Professional Documents
Culture Documents
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
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.
Special Edition2007
THE LAHORE JOURNAL OF ECONOMICS
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
follows:
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
revenues.
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
development.
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
finance.
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.
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)
Ishrat Husain*
Abstract
INTRODUCTION
*
Chairman, National Commission for Government Reform, and Former Governor, State
Bank of Pakistan.
2 Ishrat Husain
SECTION I
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.
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.
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
SECTION II
Civil Services
vii) Separate cadre of regular Civil Services at the Federal, Provincial and
District levels co-existing with contractual appointments.
ix) Introduction of four specialized cadres under the NES for Economic
Management, Regulatory, Social Sector Management and General
Management.
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.
SECTION III
Proposed Approach
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.
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.
3. Education
4. Health
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
Committee.
References
Amsden A, 1989, Asia’s Next Giant: South Korea and Late Industrialization
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.
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.
A. R. Kemal*
Abstract
*
Former Director Pakistan Institute of Development Economics (PIDE), Islamabad.
1
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.
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.
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)).
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
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
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
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
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
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.
2
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.
3
The enterprises had to use new technology to remain viable.
4
Such industries have grown at double the rate compared to the other industries.
Industrial Competitiveness of Pakistan (2000-10) 27
V. Conclusions
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.
References
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., 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
Ltd.
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,
Karachi.
Shamyla Chaudry*
Abstract
I. Introduction
*
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
competitiveness.
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
Table-I
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
better.
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.
Table-II
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
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
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.
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.
its medical instruments product categories, one of its most dynamic exports,
where Pakistan has been losing its world market share.
References
Aw, Bee Yan; Chung, Sukkyun and Roberts mark J., 2000, “Productivity and
Turnover in the Export Market: Micro-Level Evidence from the
Republic of Korea and Taiwan (China)”, The World Bank Economic
Review, Vol. 14, No. 1, pp. 65 – 90.
Oral, Muhittin and Ozkan Alev O., Apr., 1986, “An Empirical Study on
Measuring Industrial Competitiveness”, The Journal of the
Operational Research Society, Vol. 37, No. 4, pp. 345-356.
Shahid Kardar*
Abstract
Introduction
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 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
6
The State Bank continues to buy government paper and use primary auctions for
monetary management.
Monetary and Fiscal Policies 45
7
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.
8
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.
9
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
15.0
6
10.0
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
Figure 1: (right hand axis is for inflation and the left hand axis is for MSG
and DCG)
8
See Feldstein (1997), Goldstein (1995), and Mishkin (1997).
13
This section of the paper has benefited enormously from discussions with Dr. Nadeem-
ul-Haque.
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.
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
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
Fiscal Policy
14
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
7
percent
1
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
6
-9
-9
-9
-9
-9
-9
-9
-9
-9
-0
-0
-0
-0
-0
-0
-0
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
19
Figure 2:
15
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
16
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.
17
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.
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.
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.
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.
18
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.
19
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
10.9
11.0 10.8 10.8 10.8 10.8
10.7
10.6 10.6
10.5
10.0
10.0
9.5
9.0
7
6
-9
-9
-9
-0
-0
-0
-0
-0
-0
-0
96
97
98
99
00
01
02
03
04
05
19
19
19
19
20
20
20
20
20
20
Figure 3:
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.
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.
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
products/services.
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.
22
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.
23
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
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.
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.
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
Conclusions
24
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
Sources: IMF, December 2006 and State Bank Annual Report, 2005/06
25
20
15
10
-5
7
6
-9
-9
-9
-0
-0
-0
-0
-0
-0
-0
96
97
98
99
00
01
02
03
04
05
19
19
19
19
20
20
20
20
20
20
MSG DCG
64 Shahid Kardar
References
Feldstein, M, 1997. “The Cost and Benefits of Going from Low Inflation to
Price Stability,” National Bureau of Economic Research paper 5469.
Shakil Faruqi*
Abstract
*
Professor, The Lahore School of Economics, Lahore.
68 Shakil Faruqi
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.
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.
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.
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
system. The crowding out of the private sector has been mitigated, but only
in banking credit, not for resources at the macro financial level.
Consolidation or Fragmentation?
Concentration or Competition?
