Parvez Hasan*
1. Introduction
Pakistan has had a checkered economic and political history. The country’s periods of rapid growth in the 1960s, the first half of the 1980s, and 2002–07, have been followed by periods of sharp economic slowdowns. Sustained economic growth has been elusive; there has been no real deepening of the structure of the economy, and social and distribution issues have become increasingly troublesome. Yet Pakistan has somehow managed to attain an annual average gross domestic product (GDP) growth rate of 5.2 percent and a per capita income growth rate of 2.5 percent over the last half-century (1960–2010) that has more than trebled the average living standard over the period.
The distribution of gains from growth has, undoubtedly, not been equitable. However, the country’s economic record, though of course not able to match that of East Asia—especially China, and more recently India—seems to compare favorably with the average for developing countries. This is no mean achievement considering the great deal of political instability and long periods of military rule that entailed relatively good governance but a high cost in terms of defense spending, continued tension with India, and weakening institutional authority.
However, Pakistan’s past economic performance is also somewhat misleading because the growth of output, investment, and employment have very seriously slowed down during the last four years and the prospect of strong economic revival has become uncertain (Institute of Public Policy, 2012, chap. 2). GDP growth averaged less than 3 percent per annum over 2008–12. Gross fixed capital formation dropped more than 30 percent in real terms over 2008–12 and the ratio of fixed investment to GDP at around 11 percent in the financial year (FY) 2012 was at its lowest level in half a century. Public finances have deteriorated very significantly and external finances are being kept afloat largely as a result of substantial workers’ remittances, both through official channels and money market companies. Consequently, gross national product (GNP) growth has averaged 3.6 percent per annum or is 0.7 percent higher per annum than GDP growth over the last four years (2008–12).
In looking for lessons from Pakistan’s development experience, we cannot and must not overlook the factors that have made fairly respectable growth rates possible for long periods despite considerable odds. But the more important questions relate to the many missed opportunities that have come Pakistan’s way and the many policy missteps that kept it from attaining its fairly widely heralded economic promise in the 1960s. Most urgently, a look at the country’s development experience is essential to learn lessons on how to break out of the economic stagnation that now threatens not only people’s economic wellbeing but also the country’s political future.
2. Salient Aspects of Economic History
Before drawing lessons from Pakistan’s development experience, it is necessary to provide a thumbnail sketch of the major economic periods it has undergone.
When the idea of Pakistan was put forward in the 1940s, doubts were continually expressed about its economic and financial viability. Despite the turmoil caused by Partition, the early development of tension with India, and frequent changes in what were weak governments without a strong public mandate, the 1950s marked a period of rapid industrialization. The decade laid down the basis of future growth by sharply increasing investment, both in physical and human capital, and creating strong economic institutions, notably the State Bank of Pakistan, the Water and Power Development Authority (WAPDA), Pakistan Industrial Development Corporation (PIDC), and Pakistan Industrial Credit and Investment Corporation (PICIC). By 1959/60, fixed investment in West Pakistan (now Pakistan) had risen to 11.5 percent of GDP from 4.1 percent in 1949/50, with public investment accounting for nearly two thirds of capital formation (Hasan, 1998). It may seem surprising but education was not neglected in the 1950s. Gross primary enrolment grew by 10 percent per annum though girls’ enrolment accounted for only 22 percent of the increment.
The financing of investment, however, relied excessively on external flows—a pattern that was to become endemic. While private investment, especially in the rapidly growing textiles sector was financed mostly by reinvested burgeoning profits under strong protection, the more-than-six-fold increase in real public investment in the 1950s relied on foreign assistance and money creation.
Apart from foreign assistance, there were three main drivers of growth in the early years: (i) a competent, committed, and honest bureaucracy with strong economic leaders such as Ghulam Mohammad, Chaudhry Mohammad Ali, Ghulam Faruque, and Zahid Hussain; (ii) a large number of migrants consisting of well educated professionals who played a vital role in strengthening the civil services and the financial sector; and (iii) private sector entrepreneurs led mainly by members of the Bohra, Memon, and Khoja communities that had migrated from India but settled in Karachi, making it Pakistan’s premier industrial city.
The annual economic growth rate that had been a little over 3 percent in the 1950s shot up to nearly 7 percent in the 1960s, and in the heyday of the Ayub era in the mid-1960s, Pakistan’s development efforts were hailed as a rare success story (Papanek, 1996). The transformation in economic performance compared to the previous decade was the result of both a massive increase in foreign aid and investment, economic liberalization, technological breakthroughs in agriculture, and exceptionally well-coordinated economic policies and speedy decision-making supported by strong planning processes. A less well-known fact is that real defense spending from Pakistan’s own resources grew little during 1960–65, the size of the army was kept strictly under control, and all the incremental expenditure on weapons and equipment was financed through substantial US military assistance.
Public investment and aid flows were especially stimulated by large expenditures under the Indus Basin Water Treaty signed with India in 1960. The treaty was a consequence of the initiative taken by the World Bank. Including the expenditure on Indus Basin replacement works of about USD 1.2 billion, water and power investment totaled USD 2.5 billion (about 3.6 percent of GDP) during the 1960s and accounted for more than 50 percent of total public spending. Fixed investment reached an all-time peak of 20.8 percent of GDP in 1964/65, with more than 50 percent financed through external assistance. The massive long-term investment in infrastructure was critical in sustaining agricultural growth through the mid-1990s.
