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Role of the State in Pakistan's Economy

This article draws on examples from east Asia to point out that political will, well-conceived vision and clear strategic directions have been critical ingredients in the most successful stories of development. With this perspective, it examines the role of the state in guiding, stimulating and hindering growth and distribution in Pakistan over the last 60 years. It reviews Pakistan's economic progress with reference to commitment to markets and the private sector, strategic directions provided by the state, the burden of defence on national resources, the quality of governance, effectiveness of delivery of basic public services, attention to matters of distribution and domestic resource mobilisation efforts. It assesses progress under president Musharraf on macroeconomic, governance and structural economic issues. It then lays out the key economic and non-economic challenges that remain.

Role of the State in Pakistan’s Economy

Assessing the Past and Exploring Future Challenges

This article draws on examples from east Asia to point out that political will, well-conceived vision and clear strategic directions have been critical ingredients in the most successful stories of development. With this perspective, it examines the role of the state in guiding, stimulating and hindering growth and distribution in Pakistan over the last 60 years. It reviews Pakistan’s economic progress with reference to commitment to markets and the private sector, strategic directions provided by the state, the burden of defence on national resources, the quality of governance, effectiveness of delivery of basic public services, attention to matters of distribution and domestic resource mobilisation efforts. It assesses progress under president Musharraf on macroeconomic, governance and structural economic issues. It then lays out the key economic and non-economic challenges that remain.


lowly but surely Pakistan has undergone a sea change in its policies towards a liberal economic framework, privatisation and private sector development since the early 1990s. Since 2000, the restoration of strong macroeconomic fundamentals, a determined push towards privatisation and promotion of foreign investment and a recovery in essential public investments have greatly stimulated private sector activity. There is some debate over whether privatisation has been pushed too far. But by and large there appears to be a consensus that private sector development including privatisation has yet a long way to go in Pakistan.1

The private sector cannot prosper on a sustained basis and an equitable high growth rate cannot be achieved, without a strong and stable state, an effective government role in policymaking, essential public investments and delivery of basic public services.

This overview paper examines factors that have shaped state interventions and policy in Pakistan over its history, reviews recent improvements, current directions, and challenges and attempts to identify priorities for the near and longer term.

I State and Economic Development: Importance of Vision

Accepting the paradigm that reliance on markets is greatly desirable and should be encouraged as a matter of public policy, the role of the state can, nonetheless, be pivotal in economic development. The role of the state is normally put in the context of addressing market failures (defence, law and order, public health, macroeconomic management) addressing externalities (basic education, environment), regulating monopoly, and improving equity, especially protecting the poor. These definitions of the role of the state do not capture some of the dynamic elements of the state’s contribution to economic development nor do they deal with issues of an effective government. The issues of resources available to the state and the basic choice between guns and butter as constraints are also not addressed.

In my view, even with a strong commitment to the markets, four areas of state intervention can significantly influence the growth path of an economy: First, a vision or a lack thereof for the future of the country and its strategic directions by the state, as embodied in the political leadership and the elites. Second, the burden of defence on national resources and the balance between development and defence. Third, quality of governance and effectiveness of delivery of basic public services such as law and order, property rights, education and health and infrastructure. Fourth, resource mobilisation through taxation, borrowing, and foreign assistance. The last three points are rather obvious but the first one needs some elaboration.

The spectacular failure of communism to deliver on its promise of material advancement and social justice in the Soviet Union and eastern Europe is the most extreme example of unsuccessful state interventions and philosophy. The sad experience of the former Soviet Union suggests that even a combination of high rates of investment and high level of human resource development can fail to deliver sustained growth if the economic signals are distorted, competition is absent, and incentives for efficiency, productivity improvements and technological change do not exist. Soviet Union experience also points to the danger of excessive preoccupation with defence spending.

However, in sharp contrast to the Soviet model, vision, philosophy and strategic directions set by the state have, in combination with reliance on market forces, played a very positive role in some of the most successful cases of development during the last quarter century. South Korea, Singapore, Taiwan, China, Thailand, Malaysia, and more recently India have all strongly benefited from positive directions provided by a reformed or reforming state.

