The political economy of IMF assistance

THE International Monetary Fund (IMF) will be providing $7.6 billion credit to Pakistan under a two- year stand-by arrangement. Two pertinent questions are: One, should Pakistan have gone to the Fund for assistance? Two, will the agreement with the IMF compound or mitigate the country’s macro-economic problems?

The IMF provides credit to countries facing a balance of payment (BoP) crisis. Under a stand-by arrangement, an IMF member coun- try is provided a specified amount during a given period, usually in tranches, subject to the borrower’s compliance with performance criteria and other conditions embodied in the agreement. Typically, IMF conditionality re- gime stipulates reducing fiscal deficit, devalu- ation of the domestic currency, a flexible ex- change rate, liberalisation of trade and in- vestment regime, privatisation of state-owned enterprises, tightening of the monetary policy and overall de-regulation of the economy. The conditionalties or performance criteria allow the creditor to assess the borrower’s progress in carrying out agreed policies.

Thus IMF-sponsored programmes have both political and economic implications. While accepting them, the borrowing country agrees to surrender part of its sovereignty to the Fund during the period of the arrangement. The Fund monitors the country’s fiscal, monetary and exchange rate policies with a view to ensure there is little, if any, deviation from the agreed programme. In this way, the IMF comes to exercise a lot of influence on economic decision-making of the borrowing country. Of course, it is open for a country to opt out of the IMF programme if it thinks that the Fund is intruding too much into the country’s affairs or that the performance criteria are too stringent to comply with. However, the exercise of such option is not without cost: the country not only forfeits its access to the remaining tranches; its credibility with the Fund and other donors is also impaired.

The details of Pakistan’s agreement with the IMF made public so far show that the IMF conditionalities do not go beyond what the government says is its home-grown programme and what it had already committed to do in the budget for the current fiscal year: reducing fiscal deficit and current account deficits respectively, no more government borrowing from the central bank as a source of deficit financing, increase in interest rates, exchange rate flexibility and increasing taxGDP ratio. A statement from IMF chief dated November 15 revealed that the Pakistan’s programme had two objectives: One, to restore investors’ confidence by addressing macro-economic imbalances through restrictive fiscal and monetary policies; and two, to protect the poor and preserve social stability through a well-targeted and adequately funded social safety net.

Having outlined the IMF conditionality, let us return to the two questions posed in the beginning of this write-up.

A country’s request for IMF credit signifies two things in the main: that the economy is in a critical condition and needs immediate injection of capital; and that — given political and economic costs of the Fund’s assistance — cash inflows from other potential sources are not coming through. This is not to suggest that assistance from other multilateral or bilateral sources has no strings attached to it.

However, because IMF conditionality is perceived to be tougher and politically unpleasant, its assistance is usually sought as the last resort. In an ideal situation, the country need not knock at the door of the IMF, or for that matter any other door, for credit. But then in an ideal situation, Pakistan would not face trade deficit of $21 billion, current ac- count deficit of $14 billion (at the close of FY08), depletion of foreign exchange re- serves to $7.31 billion (as on October 17, 2008), drastic depreciation of the rupee and 25 pc inflation.

Again, in an ideal situation the affluent Pakistanis will bring back their dollars, euros, pounds and francs. However, we live in the actual world and the country is in the throes of an economic crisis. The foreign currency accounts that the well-to-do Pakistanis main- tain abroad will not be repatriated back for two reasons: One, the bulk of the money is ill- gotten and if it is brought back questions will arise about its source. Two, when a country is precariously placed politically and economi- cally, the dominant trend is capital flight rather than capital inflows. Capital, it hardly needs to be emphasised, is attracted to places where it is safe and produces higher returns.

As for assistance from Pakistan’s allies and friends, the same was made contingent on var- ious factors, notably a certificate of credit wor- thiness from the IMF. Though some politicians will have us believe that even in that event it was better to eat grass than swallow the IMF pill, such pieces of advice are no more than hollow political statements. In short, it is very much doubtful whether there was any alterna- tive to swallowing the “bitter” pill of the IMF’s conditionality-linked assistance.