The 1965 war with India had the disastrous consequences of a decline in aid flows, upsetting the balance between defense and development, and setting in motion currents that led to the separation of East Pakistan in December 1971. The near-doubling of defense spending between the first and the second half of the 1970s was also a major setback for education—additional primary school enrolment during 1965–70 was one third less than in 1960–65. Based on an imperfect knowledge of the level and rate of growth of population, the Third Plan had set an ambitious 70 percent enrolment target for 1969/70—the actual result was only 40 percent enrolment.
Had it not been for the country’s exceptional agricultural growth rate of 5 percent made possible by speedy private tube-well development and the highly successful exploitation of the green revolution in wheat and rice production, economic activity would have slowed down very seriously in the second half of the 1960s. Even so, the fixed investment-to-GDP ratio fell to 14.3 percent by 1969/70. More importantly, the exchange rate and trade policies that were initially supported by the large influx of aid flows had progressively distorting effects on the economy.
The large supplies of long-term credit available for industry through PICIC and the Industrial Development Bank of Pakistan at a grossly overvalued exchange rate led to wasteful and unviable investments. The multiple exchange rate regime that had been put into place under the export bonus scheme in 1959 created an effective subsidy to manufactured exports of over 100 percent for textiles, while substantially taxing agricultural exports. This stalled industrial deepening and inhibited the development of a really competitive diversified manufactured export base while low value-added cotton yarn exports were aggressively promoted.
Z. A. Bhutto’s five-and-a-half-year rule encompassed a wide range of economic policy initiatives and state interventions. While Bhutto did not have a grand design for the economy and only a vague belief in socialism, he felt he had the popular mandate to curb the power of the industrialists and bureaucrats and improve the lot of the poor. He therefore vastly expanded the state’s role in economic activity by nationalizing education, banking, insurance, and a number of heavy industries. While he did not nationalize light industry, the Punjab government under the Pakistan Peoples Party invested in several sugar and textile mills. Including the large and not very economical steel mill and other investments in cement, fertilizers, and heavy industries, public sector industrial investment grew tenfold in real terms while the large-scale private industrial sector essentially shriveled because of perceived hostility to the “twenty-two families”.
It is not an exaggeration that Bhutto’s economic policies virtually halted the growth of the modern industrial sector and reinforced the anti-export bias of the country’s industrial strategy. To this day, labor-related and other regulations adopted have continued to provide strong disincentives to the growth of large-scale industry.
Other Bhutto policies that had a negative impact on long-term growth were the large increase in defense establishment (even after the country was reduced by half); the nationalization of educational institutions; a cavalier attitude toward public spending (that his nemesis, Zia-ul-Haq eagerly replicated); and the serious erosion of the capacity and authority of public institutions, especially those responsible for planning. A great deal of the responsibility for the failures in basic education, which remain an important constraint to growth, can be traced back to the decision to nationalize educational institutions in 1972. As a direct consequence of this decision, the government’s management capacity was extended, competition for resources within the education sector deepened the urban bias of education, and the development of basic education and literacy slowed down.
In terms of Bhutto’s short-term policies, three points stand out. On the positive side, following his populist instincts, his decision to greatly relax passport controls did much to help migrant workers and initiate a stream of remittances that, for a while, became a flood in the first half of the 1980s. The same populist instinct led Bhutto to postpone energy price adjustments that became necessary after the first oil shock at the end of 1973. Consumers were protected through grants and loans from friendly Arab countries, and it was only after the second oil shock in 1979/80 that the painful adjustment of energy prices was undertaken in Zia-ul-Haq’s time. Meanwhile, a well-functioning public entity such as WAPDA had become a loss-making enterprise. Finally, the loss of fiscal and monetary discipline in the Bhutto years had the consequence of triggering strong inflationary pressure—consumer prices doubled between 1972 and 1976—that wiped out a good part of the gains accruing to labor through increases in nominal wages.
GDP growth in the Bhutto period, though a respectable 4.9 percent per annum, suffered as a result of several natural disasters, including floods and drought. The substantial additional availability of irrigation water from Tarbela dam was delayed by two years due to technical problems, which proved to be a lucky break for Bhutto’s successor, General Zia-ul-Haq.
Compared to other Pakistani rulers, Zia-ul-Haq took relatively little interest in the economy, partly because it performed quite well through most of his period as a result of a number of exogenous factors. Agricultural growth recovered to nearly 4 percent per annum during 1977–88 from a dismal 2 percent during 1972–77. A good deal of this was not related to price policies but rather to the huge addition to water supplies from Tarbela and private tube-wells, and to the breakthrough in cotton productivity in the mid-1980s. The fivefold jump in workers’ remittances between 1976/77 and 1982/83 to a peak of nearly USD 3 billion or 10 percent of GDP was another strong boost to economic activity. At the same time, external assistance for the Afghan Mujahedin, estimated to be USD 5–7 billion in the first half of the 1980s and channeled through Pakistan also helped the economy.
Lulled by high economic growth and a comfortable foreign exchange position, Zia-ul-Haq’s regime, with Ghulam Ishaq Khan as finance minister, made economic decisions and policy choices that were to have serious long-term consequences. First, the defense budget, which had already expanded significantly under Bhutto, increased by more than two-and-a-half times in real terms or at an average rate of 9 percent per annum. The result was a sharp rise in public expenditure and sizable fiscal deficits since there was only a marginal improvement in the tax-to-GDP ratio. At the same time, development outlays were squeezed, rising only 3 percent per annum over 1977–88 in real terms: by 1987/88, defense spending had overtaken development spending.