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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
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.
Looking Ahead
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.
References
Barth J, Litan R., Lessons from Bank Failures in the United States, in
Hunter Caprio and Leipziger (eds.), Preventing Bank Crises: Lessons
from Recent Global Failures, Federal Reserve Bank, Chicago,
EDI/World Bank Development Studies, pp 133-172.
Bydalek, P., Lessons from Recent Global Bank Failures: The Case of Brazil,
in Hunter Caprio and Leipziger (eds.), Preventing Bank Crises:
Lessons from Recent Global Failures, Federal Reserve Bank, Chicago,
EDI/World Bank Development Studies, pp 249-254.
Chang, Roberto and Andres’ Velasco: The Asian Liquidity Crisis Federal
Reserve Bank of Atlanta, Working Paper 98-11, July 1998.
Corbo, Vittorio, Jaime de Melo, and James Tybout, 1986, “What went
wrong with recent reforms in the Southern Cone,” Economic
Development and Cultural Change (April): 607-40.
94 Shakil Faruqi
Enoch, Charles, and Green, John (eds), 1997, Banking Soundness and
Monetary Policy Issues and Experiences in the Global Economy, IMF
Institute, Washington DC.
Faruqi, Shakil (ed), 1992, Financial Sector Reforms in Asian and LAC
Countries; Lessons of Comparative Experience, EDI/World Bank,
Seminar Series.
Faruqi, Shakil (ed), 1994, Financial Sector Reforms; Economic Growth and
Stability EDI/World Bank, Seminar Series.
The Post-Reform Era Maintaining Stability and Growth 95
Lin See Yan, The Institutional Perspective of Financial Market Reform, The
Malaysian Experience, in Hunter Caprio and Leipziger (eds.),
Preventing Bank Crises: Lessons from Recent Global Failures,
Federal Reserve Bank, Chicago, EDI/World Bank Development
Studies, pp 215-248.
Truman, Edwin, What Can and Should Be Done to Prevent Future Financial
Crises? in Hunter Caprio and Leipziger (eds.), Preventing Bank
Crises: Lessons from Recent Global Failures, Federal Reserve Bank,
Chicago, EDI/World Bank Development Studies,
Abstract
I. Introduction
*
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).
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
framework.
25
Such as, owners, borrowers, depositors, regulators and government.
26
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).
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
supervision.
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
27
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
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.
28
The early phase of financial reforms as a part of financial restructuring policies started
in the late 1980s to early 1990s.
29
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
30
The second phase of banking sector reforms started from 1997 to 2001.
108 Muhammad Arshad Khan and Sajawal Khan
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%
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
financing.
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.
31
CAMELSS indicate Capital, Assets, Management, Earnings, Liquidity, and Sensitivity
to Market Risk, Systems.
32
IRAF indicate Institutional Risk Assessment Framework.
Financial Sector Restructuring in Pakistan 111
33
Although in 2004 the rate fell to 7.28 %.
112 Muhammad Arshad Khan and Sajawal Khan
34
Interest Rate Spread = (Average Lending Rate – Average Deposit Rate).
35
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.
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.
36
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.
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
(M2)/GDP
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
Credit/GDP
Stock market 8.42 4.08 3.75 4.68 10.24 8.15 9.26 15.48 24.05 30.95
capitalization/
GDP
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.
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
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.
37
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%.
38
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
V. Conclusions
• Macroeconomic stability,
• A greater degree of consolidation should be necessary for strong and
robust banking,
• Prudent regulatory and supervisory framework,
• Maturity and reorientation of financial industry,
• A well diversified and competitive financial system is still needed,
• Strong corporate governance, effective risk management system and
mitigation, and
122 Muhammad Arshad Khan and Sajawal Khan
References
Akhtar, S., 2007, “Pakistan Banking Sector- The Need for Second Tier of
Reforms”, Bank of International Settlement Review, Vol. 5, pp. 1-6.
Alawode, A.A. and S.I. Ikhide, 1977, “Why Should Financial Liberalization
Induce Financial Crisis?”, Saving and Development, Vol. XXI, No. 3.
Barth Richard, Alan R. Roe, and Chorng-Huey Wong (ed.), IMF Institute
(Washinton: International Monetary Fund).