In Korea, manufactured exports were almost negligible in the early 1960s and saving and investment and balance of payments gaps were huge. Park Chung He who assumed leadership in 1961, put his trust in export development and export-led growth became almost a religion in Korea during the 1960s and 1970s. The Korean export drive would not have been quite so successful, if, in the early 1970s the Korean planning board had not, again under the direction of president Park, drawn up an ambitious plan to diversify and deepen the export and industrial structures. Till that time, Korean exports were heavily concentrated in labourintensive manufactured goods such as textiles, clothing, footwear and wigs accounted for nearly 70 per cent of manufactured goods exports in 1970.

Recognising that relatively low skill intensive manufactured exports will be losing their comparative advantage as real wages had started to rise sharply, the political leadership launched a long term plan in 1973 to develop more skill and capital intensive heavy industries including steel and shipbuilding as well as electronics – the new growth pole in international trade. Apparently, the impulse for shipbuilding came directly from president Park who wanted to emulate and ultimately challenge Japan’s dominant place in world shipbuilding at the time.

In the same way, as south Korea’s development strategy drew its inspiration from examples of Japan, Taiwan and Singapore, China in its historic opening to the outside world under Deng Xiaoping, drew on the example of Hong Kong, starting as late as 1979. A couple of decades ago, few could have imagined that a continental economy like China could make exports expansion its growth engine by turning large parts of its eastern coast into essentially free trade zones. In a generation, exports of goods and services from China have risen to $ 800 billion or well over 35 per cent of GDP. China is the most export-oriented large country in the world, its ratio of exports of goods and services compares very favourably with the ratios of 15 and 11 per cent for India and US respectively.

Malaysia represents a success story of a different sort but again one in which state vision and a well articulated strategy played a key role. While GDP, investment and export growth from Malaysia have all been very impressive, Malaysia’s most significant achievement has been the creation of a more equitable society in a multiracial setting. In 1970, Malays constituted about 53 per cent of the peninsular Malaysian population. However, the share of Malay entities in corporate sector assets was only 2 per cent. The incidence of poverty in Malaysia was the highest among Malays (nearly two-thirds) compared to 39 per cent among Indians and 26 per cent among Chinese. This was largely because Malays were concentrated in rural areas where the incidence of poverty was twice as high as in urban areas. The average Malay household income in 1970 was half that of a Chinese household.

The point of the above examples is that political will, well conceived vision, and clear strategic directions can help stimulate and support the private sector as a part of an overall effort to accelerate growth and ensure equitable distribution. At the same time, as the Korean example in early 1980s and less than successful Malaysian public industrial projects show, state attempts to manage precise directions of the economy are likely to fail as the economy becomes more complex and sophisticated. Still, an enlightened state can help push economic growth as well as poverty alleviation, particularly in the early stages of development.

II State and Economy in Pakistan 1950-2000

The previous section outlines some of the ways in which the state can help or hinder economic development. What has been the Pakistan experience? What state directions and policies have promoted economic development? What state notions or priorities have hurt growth and social change?

Vision, Strategy and Priorities

Pakistan has never had a very strong, coherent and clear economic vision about its future a la Korea, China, and Malaysia.

Table 1: State and the Economy – A Profile by Political Periods

Key Aspects of State’s Role Vision, strategy and priorities Defence spending Domestic resource mobilisation Degree of economic liberalisation Priority to private sector Level of public economic, social and development spending Effectiveness of policy coordination Quality of governance/ public services delivery/ effectiveness of spending Concern with social justice/poverty reduction Early Years Rapid industrialisation, reducing dependence on trade with India, and seeking large scale US military and economic assistance High Moderate Low Moderate Moderate Moderate Moderate Low Ayub Khan’s Era Foreign aid mobilisation, accelerating growth, long term water and power investments, and speedy spread of green revolution Moderate till 1965, High afterwards Moderate Moderate Moderate to high High High Moderate Low Z A Bhutto’s Rule Public control of modern sector, nationalisation of education, and weakening of bureaucracy High Moderate but with heavy reliance on foreign trade taxation Low Very low Very high Low Declining High but ineffective Zia-ul-Haq Return to Musharraf Years Period Democracy Largely status quo Economic Debt burden, reduction, with very few really liberalisation and revival of high important policy promotion of private economic growth and initiatives sector, relative accelerated neglect of privatisation, induction macroeconomic of foreign private imbalances investment Very high Moderate Moderate Moderate but with Low but with Low but with heavy reliance on improving tax improving tax foreign trade structure structure taxation Moderate High High Moderate High Very high Moderate but Low and declining Low but rising declining Moderate Low Moderate Declining Declining Low but improving Low Low Low but improving
1624 Economic and Political Weekly May 5, 2007

But fairly distinct national agendas and notions of economic development have guided economic policies and priorities in almost all political periods. Economic strategies have evolved over time influenced not only by the personal views of the leadership, most notably Ayub Khan and Zulfiqar Ali Bhutto but also by the contemporary currents of international thinking about planning and economic development. Major points are summarised in Table 1 and discussed below. The categorisation of state performance is, in the final analysis, subjective and not scientific and I realise that it could be challenged.