The shift in priorities and the way in which budget deficits were financed had two results. They led to a slowing down in investment and a sharp rise in public debt. The rise in national savings as a result of the large inflow of remittances made it possible to finance the large deficits, mainly through nonbank borrowing, especially as government savings schemes offered highly favorable tax-free interest rates. This kept inflation low but the large pre-emption of savings by the public sector crowded out the private sector and dampened private investment.
Combined with stalled public development expenditures, this resulted in an essentially stagnant investment-to-GDP ratio that had negative consequences for long-run growth. Although economic policies became more market-friendly, Zia-ul-Haq did not do much to reverse the nationalization of the Bhutto period. Ghulam Ishaq Khan had an instinctive distrust of the private sector, and the bureaucracy had quickly come to appreciate the power and privilege that an extended public sector afforded.
Finally, two important structural problems—the high population growth rate and the serious lag in education—were neglected. Additionally, the two policy problems inherited from the 1960s and 1970s—the inelasticity of the tax system and the strong anti-export bias of trade policy—actually worsened because of increasing reliance on foreign trade taxation.
The succession of weak political governments that followed found it difficult to deal with the worsening macroeconomic balances and buildup of debt. There were, however, major efforts, starting with the first Nawaz Sharif government in the early 1990s, to liberalize the economy, expand the role of the private sector, and redress the imbalances in the social services. Investment controls on both domestic and foreign investors were greatly relaxed; the foreign exchange regime was substantially liberalized; high tariffs began to be dismantled; the economy’s heavy reliance on foreign trade taxation was reduced; private sector involvement in infrastructure, especially energy, was encouraged; and the prices of agricultural outputs and inputs were aligned more closely with international prices. At the same time, interest rates were considerably liberalized and credit subsidies reduced. A start was made to privatize public sector assets, not only in industry but also in banking, telecommunications, and energy.
Privatization efforts and the shift toward the private sector were influenced largely by pragmatic considerations. The losses of public sector enterprises hastened the decision to divest industrial assets. The policy decision to involve the private sector in energy and infrastructure development reflected the realization going back to 1987 that public sector funds had become had become a major constraint to development.
However, for a number of reasons, the reforms did not succeed in avoiding an economic slowdown and an external debt crisis by the end of the 1990s. The biggest factor was the failure to reduce macroeconomic imbalances: sizeable deficits financed by credit creation led to a large spurt in inflation and a loss of competitiveness as exchange rate adjustment lagged. The attraction of large foreign currency deposits with a large implicit interest rate subsidy sustained consumption and imports at a high level, but sowed the seeds of a future foreign exchange crisis.
The effectiveness of public sector resource use also deteriorated; the well-intentioned Social Action Program to expand and improve primary education, basic healthcare, family planning, and rural water supply and sanitation did not deliver because of leakages, such as the phenomenon of “ghost schools” and “phantom teachers”. Finally, growing abuses in the largely public sector-controlled financial system led to the siphoning off of valuable resources. The result was that per capita GDP growth slowed down to 1 percent per annum in the 1990s compared to the average of over 3 percent per annum during 1960–90 and the rate of investment declined significantly.
Overall, the Musharraf era delivered high growth for a number of years (2002–07), partly as a result of good management and partly as a result of good luck (see Hasan, 2011). For a few shining years, a new economic dawn even appeared possible, but the return of old-style politics after the 2002 elections and the increasing compromises made by Musharraf in order to stay in power led to policy mistakes. When adverse exogenous shocks struck—the 2005 earthquake and the sharp rise in international oil prices during 2005–08—the government in its hubris ignored the need for adjustments, hoping to ride the tide on the mistaken assumption of wide public approval. As a result, the need to deepen structural reforms was put on the backburner, and thus, in terms of fundamentals, Pakistan’s economy in 2008 found itself in not much better shape than it was at the end of the 1990s. However, credit must be given to Musharraf for giving greater voice to women, local bodies, and the media, initiatives that in the long run benefitted governance considerably.
3. Lessons from Experience
3.1. Positive Policy Actions
This brief economic history narrative throws up several points. Political leaders, both civil and military, have had a major impact on the course of economic and social development. On the positive side, the emphasis on infrastructure development in the early years; the rapid development of the textiles industry in the mid-1950s, initially under heavy protection; the sharp acceleration of growth in the Ayub era through an unmatched rise in investment—especially in the water and power sectors—through large foreign aid inflows and effective planning and policy coordination; Nawaz Sharif’s major initiatives for economic liberalization in the early 1990s; and Musharraf’s strong push for both stabilization and growth in the first half of his rule were important elements in whatever economic success Pakistan has achieved. The 1950s and the 1960s were also periods of institution building, including the establishment of public enterprises that worked.
3.2. Early Policy Mistakes
Notwithstanding the positive side, there is a long list of policy mistakes made and opportunities missed over several decades, which is vital to understanding why Pakistan has been unable to achieve a sustainable high rate of growth. The decision in September 1949 not to follow the devaluation of the pound sterling and Indian rupee, in the final analysis on the ground that it would make Pakistan look good in relation to India, was costly because it led to a trade deadlock with India and eventually a sharp reduction in trade with the big neighbor—though it yielded some benefits in import substitution, such as in fruit production.