Caprio Jr. G, and D. Klingebiel, 1996, “Bank Insolvency: Bad Luck, Bad
Policy or Bad Banking?” Annual Conference on Development
Economics, The World Bank.
Fazil, Muhammad Sharif Bin, 1995, “Need and Scope for Further Reforms in
the Financial Sector in Pakistan”, Journal of Islamic Banking and
Finance, Vol. 12, No.5.
Iqbal, Zubair (2001). “Macroeconomic Issues and Policies in the Middle East
and North Africa”, International Monetary Fund (ed).
Jhili, Abdelali, Klaus Ender and Volker Treichel, 1997, “Financial Sector
Reforms in Algeria, Morocca, and Tunisia: A Preliminary
Assessment”, IMF Working Paper No. 81 (Washington: International
Monetary Fund).
Khan, Ashfaq Hasan, 1995, “Need and Scope for Further Reforms in the
Financial Sector in Pakistan”, Journal of the Institute of Bankers in
Pakistan, June 1995.
Sheng, A., 1996, “Bank Restructuring: Lesson from the 1980s”, The World
Bank.
Ziobek, Claudia and Ceyla Pazarbasioglu, 1997, “Lesson from Systemic Bank
Restructuring: A Survey of 24 Countries”, IMF Working Paper No.
161, (Washington: International Monetary Fund).
M. Ashraf Janjua*
Abstract
I. Introduction
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
account.
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.
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.
50,000 70
60
40,000
50
Million US $
Rupees
30,000 40
20,000 30
20
10,000
10
0 0
79
81
83
85
87
89
91
93
95
97
99
01
03
05
t
07
FY
FY
FY
FY
FY
FY
FY
FY
FY
FY
FY
FY
FY
FY
FY
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
39
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
150 -3
130 -6
110 -9
90 -12
70 -15
50 -18
FY-78
FY-7 9
FY-8 0
FY-8 2
FY-86
FY-88
FY-89
FY-90
FY-91
FY-92
FY-93
FY-94
FY-95
FY-96
FY-97
FY-9 8
FY-0 0
FY-05
FY-81
FY-83
FY-84
FY-85
FY-87
FY-99
FY-01
FY-02
FY-03
FY-04
40
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
140.00
120.00
100.00
80.00
60.00
40.00
20.00
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
RS/yen RS/PSt
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.
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.
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.
In Percent
12,000
10,000 -5
8,000
6,000 -10
4,000 -15
2,000
0 -20
FY 9
FY 1
83
FY 5
87
FY 9
91
FY 3
FY 5
97
FY 9
01
FY 3
FY 5
t
07
7
8
9
9
0
0
FY
FY
FY
FY
FY
FY
App/Dep Exports
only 13 countries including the USA, UK, Hong Kong, Germany, Dubai,
France, Japan, South Korea and Canada, etc.
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
Empirical Framework
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
below:
41
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
• The sign of rigdp would be negative as the rise in rigdp means higher
spending on tradables (imported machinery and raw materials).
• 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.
Results Interpretation
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.
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
R2 = 0.96
Adj R2 = 0.94
S.E Regression = 0.07
D.W Statistics= 1.60
200.0
185.0
170.0
155.0
140.0
125.0
110.0
95.0
80.0
FY78
FY79
FY80
FY81
FY82
FY83
FY84
FY85
FY86
FY87
FY88
FY89
FY90
FY91
FY92
FY93
FY94
FY95
FY96
FY97
FY98
FY99
FY00
FY01
FY02
FY03
FY04
FY05
FY06
FY07
FY08
FY09
FY10
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
25.0
20.0
15.0
10.0
5.0
0.0
-5.0
-10.0
-15.0
FY78
FY79
FY80
FY81
FY82
FY83
FY84
FY85
FY86
FY87
FY88
FY89
FY90
FY91
FY92
FY93
FY94
FY95
FY96
FY97
FY98
FY99
FY00
FY01
FY02
FY03
FY04
FY05
FY06
FY07
FY08
FY09
FY10
- Export industries
- 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.
- Diversification of exports.
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.
References
Arslaner, F. and G. Erlat, 1997, “Measuring Annual Real Exchange Rate
Series for Turkey”, Yapi Kredi Economic Review Vol. 8, No. 2, pp.