Regarding the impact of the IMF-sponsored programme, it is a bailout and not a develop- ment package. The purpose is to help the country service its debt, make payment for imports, and build up its reserves. The assis- tance will not be spent on poverty alleviation or infrastructure development. As for IMF chief’s statement that the package also aims at protecting the poor, the only possible ex- planation can be that it will pave the way for assistance from other donors notably the World Bank and the Asian Development Bank.

The assistance from the IMF will thus save the country from having to default on debt re- payment and make it possible to pay for im- ports. Now what we import from the IMF money is another issue. It may be essential goods like food, raw materials and machinery necessary for industrial development, luxu- ries like bullet-proof cars for the people in high places or defence related equipment. The World Trade Organisation (WTO) rules allow a country facing a BoP problem to tem- porarily restrict imports. But do we have the political will to restrict import of non-essen- tial or non-development goods? Or would the IMF allow the government to impose such re- strictions? As mentioned above, a country running an IMF-sponsored programme has a limited policy space available to it.

The reserves build-up from the IMF assis- tance and the possibility of capital inflows from other donors will increase Pakistan’s credit rating and convey a positive signal to the domestic foreign exchange market and may bring some stability, in the short-run, to the rupee-dollar parity. However, in the long- run the exchange value of the rupee will be determined by the relative demand for (im- ports, debt servicing) and supply of (exports, foreign capital inflows) foreign exchange. A continuing adverse balance of trade will put pressure on the reserves and depreciate the rupee. Already, during first four months of the current fiscal year, the country has registered trade deficit of $5.83 billion, which is 74 pc higher than that during the corresponding period of the preceding fiscal year.

The IMF-sponsored programme can contribute little to reducing trade deficit, which is the major component of current account deficit and source of the BoP problem. One may argue that depreciation/devaluation of the rupee may make exports cheaper and imports expensive and thus help narrow trade deficit. However, the relationship between depreciation/devaluation and trade balance is not that simple. The effect on trade balance is contingent upon many factors.

For a country like Pakistan which depends on import of capital equipment and raw materials for its exports, the increase in import prices increases the cost of production of exportable goods, which adversely affects their competitiveness. Hence, the effect of the depreciation on exports can go either way. As for effects on imports, nearly two-thirds of our imports consist of petroleum products, capital equipment, raw materials and food products for which the demand tends to be largely in elastic. This means that the rupee depreciation is not likely to significantly attenuate the import demand. Hence, instead of narrowing current account deficit, the depreciation may actually widen it thus aggravating an already precarious BoP position. The $5.83 billion trade deficit during last four months of the cur rent fiscal year despite rupee depreciation confirms this.

Besides, trade liberlisation, which is generally a component of the IMF-sponsored packages, has potentially both beneficial and harmful effects. Reduced tariffs can help make exports competitive by reducing the cost of imported inputs. In that event, export promotion will generate employment and incomes. On the other hand, trade liberalisation may lead to de-industrialisation as domestic firms are priced out by cheaper imports. The result will be loss of employment and incomes. Already during last one decade in the wake of trade liberlisation, Pakistan’s trade deficit has increased from $2 billion to $21 billion, which means that imports have grown at a much faster pace than exports resulting in loss of jobs and incomes.

By forcing the government to slash its borrowing from the central bank as well as providing for a restrictive monetary policy, the agreement with the IMF may help contain inflation. However, this applies only to demandside inflation. The package will be of little help in containing supply-side inflation. Instead, restrictive monetary and fiscal policies may aggravate the supply-side inflation mainly by acting as a drag on investment. Already, the IMF has predicted (World Economic Outlook October 2008) that the Pakistan economy may grow between 5.8 pc and 3.5 pc during the current year and 2009 respectively.

In order to drastically reduce fiscal deficit, the government will have to reduce public spending. Given the political economy of Pakistan, if there are to be any drastic cuts in public spending, these have to be on subsidies or development expenditure. The government has already eliminated oil subsidy and announced to phase out power subsidy by the end of the current fiscal year. The size of the public sector development programme will also be trimmed. Removal of oil and power subsidy and cuts in development spending will hit hardest the poor and low-income sections of society.