Next, a huge foreign exchange windfall—worth several billion dollars in today’s prices—from the Korean War boom that increased the prices of jute and cotton, was frittered away in 18 months in the totally unsustainable liberalization of imports under an overvalued exchange rate regime. The fact that imported cloth became cheaper than in India for a while was a source of great pride for citizens as well as populist politicians. Meanwhile, the emerging elite, both civil and military, indulged in large imports of luxury automobiles with low import duties at an overvalued exchange rate.
These early policy mistakes clearly point to the two fundamental drivers of policy that have continued to shape economic development in Pakistan for most of its history: tension and competition with India, and the real or perceived need to maintain a high level of defense spending.
Because relations with India deteriorated early after independence, especially on the issue of Kashmir, a strong defense capability was a top priority, even under successive civilian governments in the early years. It is to Ayub Khan’s credit that he gave very high priority in the early years of his rule to economic development by containing military spending, partly because military assistance obviated the need to spend money on arms and equipment. However, hubris and the miscalculation that resulted in the 1965 war with India led to a sharp increase in military spending as US military assistance disappeared. After a military defeat and the separation of East Pakistan, real defense expenditures were increased under Bhutto and rose sharply under Zia-ul-Haq. With the debt hangover, real defense expenditures did not increase in the 1990s but neither did other public spending.
High spending on defense has been a constraining factor on social and economic development almost throughout Pakistan’s history. The problem has been compounded by the fact that, after the mid-1980s, government revenue expenditures in most years have not covered current expenditures, including defense, necessitating government borrowing to finance nondevelopment expenditures. Another way of putting it would be that governments have desired strong defense but not been able to raise the commensurate tax revenues.
Several other factors and policies that have also affected economic outcomes adversely are: (i) high population growth; (ii) the neglect of education; (iii) the persistent failure to exploit tremendous opportunities offered by rapidly growing international trade in manufactured goods; (iv) a low savings rate and the inability to translate large foreign aid inflows into a high, sustainable level of investment and growth; and (v) an almost steady decline in governance over the decades, which is now reflected in serious institutional decline, the weakening of public services, and slow reduction in poverty incidence.
3.3. High Rate of Population Growth
Pakistan’s population is six times what it was at independence in 1947, having increased from 30 million to 180 million in 60 years. Its high average population growth rate of 2.8 percent per annum has seriously affected the level and sustainability of growth in per capita income. At the same time, high population growth has contributed to an abysmal record in social and human development and to persistently high levels of poverty despite an agricultural sector that has performed reasonably well for long periods.
Of course, low level of tax revenues, high levels of spending on defense, and poor governance of the large public education sector are also responsible for the low level of human development in Pakistan. But if the annual population growth rate had been only half a percent lower over Pakistan’s history, its population would be more than 25 percent smaller than it is today. The political, economic, and social landscape might then have been vastly different, and the divisions in society not as deep as they are now.
The population control policies of the 1960s and 1970s did not succeed because of the excessive focus on provision of contraceptives. During Zia-ul-Haq’s rule, the policy on limiting family size was, at best, ambivalent. This was in sharp contrast to the effective policy success in Bangladesh, which focused on reducing desired family size through women’s education, employment, and social mobilization.
3.4. Neglect of Education
The makings of a disaster in education have been a slow process. Progress in education was reasonable during 1950–65. High targets for universal education were set from the beginning, but then there were three major setbacks. First, as noted earlier, after the 1965 war with India, the sharp increase in defense spending, reduction in foreign aid inflows, and the urgent need to increase food grain production dealt a blow to the allocations for the social sectors.
Second, Bhutto’s nationalization of educational institutions in 1972 had continually weakened the effectiveness of public sector education expenditures and educational institutions. Third, the allocations for education remained low during the Zia period despite the iqra tax. More attention has been given to the social sectors, including education, during the last two decades, but the results have been mixed because of poor governance and the reemergence of serious financial constraints.
Less than 60 percent of Pakistan’s adults are literate. The situation is worse for women with less than 40 percent of adult females literate. Despite rapid progress in increasing primary enrolment across regions and gender, only three out of five children aged 5–9 years are enrolled in primary school, and only two thirds of those who enroll actually complete Grade 5. Currently, public educational expenditures are only 2 percent of GDP. In almost all these respects, Pakistan compares unfavorably with India and Bangladesh.
3.5. Missed Export Opportunities
An important feature of Pakistan’s history is that it has continued to fall behind other developing countries in export development and has not exploited the tremendous opportunities for exports offered by international developments. Stimulated by growth in world income, the liberalization of trade, reduction of tariffs, and technological changes reducing transport costs and improving information flows, world trade has grown at a much faster pace than world output since the 1960s.
The leading edge of this expansion was the growth in world exports of manufactured goods, which increased steadily from less than USD 200 billion in 1970 to a peak of USD 11.5 trillion in 2011, showing an average annual growth of 10 percent. While the nature of international trade in manufactures has changed quite significantly from finished goods to intermediate products or components, the growth trend was sustained till 2008. There was a fairly sharp decline in 2009 due to the deep international recession, but growth recovered quickly in 2010, and had exceeded the earlier peak by 2011.
The biggest economic story of recent times is the rise of China in large part due to its spectacular success in expanding exports. Chinese manufactured exports have risen nearly two-hundred-fold over the last three decades, and their share in world trade has grown from less than 1 percent to 15 percent over 1980–2010. Other major developing countries have also increased their share in world manufactured exports from 7 percent to 22 percent over the period. In contrast, Pakistan’s share has improved only marginally from 0.12 percent to 0.16 percent, and is now probably lower than it was in 1970 (Hasan, 2011).