35-61.
Black, S., 1994, “On the Concept and Usefulness of the Equilibrium Rate of
Exchange”, in J. Williamson (ed.), Estimating Equilibrium Exchange
Rates, Institute for International Economics, Washington, DC.
Chinn, M., 1998, “Before the Fall: Were East Asian Currencies Overvalued?”
NBER Working Paper No. 6491.
Edwards, S., 1994, “Real and Monetary Determinants of Real Exchange Rate
Behavior: Theory and Evidence from Developing Countries”, in
Estimating Equilibrium Exchange Rates, ed. by J. Williamson,
Institute for International Economics, Washington, DC.
Appendix
Bilateral Misalignment
140.0
120.0
100.0
80.0
60.0
40.0
20.0
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Misalignment (in percent)
30.0
Depreciation
20.0
10.0
0.0
-10.0 Appreciation
-20.0
-30.0
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
152
20.0
30.0
40.0
50.0
60.0
70.0
80.0
90.0
100.0
110.0
-30.0
-20.0
-10.0
0.0
10.0
20.0
30.0
40.0
1978
1978 1979
1979 1980
Actual BRER
1980 1981
1981 1982
1982 1983
1983 1984
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
Appreciation
2001 2002
2002 2003
2003 2004
Depreciation
2004 2005
2005 2006
2006
The Lahore Journal of Economics
Special Edition (September 2007)
Abstract
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.
Introduction
Part I
1
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
2
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).
3
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).
4
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
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.
5
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
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) - - - - - -
É
All prices are in rupees per 40 kg.
Ø
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
8
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).
9
See, ‘A Survey of Agriculture’, The Economist, December 12, 1992.
162 Naheed Zia Khan
10
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
11
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
Part IV
15
The European Union, Japan and the United States account for over 85 percent of total
domestic support under the AMS [see, OECD 2002].
16
For a better insight into the plan, see “More fudge than breakthrough,” The Economist,
June 26th 2003.
17
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
18
See “The WTO under fire,” The Economist, September 18, 2003.
19
See http://www.business-standard.com, August 7, 2003.
168 Naheed Zia Khan
Conclusion
20
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.
21
See http://www.business-standard.com, August 7, 2003.
Implications for Economic Reforms in Pakistan and other Southern Countries 169
22
http://www.business-standard.com, August 7, 2003.
170 Naheed Zia Khan
References
Blaker M., 1999, “Japan Negotiates With the United States on Rice: “No,
No, A Thousand Times, No!”, in Berton P., H. Kimura and I. W.
ZartMan (ed.), International Negotiation, Macmillan, Hampshire.
FAO, 2000, Agriculture, Trade and Food Security, Vol. 1 and 2, Rome,
Food and Agricultural Organization, Rome, Italy.
Smith A., 1776, An Inquiry into the Nature and Causes of the Wealth of
Nations, by J. R. McCulloch, Published by the Grand Colosseum
Warehouse Co., Glasgow, U.K.
Abstract
I. Introduction
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
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
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.
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.
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.
Pakistan - SAFTA3
1
The Economic and Commercial Counselor’s office of the Embassy of People’s
Republic of China, Nov. 18, 2005.
2
ibid
3
Wikipedia
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.
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.
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
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
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.
4. 4.2
4
3. 3.
3
2.4
2.
2 1.
1.
1. 1.0 0.97 1.0
0.91
1
0.
0
199 199 199 200 200 200 200 200 200
4
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
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
exports.
188 Samina Shabir and Reema Kazmi
50000
40000
30000
20000
10000
0
-10000
1990-91 1992-93 1994-95 1996-97 1998-99 2000-01 2002-03 2004-05
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
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
5
Economic Survey of Pakistan 2005-06, Manufacturing, Mining and Investment Policies
(Ch: 3).
192 Samina Shabir and Reema Kazmi
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.
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.
Cellular 93.87
Motor 26.70%
Cars 20.80
Van 12.50%
Refrigirator 10.90%
TV 7.50
Source: PRSP II
Economic Effects of the Recently Signed Pak-China Free Trade Agreement 195
Food basket
Cigarettes
Locally manufactured inorganic and organic chemicals
Plastic products
Edible products e.g., Edible oils
Paper and paper board
Engineering goods
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.
