies to lifeline consumers and distribution losses, will provide a large enough stimulus since, for instance, electricity costs account for around 30 to 40 percent of total conversion costs in the textile sector. There is no other option.