In 1980, Pakistan was still substantially ahead of Turkey and Indonesia in the level of its manufactured exports and had about a quarter of Indian exports, though it had already fallen behind Malaysia, the Philippines, and Mexico in the 1970s. Thirty years later, Pakistan's manufactured exports are less than 30 percent of Indonesia’s, and only 18 percent of Turkey’s. India’s exports are now eight to nine times larger, while Vietnam, a newcomer to the field, has manufactured exports three times those of Pakistan (Institute of Public Policy, 2012, chap. 2).
Table 2.1, which provides a country comparison on the basis of the total export of goods and services, presents clear evidence of how far Pakistan has fallen in orienting its economy toward exports, which have been virtually the engine of global growth. China and most other East Asian countries are in a class by themselves, but even traditionally inward-looking economies such as India, Turkey, and Bangladesh have increased their export orientation remarkably in the last 30 years. In 1980, India had an export-to-GDP ratio (6 percent) half that of Pakistan (12 percent); now its ratio at 23 percent far exceeds that of Pakistan. Even Bangladesh has moved ahead in this respect.
Table 2.1: Export of goods and services as a percentage of GDP
Source: World Bank.
Why has Pakistan fallen so far behind in the export field? (See Institute of Public Policy, 2008, chap. 9). There are several reasons for this that are rooted in past policies and attitudes toward exports. First, export growth was never a central pillar of development strategy a la Korea, Malaysia, and China. Second, exports were not as profitable as sales in the domestic markets, which were heavily protected for a long period. The anti-export bias in policy was reinforced by an industrial strategy that favored manufacturing based on processing domestic raw materials. Export development based on imported inputs was strongly discriminated against by generally high import duties. Finally, the spurts of export growth that materialized in the 1960s and 1980s were, to a large extent, supported artificially by indirect subsidies to the textiles sector, which kept the domestic price of cotton well below the international price and thus encouraged relatively low value-added textile exports, notably cotton yarn.
Over time, many of the distortions in trade policy acting against exports were removed or reduced. The export taxation of cotton was phased out at the end of the 1980s. Import tariffs were gradually reduced and imports greatly liberalized in the 1990s.
Why then, has the liberalization of trade in Pakistan, which went further than countries like India, not resulted in major gains in exports? One explanation is that Pakistan’s real exchange rate was periodically overvalued, for example, after the mid-1990s and again after 2004/05. Moreover, some of the consequences of past policies, including the neglect of human capital development, insufficient investment in infrastructure, and excessive attention to textiles remain with us, and are reflected not only in the relatively low level of our manufactured exports but also in the structure of these exports.
Among large developing countries, Pakistan has the least diversified pattern of manufactured exports with the exception of Bangladesh. Nearly 75 percent of Pakistan’s manufactured exports consist of textiles and clothing compared with less than 12 percent for developing countries as a group and 6.5 percent for the world as a whole. While Pakistan is a major exporter of textiles and clothing—accounting for nearly 2 percent of world exports—its exports of manufactured exports other than textiles and clothing are small. At USD 4.5 billion in 2011, they were only 0.04 percent of world exports of manufactured goods. In comparison, Vietnam, a relatively new exporter, had other manufactured goods exports ten times that of Pakistan in 2011.
3.6. Savings, Investment, and Foreign Aid
Pakistan has received enormous amounts of foreign aid over the last half-century or so. Both in per capita terms in constant dollars and as a percentage of gross national income (GNI), net official development assistance (ODA) peaked in the 1960s but declined as repayments on all fronts except grant aid naturally continued to climb. Even so, net ODA in the last decade was 1.7 percent of GDP—close to 10 percent of gross fixed investment.
As Table 2.2 shows, the availability of foreign aid in relation to national income in Pakistan compared to that in India was fourfold in the 1980s; during the last decade, the difference has grown more than eightfold. The more important point is that aid flows are no longer significant for India for sustaining its fairly high rate of investment and growth, whereas Pakistan’s growth and investment are in the doldrums and the country is far from reviving sustained high growth on its own.
Table 2.2: Net official assistance to Pakistan and India
Source: World Bank.
It would be difficult to argue that foreign aid in Pakistan was used particularly ineffectively compared to most other developing countries. Indeed, the large early aid inflows financed an extraordinary level of investment in the water and power sectors in the 1960s and 1970s, partly for Indus Basin works under the water treaty with India that was facilitated by the World Bank. These large investments helped sustain the high agricultural growth of 4 percent per annum over 1960–2000.
The more serious problem was that large external flows—foreign aid in the 1960s and 1970s, workers’ remittances in the 1980s, resident foreign currency deposits in the 1990s, and direct private investment in 2003–08—reduced incentives for export development on one hand, and on the other, allowed policymakers to avoid difficult choices between consumption and savings. Judging from the long-term trends in gross capital formation (Table 2.3), and the foreign savings available to finance the current account balance of payments deficits, it would appear that gross national savings, which averaged 14–15 percent of GDP in the 1980s and the first half of the 1990s, have shown no clear upward trend. After a brief growth spurt to over 20 percent of GDP during 2002–4, gross national savings have dropped almost steadily since and touched a low level of 13 percent of GDP in FY2012 (see Institute of Public Policy, 2012; Hasan, 1998).
Table 2.3: Gross fixed capital formation as a percentage of GDP 
Source: World Bank.