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
Metal
521 Transport
Others, 76194
Equipmen
Communications (Motorcycles
Automobiles)
2228
15106
Construction
18900
V. Conclusion
References
Hong, H., 2004, “ASEAN and China Sign “Dirty” FTA”, Taipei Times, Dec. 18.
Kalegama, S., “Sri Lanka's Free Trade Agreement with Pakistan”, Economic
Watch.
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.
People’s Daily Online, “China Established Nine FTAs in Past Five Years”,
February 9 2006.
Mehak Ejaz∗
Abstract
I. Introduction
∗
The author is a Research Associate at the Centre for Research, Lahore School of
Economics, Lahore.
69
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
90.00
Percentage of Participation
80.00
70.00
60.00
50.00
40.00
30.00
20.00
10.00
0.00
73
76
79
82
85
88
91
94
97
00
03
06
19
19
19
19
19
19
19
19
19
20
20
20
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.
70
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
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
implications.
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
71
The literature entails cases both within and outside Pakistan.
206 Mehak Ejaz
72
Heckman, Killingsworth and Macurdy(1981).
73
Nakamura and Nakamura (1981)
Determinants of Female Labor Force Participation in Pakistan 207
74
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
force.
General equation
Υ i = f ( Χ 1 ....... Χ i )
* k
y i = β 0 + ∑ β j χ ij + ε i
j =1
yi = 1 if y i* > 0
=0 otherwise
75
Maddala (2001), Gujrati (1995)and Berndt (1991)
210 Mehak Ejaz
Data Source
1
Prob [female in work force] =
1 + e −z
Z = β0 + β1Χ1 + β2 Χ2 + .......... . + βk Χk
∂ log(oddsratio ) 77
= - βi 78
∂χ i
∂P B j e −z
=
∂X j [
1 + e −z ]
2
76
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
78
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
Independent variables
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%
79
Sayed Kalim Hayder (Senior Research Fellow) helped in the econometric results
Determinants of Female Labor Force Participation in Pakistan 213
*, **, *** presents significance at 1%, 5%, and 10% level respectively
214 Mehak Ejaz
*, **, *** presents significance at 1%, 5%, and 10% level respectively
Determinants of Female Labor Force Participation in Pakistan 215
V. Empirical Findings
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
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
80
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.
81
Female literacy rate: India 48.3%, Pakistan 35.2% and Bangladesh 31.8%. UNESCO
(2003-2004)
Determinants of Female Labor Force Participation in Pakistan 219
References
Bailey, Martha J., 2004, “More Power to the Pill: The Impact of
Contraceptive Freedom on Women’s Labor Supply,” Draft,
University of Michigan.
Bradbury, Katharine and Jane Katz, 2005, “Women’s Rise,” Federal Reserve
Bank of Boston Regional Review, Vol.14, No. 3:58-67.
Hotchkiss, Julie. L., Mary Melinda Pitts, 2005, Female labor force
intermittency and current earnings: Switching regression model with
unknown sample selection. Applied Economics, Vol. 37, No.5:545-60.
222 Mehak Ejaz
Keeley, Michael C., 1978, “The Estimation of Labor Supply Models Using
Experimental Data”, The American Economic Review, Vol.68, No.5
(December):873-887.Killingsworth, Mark R., 1983, “Labor Supply”.
New York: Cambridge University Press.
Nakamura, Alice and Masao Nakamura, 1983, “Part Time and Full Time
Work Behavior of Married Woman: A Model with a Doubly
Truncated Dependent Variable,” The Canadian Journal of
Economics, Vol.16, No.2:229-257.
Determinants of Female Labor Force Participation in Pakistan 223
Shah N.M., 1986, “Changes in Women Role in Pakistan: Are the Volume
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Appendix
Overall Pakistan
Table 2.1: Descriptive Statistics
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
225
226 Mehak Ejaz
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
227
228 Mehak Ejaz
RURAL
Table-4.1: Descriptive Statistics
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
229
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
Note.
PAKISTAN (logit)
Dependent variable: LFP
Urban (Probit)
Urban (logit)
Rural (probit)
Rural (logit)
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