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Analysis of Pakistan’s macroeconomic situation and prospects: ADB Report
12-19-2008, 09:27 AM
Post: #1
Analysis of Pakistan’s macroeconomic situation and prospects: ADB Report
ADB warns of a balance of payment crisis

By Sajid Chaudhry

ISLAMABAD: Asian Development Bank (ADB) has warned that desperately defending the Pakistani rupee may lead to the depletion of international reserves, and the situation may worsen to a full-fledged balance of payment crisis.

The rupee is not overvalued and currency depreciation may aggravate inflation and lead to further loss in confidence, so there are reasons to try to moderate it, states "An Analysis of Pakistan's Macroeconomic Situation and Prospects" report released by ADB on Thursday.

Exchange rate: As mentioned earlier, monetary tightening may help contain the depreciation of the rupee, which is facing tremendous pressures as a result of the macroeconomic and political instability. The rupee is not overvalued. Currency depreciation may aggravate inflation and lead to further loss in confidence, so there are reasons to try to moderate it. The government has tried to do this by intervening in the foreign exchange market and increasing interest rates and reserve ratios and monetary tightening. However, the lessons of the Asian crisis a decade ago are such that desperately defending the currency may lead to the depletion of international reserves, and the situation may worsen leading to a full-fledged balance of payments crisis. Increasing interest rates and unduly reducing money and credit may deteriorate firms' balance sheets and lead to financial defaults and a financial crisis (as happened during the East Asian crisis of 1997-1998). In the current situation, the best way to tame pressures for currency depreciation is to lower political instability. Without a return of political confidence and certainty, using monetary tightening in excess may prove futile and ultimately damaging to the economy.

Maintaining a competitive exchange rate is fundamental for Pakistan and is a desirable target policy. Real exchange rate overvaluation is bad for growth, while undervaluation is good. Moreover, a competitive real exchange rate contributes to employment generation through a number of channels. The first is through its impact on the level of aggregate demand (the macroeconomic channel). The second is through its impact on the cost of labor relative to other goods and, thereby, affecting the amount of labor hired per unit of output (the labor intensity channel). The third one is through its impact on investment and growth (the development channel). In an economy characterised by vastly underutilised resources, there are growth-related externalities derived from a policy of maintaining a competitive exchange rate, as the higher demand for exports, as well as the increasing production of import-competitive goods, can spill over into demand for non-tradables as a result of higher income in sectors that produce tradables.

Subsidies: The new government needs to analyse the impact of the subsidy burden on the budget and decide what is crucial to guarantee a minimum living standard to the disadvantaged groups (this calls for well-designed targeted programmes); and what has to be passed on to consumers.

Budget deficit: Pakistan's fiscal deficit is the result of a low revenue-generating capacity, more than fiscal profligacy. Nevertheless, the government has to analyse the structure of spending, eliminate all superfluous categories (including subsidies) and projects with questionable benefits, and get rid of unprofitable state-owned enterprises. These measures will also help address the inflation problem. Likewise, the law should limit (through the Fiscal Responsibility and Debt Limitation Act 2005) the maximum amount that the government can borrow from the SBP.

It is important to note that budget deficits are not sins if they are well understood and adequately managed. More over, they need not always reflect loose fiscal stance, but may signal stagnation in a destabilised economy. Government expenditure and fiscal policy in general should be seen from the point of view of how to keep the total spending in the economy at the rate that would buy all the goods that is possible to produce. Fiscal policy should be conceived as a mechanism that balances the system, exogenously increasing aggregate demand (e.g., by injecting expenditures) whenever private sector spending falls short of a full employment level of effective demand.

http://www.dailytimes.com.pk/default.asp...2008_pg5_1
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