Apart from the relative ease with which external resources were available, other factors also help explain Pakistan’s dismal savings performance. The political leadership has rarely emphasized the importance of sacrifice and savings for long-term development. Indeed, the governing elite have often set high standards of conspicuous consumption. At a more basic level, the low measured savings rate reflects low confidence in the future. Indeed, real savings are understated because of considerable capital flight. The high savings rate during 2002–04 partly reflected returning capital because political stability seemed to be assured and the investment climate had improved considerably.
In addition, for long periods, the high population growth rate meant that Pakistan had a dependency ratio (the ratio of dependent children to the working-age population) of 0.9, compared to 0.7 in India and 0.5 in China (Hasan, 1998, p. 36). Finally, for most years since the mid-1980s, general government savings have been significantly negative—in many years, as high as 3 percent of GDP—as stagnant or slowly growing tax revenues have not been able to cover government current expenditures in most years.
The low ‘available’ savings are reflected in the persistently low level of gross fixed capital formation. As mentioned earlier, after a recovery during 2005–08 from the low level reached in 2000, fixed investment as a percentage of GDP has, again, fallen to a very low level.
3.7. Deteriorating Governance, Institutional Decline, and Weakened Public Services
Looking at Pakistan’s history over the last half-century, governance failures stand out even more than growth disappointments. Indeed, poor governance has been even more of a problem than poor policy choices. Had governance not deteriorated so much and the strength of public institutions not eroded over time, the resources mobilized through taxation would have been more adequate and the quality of public services—especially law and order and education—would not have declined so precipitously. Poor governance hurts the poor and low-income groups especially as they depend more heavily on public services.
Over time, growth and governance problems became increasingly intertwined. Because growth benefits were not widely shared, the quality of public services, especially education, deteriorated; the pace of poverty reduction slowed down; and the tensions in society began to erupt with increasing frequency in ethnic, sectarian, and random violence. Now, the extremely uncertain security situation has become a major constraint to investment and growth, second only to power shortages. The biggest threat to the country and the economy comes from the militants and jihadists who would like to impose their narrow version of Islam. Only belatedly is there a realization that the Pakistani Taliban pose an existential threat to the country as a modern, moderate, and progressive state (Amir, 2012).
Unfortunately, the religious extremists draw some tacit support from sections of society that rightly perceive widespread corruption, growing income inequalities, and lack of any meaningful accountability of the political leadership as the very antithesis of Islam. These quiet sympathizers do not see, however, the dangers of an extremist, theocratic, authoritarian rule.
The greatest sources of public dissatisfaction are high-level corruption and a governance style that does not give regard to merit and integrity in key appointments. The 2011 Transparency International corruptions perception index puts Pakistan’s score at 2.5—on a scale of 0 (worst) to 10 (best)—and 137th out of 182 countries. Pakistan’s score is well below India’s (3.1), lower than Bangladesh’s (2.7), and very close to that of Nigeria (2.4).
Why did governance, which was relatively good till the end of the 1960s, decline so sharply over time? In the early years, the sanctity of public expenditure was observed and there was not the cavalier attitude toward the use of public funds. High-level corruption was relatively rare. It seemed that the politicians who grew up under the British Raj and were either lawyers or feudal landlords did not focus on accumulating fortunes. Relatively new public entities such as WAPDA and PIDC had strong leadership and were fairly effective because they had more operational freedom, including the ability to adjust prices. Later governments were either populist or weak and unsure, and tended to postpone difficult decisions for the sake of short-term gain.
Arguably, extra-judicial interventions, first by Ghulam Mohammad as Governor General in 1951 and later by military regimes, and disregard for the Constitution—facilitated by either a pliant or weak higher judiciary—were the root cause of the problem. It needs to be noted, however, that in some respects Pakistan’s military regimes were less arbitrary than some democratically elected leaders, starting with Z. A. Bhutto. The democratic governments of Benazir Bhutto and Nawaz Sharif that followed the end of Zia-ul-Haq’s rule in 1988 did not play by democratic norms and often proceeded to persecute opposition leaders. For instance, the well-conceived establishment of a high-level public accountability bureau was undermined by its use as a political tool. Meanwhile, the core competency and authority of the bureaucracy—central to effective administration and the delivery of public services—declined steadily because of falling real compensation and frequent political interventions in violation of rules and regulations.
The early Musharraf years saw a significant improvement in economic management with greater reliance on technocrats and greater stress on merit in recruitment and promotion. Ultimately, however, political compromises after the 2002 elections limited progress on some fundamental issues such as improving tax administration and reforming the civil services.
The last five years represent somewhat of a paradox. On one hand, governance has declined further, corruption has risen, and effective decision-making has suffered because merit has not been the key criterion for senior appointments. Militancy and terrorism have increased and the authorities have dragged their feet on holding high-ranking public servants accountable for abuse of power. On the other hand, the higher judiciary, especially the very independent-minded Supreme Court, has become highly proactive in governance issues and the free media, especially the electronic media, has come to play an important role in highlighting public policy issues and exposing wrongdoings.
Furthermore, there are basic constitutional changes that augur well for the future of democracy in a meaningful federal setting. The 18th Amendment to the Constitution, passed in April 2010, restored in letter and spirit parliamentary democracy and the relationship between the federation and the provinces as envisaged in the 1973 Constitution. This amendment does more than repeal the 17th Amendment introduced by Zia-ul-Haq, which gave enormous authority to the President. It transfers major economic powers to the provinces by abolishing the concurrent list in the 1973 Constitution.
