Need For A New Growth Model for Pakistan Based On Domestic Capital Formation; Will It or Not?

Pakistan which was struggling hard for the post Covid-19 economic recovery is now witnessing additional challenges such as unprecedented depletion of foreign exchange reserves, a galloping inflation, a steep depreciation in the value of PKR, drying foreign investment and twin deficits leading to deep macro economic instability. The prospects of Pak economy has worsened further due to Russia-Ukraine war and expected ripple effects of failed US Banks, Silicon Valley Bank (SVB) and Credit Suisse.

As Pak debt dependent economic growth model has been discredited much by now, there is increasing clamor in the country for a growth model based on domestic capital formation and investment. But Pakistan has crippled its domestic capital formation and investment capability to a disappointingly low level. This has happened due to unrestricted siphoning up of development funds due mainly to rampant corruption, setting wrong priorities such as channelization of resources disproportionately to military and covertly to terror outfits through the ISI, besides poor economic management and senseless populism totally ignoring the budgetary constraints, especially the requirement for capital formation.

It is felt that the only hope for economic recovery of Pakistan lies in domestic capital formation when its development partners and foreign investors are shying away due to its worsening economic prospects and declining credit rating. Various global agencies have forecast the growth rate of Pakistan to trend around 2.30% in 2024 and 3.9% in 2025. Its credit rating is barely one notch up from what is called as non-investible grade, be it Moody’s, Fitch or S&P. Now with low growth and drying up foreign investment, Pakistan needs to increase gross domestic capital formation to realize its growth potential. But the previous and present government’s flawed policies and priorities have irreparably damaged its capacity for capital formation. Given its poor economic indicators, raising the rate of capital formation would require complete overhaul of its fiscal strategy.

Gross capital formation in Pakistan was appallingly low at 14.64% of GDP according to the World Bank in 2022. It is not the case of the country in crisis, in the last 10 years the rate of capital formation has remained below 17% reflecting Pakistan’s deliberate choice of debt and foreign investment dependent growth strategy. It never realized that debt could become unsustainable over a period of time and foreign investment it received was not due to its good investment climate and business environment, but strategic interests of the investing countries. Development expenditure in Pak budgets have been less than 45% of the total expenditure since long.

Its wrong priorities over a long period of time have led to increasing military expenditure and rising subsidy cost. Pakistan’s military spending/defense budget for 2021 was USD 11.30 billion marking an 8.76% increase from over USD 10 billion in 2020, which was 0.06% above that of 2019. In FY 2023 also defense expenditure increased. The defense expenditure in Pakistan has remained over 16% of the total budgetary expenditure. As a proption of GDP Pak military expenditure had remained in the range of 4-6% of the GDP while for most of the developing countries, this has been around 3% of GDP. Despite Islamabad’s claim that its military expenditure is less than what is believed, observers feel that there are many hidden components of expenditure in the budget for other departments which finally go to military.

In the budget 2021, Pakistan more than doubled and increased subsidies by 226% being in an illusion that its goals of macro-economic stabilization and fiscal consolidation have been realized. Today, the facts are loudly speaking what is the fiscal state of Islamabad. Total subsidies in Pakistan stood at PKR 682 billion in FY 2022 budget. These budgetary figures are always breached in Pakistan as it is clear from its actual expenditure of PKR 387.35 billion against a budgetary allocation of PKR 149.5 billion in FY 2021.

Pakistan spends disproportionately high on its security services including the Inter Service Intelligence (ISI) and non-state players which include fundamentalists and terrorists groups, the latter being funded covertly. When the economic crisis saturated in Pakistan in recent years, it was decided by Islamabad that discretionary grants and secret service funds of the ISI and Intelligence Bureau (IB) would be capped. But the plan remains opaque and many observers see it as a bluff to IMF for restoring the scuttled bailout package under its Extended Fund Facility (EFF). Although the budget for Pak security services is not known, it is estimated in the vicinity of PKR 850-1000 million. Much of it is believed to have come from the funds it received in its fight against terror from world powers including the US.

A Brooking article had pointed way back in 2018 that despite the Trump regime’s decision to suspend military aid to Pakistan and other coercion measures, it is most “unlikely to get Pakistan to fundamentally alter its behavior” towards using terror as a tool of foreign policy. The article stated that “Pakistan has long been a difficult and disruptive neigbour to Afghanistan, hoping to limit India’s influence there, and cultivate radical groups within Afghanistan as proxies – providing intelligence, weapons and protection to Afghan Taliban and Haqqani network.” An earlier report of Saban Center of Middle East Policy at the Brooking Institution in 2008 stated that Pakistan was reportedly, with the possible exception of Iran, perhaps the world’s most active sponsor of terrorist groups. Support provided by Pakistan to terrorist outfits is a leakage from its development budget.

A terrorist mindset, miliue and safe haven is never considered conducive for making a good business and investment environment. The Pak media is full of reports about kidnapping, killings, violation of human rights and sectarian and racial violence in the name of blasphemy. An economy which is shattered and has come on the brink of default could have improved business environment for attracting foreign investment instead of building military power and providing terror funding. Now, in the absence of foreign investment, the only source of capital formation accessible to Pakistan is surplus revenue of the federal and provincial governments over their expenditures. But deficit is a more of a routine for federal government of Pakistan than exception. In such a situation what is the way out?

It is high time that Pakistan moves on a different growth model primarily driven by domestic capital formation and investment. All the emerging and developing economies recording higher growth rates have higher rates of domestic capital formation and investment rates (above 30% of GDP) and good macro-economic management, especially the twin deficits and inflation. Pakistan has never truly tried these recipes because it has chosen to depend on foreign debt and investment. Now the water is flowing overhead. Raising capital formation in Pakistan would require pruning fiscal and trade deficits, military and security services expenditures and rationalization and cutting of subsidies apart from stopping channeling money to terror outfits, overtly or covertly. The key to self-reliant and sustainable growth lies in diversification and expansion of industrial and service sectors while reducing shortage of food items would require adopting a system of multiple cropping and diversification of agriculture. All these require a critical minimum rate of capital formation which Nurkse, a classical development economist described as the most important determinant of economic growth. So far Pakistan has been a poor learner from its past mistakes. Only the time would tell whether it is ready to change and give up its dangerous inertia taking a lesson from the crisis which led it almost to begging.

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