The amendment also lays down procedures for nominating judges for the higher judiciary, makes the office of chief election commissioner autonomous of both the executive and the Parliament, and prescribes a procedure for appointing the head of the Accountability Bureau. Through the subsequent 19th and 20th amendments, procedures for appointments to the high courts and Supreme Court are clarified and arrangements for caretaker governments to oversee elections laid out with the final authority on the caretaker Prime Minister being given to the chief election commissioner in case the outgoing Prime Minister and leader of the opposition are unable to agree on a nominee.
The substantial devolution of power to the provinces is underpinned by the 2009 National Finance Commission (NFC) award, which substantially increased the share of the provinces, and within the provincial allocation, the share of the two poorer provinces, Balochistan and Khyber Pakhtunkhwa. However, it has been rightly pointed out that, ideally, the transfer of additional resources to the provinces under the award should have followed the transfer of increased executive responsibilities to avoid wrangling over additional resource transfers and a significantly weakened federal revenue position.
The impact of significant new structural changes will depend on, among other things, how effectively the provinces improve the efficiency of expenditure and mobilize additional taxation to meet their greatly enhanced responsibilities in the social sectors. One key question is whether the provinces will take steps in turn to devolve greater authority to the local level as broadly envisaged by the Musharraf government (see the discussion below). The results of the next election will also be important in indicating whether the hold of traditional parties remains strong or whether new leadership can emerge.
3.8. Translating Lessons into Future Actions
The above discussion clearly suggests that, first and foremost, good governance in the broadest sense and realistic national agendas focused on equitable economic development are critical to “moving Pakistan’s economy forward”. What Pakistan needs is an enlightened leadership that can take a long-term view, inspire national confidence and cohesion, and that does not concern itself unduly with perpetuating its own rule. Although this cannot be ordained, a democratic set-up with decentralized authority, guarantees of open and fair elections at all levels, and strong deterrents against abuse of power and law-breaking applied to all citizens is a prerequisite.
Specifically, governance will not improve significantly unless three conditions are met: (i) a firewall is established between the executive authority and accountability mechanisms—it would be fair to say that Pakistan has one of the worst records in punishing wrongdoers, whether politicians, bureaucrats, businesspersons, or military leaders; (ii) a deliberate effort is made to reform the civil service and restore the independence of public institutions through autonomy, proper selection of top management and professional staff, and adequate pay; and (iii) effective steps are taken to decentralize authority to the local government level.
Hopefully, both politicians and the military will have learnt their lesson, given their less-than-glorious record, and collaborate rather than confront each other in efforts to move Pakistan toward a better future. They need to remember that no leader after Jinnah in Pakistan’s 65-year history has become a national icon—something of a shame and of course a considerable cost to the country.
Among the specific steps mentioned above to strengthen governance, decentralizing governance to the local level deserves special mention. In an important study on decentralization, Cheema, Khwaja, and Qadir (cited in Institute of Public Policy, 2010) make two important points. First, historically, military governments seeking political legitimacy have undertaken decentralization to local governments while centralizing political power in their own hands. Second, the bureaucracy has also sought to exercise control through local governments.
Under Musharraff, however, a genuine, albeit highly ambitious, devolution plan was introduced in 2000 (see Institute of Public Policy, 2010, chap. 8, for details). The lynchpin of the plan was to create the elected office of district nazim (mayor) invested with substantial authority and responsibility for economic and social development functions. It is not clear, however, whether the local government system devised by Musharraf will survive.
The provincial government in general and members of the national and provincial assemblies in particular regard elected local district heads as competitors for influence in their respective domains. The Sindh government seems particularly opposed to the transfer of much authority to elected local representatives; under pressure from the Muttahida Qaumi Movement, it has now proposed a hybrid system of local government in which only major urban centers will have decentralized authority.
The danger of elite capture and further increase in corruption are often cited as arguments against devolving too much authority to local governments. These dangers are real but can be mitigated by instituting the office of independent provincial prosecutors in all districts, accountable only to the federal or provincial ombudsman, depending on the nature of crimes being investigated. On the positive side, healthy competition among districts might improve performance as nazims attempt to burnish their reputations and showcase their administrative skills.
Without devolution, much needed improvements in public service delivery, especially education, will not take place. While public expenditure on education at 2 percent of GDP is woefully inadequate, political promises to treble or quadruple this level are unrealistic because of the financial constraint the country faces. The fact is that public schools are steadily losing ground to private schools even in the rural areas where private schools do not charge very high fees. The quality of public sector education remains a critical concern—there are too many stories about ghost schools and phantom teachers that require structural solutions such as the transfer of authority to local bodies, public-private partnerships, and even school vouchers that can be used in private schools.
The public sector can and should play leadership and catalytic roles. Shahbaz Sharif’s initiative and idea for Danish schools is an excellent one, but why should Danish schools be restricted to the public sector that is so short of funds? Civil society in the districts could be encouraged through promotion, land grants, and selective subsidies to establish such schools countrywide on a scale and at a speed that is not likely to be possible otherwise.
4. The Need for a National Economic Strategy
Along with an agreed governance agenda, the major political parties need to seek a broad consensus on key elements of a long-term economic strategy, for instance, on the lines of the Charter of Democracy, which led to many constitutional changes aimed at strengthening democracy. The Framework of Growth formulated by the Planning Commission last year already stresses a number of important points, the need for urban development, public transport, and strengthening of internal markets. It is, thus, an important start, but there remains a need for a comprehensive national strategy for an accelerated economic and social advance that recognizes squarely the faults and shortcomings of the past and attempts to develop a national consensus on at least six broad areas:
- Better political and economic relations with India, especially the opening of trade, travel, and investment.
- A better balance between defense and development.
- Recognition of the major role that the private sector has to play in economic development—not a private sector that actively seeks economic rents and government patronage, but one that is open to fair completion from both inside and outside.
- A strong revival of investment in both human and physical capital.
- Strong export orientation with emphasis on technological changes, productivity improvements, and diversification.
- Greater attention to population control.
Many of these subjects are discussed in other chapters in this book, and so this chapter is confined to only a few points where policies need either more thrust or better definition.
4.1. Population
As discussed earlier, population pressures have hampered growth in incomes and employment. Population control issues deserve more attention than they are receiving. Fortunately, the population transition has begun: the growth rate of population has come down to 1.8 percent per annum. However, the fertility rate is still high—3.6 compared to Bangladesh (2.4) and India (2.6)—and so is the desired family size. This accounts for the much lower growth rate of population in these two countries than in Pakistan.
In terms of policy action, the focus should be on the high fertility rate of 4.5 in rural areas through the continued acceleration of women’s education, employment opportunities for women, and availability of family planning services. In general, and especially in rural areas, continued policy efforts to encourage a reduction in birth rates will help increase savings, reduce poverty, and make it easier to improve social indicators.
4.2. Exports
Another area in which Pakistan’s policymakers need to make a resolute commitment and a big push—beyond the crippling energy crisis—is increasing the economy’s export orientation. As discussed earlier and as Table 2.1 illustrates, Pakistan did not make much use of the opportunities offered by the almost explosive growth in global trade, especially in manufactured goods, and fell far behind other major developing countries. However, it is not too late to change course and focus.
Some will argue that the boom in world exports is over and, in any case, that Pakistan now has a very steep hill to climb in terms of competitiveness. However, the pessimism about further globalization is not justified. International comparative advantage will continue to shift. Like Japan earlier, the share of many East Asian countries in labor-intensive manufactured goods has been declining. Recently, the rate of exports from China has also slowed down, reflecting cost pressures emanating from higher wages. Pakistan has the further advantage that its share in manufactured goods other than textiles and clothing is miniscule. So, even with international trade slowing down somewhat, Pakistan can hope to gain a market share provided it follows policies that strengthen competitiveness, diversify the product mix, and move up the value chain.
In the foreseeable future, Pakistan cannot catch up with its competitors in the rate of capital formation. It must rely on sharper gains in factor productivity to move onto a higher growth path. Rapidly rising exports can be an important instrument for improving productivity and keeping capital requirements for growth low.
Specific policy actions that should be taken to promote exports include:
- An exchange rate that fully reflects the differential between movements in Pakistani prices and the international price level.
- Strong incentives for new investments and skill upgrading in textiles that increase the scale of and update technology, and encourage mills with low productivity and profitability to exit the industry.
- A determined push aimed at small and medium industries to expand and diversify exports in areas outside textiles.
- Joint public and private sector efforts to promote foreign investment in textiles, clothing, and other promising export sectors from countries such as the Republic of Korea, Hong Kong, Malaysia, and Taiwan, which are losing ground in labor-intensive industries due to high and rising wage costs. The focus of these efforts should be to upgrade skills and technology and utilize established export channels.
- A special focus on expanding exports to regional partners, especially China and India, the two fastest growing economies in the world. The large negative trade balance with these countries could provide some leverage.
- A special and speedy implementation review of the free trade agreement and establishment of a free trade zone with China, and assessment of their likely impact on exports in the near term.
- A similar review of key constraints and principal opportunities for expanding trade with India.
- Focus on the development of export supply chains using the work being done in the context of the National Trade Corridor Improvement Project.
- Strengthening monitoring mechanisms, including quarterly meetings of the high-level Export Board.
- Implementing the recommendations of the Strategic Trade Policy Framework 2009–12 to reduce anti-export bias by withdrawing protection from inefficient industries, minimizing taxation at the investment stage, and eliminating or zero-rating customs duty on important inputs to textiles and clothing exports.
- Closer coordination of commerce ministry policies and activities not only with the textile ministry but all other production-related ministries, which appears to be sorely needed.
4.3. Investment
The control of fiscal deficits, which have averaged over 7 percent of GDP annually in recent years, should be a top priority; this will require improvements in tax revenues, sharp cutbacks in wasteful administrative expenditures, restraints in military purchases, and a solution for loss-making enterprises. This may appear to be a very tall order, but the fact is that there have significant slippages in these areas and resolute government action has been lacking. There has not been much attempt to introduce austerity in spending—public or private. Real private consumption in 2011/12 was 27 percent higher than in 2007/08, suggesting that there is certainly room for belt-tightening, especially because of substantial income inequalities. Strong governance and committed political leadership can help bring public finance problems under control.
In the somewhat longer run, resources need not be a major constraint to reviving growth and investment. Provided the security situation and governance improve, and economic relations with India expand, investors’ confidence—both domestic and foreign—in Pakistan will revive. Capital flight will slow down and, in time, be reversed. There is a large amount of Pakistani capital sitting on the other side hesitant to invest because of noneconomic factors.
Similarly, forei