Policy thinking and development in early years were primarily focused above four things: building defence capability, rapid industrialisation, reducing dependence on trade with India, and seeking large scale US military and economic assistance.

With a firm grip on power and relative political stability, Ayub Khan, Pakistan’s first military ruler, put economic and social development high on his agenda. His commitment to economic development was strong and clear and his approach to economic issues was essentially pragmatic.

The basic model of development under Khan relied heavily on the key relationship with the US for military and economic assistance, a strong push for public sector investments especially in water and power facilitated by the Indus basin treaty with India, relaxation of foreign exchange and investment controls, and improved availability of long term industrial credit for the private sector through Pakistan Industrial Credit and Investment Corporation and International Development Bank.

The essential parameters of his vision, however, fell apart after the 1965 war with India which led to a very sharp increase in defence spending from Pakistan’s own resources as US assistance, both military and economic, decreased sharply.

Bhutto came to power in December 1971. His Pakistan People’s Party (PPP) had captured the imagination of the general public with the slogan of ‘roti, kapara, makan’. Though Bhutto had no clear notions about socialism, he felt he had the public mandate to bring about fundamental changes in public ownership of means of production. Bhutto undertook large-scale nationalisation of industry, insurance, and banking, extending the state control of the modern sector significantly. The Bhutto government also took full control of country’s educational system by nationalising private educational establishments. This experiment with socialism had far-reaching and long-term consequences. Though successive governments in the next two decades attempted privatisation, large segments of banking, insurance, and industry remained with the state till the late 1990s.

From the economic point of view, Zial-ul-Haq’s rule (197788) was the least ideological and the least innovative. Fortunately for Haq, the economy showed a high and sustained growth rate helped mainly by a number of special factors both domestic and external. The completion of the long-gestation period Tarbela dam project in 1977 added considerably to irrigation water availability and hydel power capacity. A tremendous boost to economic activity was also provided by increasing worker remittances and large external assistance for Afghan Mujahedin, channeled through Pakistan.

Lulled by a comfortable growth rate and a balance of payments situation greatly helped by remittances and other external factors mentioned above, the Haq regime did little to deal with the serious structural problems inherited from the 1960s and 1970s: the overextension of government, the poor climate for private sector investment, heavy dependence of exports on cotton based exports, and the inelasticity of the tax system. Indeed some structural problems were intensified. Relentless growth in public spending, a major shift in public expenditure priorities from development to defence, and consequent rise in fiscal deficits increased debt burden sharply.

There is no doubt that macroeconomic imbalances were worsening and growth was slowing down after the mid-1980s. Had Haq lived, he would have had to face the consequences of his neglect of some basic economic issues. As it turned out, the responsibility of sorting out the difficulties fell to a succession of weak political democratic governments which followed Haq.

Notwithstanding substantial macroeconomic mismanagement over decades (less visible in the 1980s than in the 1970s and 1990s), there was a gradual process of liberalisation of the economy starting in the late 1980s – notably the reduction of interventions in agricultural prices, relaxation of import and investment controls and financial sector reforms. Major agreements with the International Monetary Fund and World Bank financially supported the structural reform process which was further accelerated by the removal of foreign exchange controls and stepping up of the pace of privatisation under the first Nawaz Sharif government in 1991-92.

The policy shift towards the private sector and greater reliance on market signals rather than administered prices was influenced largely by pragmatic considerations. Policy decisions to involve the private sector in energy and infrastructure development reflected a realisation going back to 1987 that the public sector funds had become a serious constraint on development. Similarly, the drain caused by losses of public sector enterprises was a major factor in the decision to hasten privatisation of industrial assets. Efficiency considerations were also behind the drive to privatise government banks and telecommunications corporations.

Defence Spending

Because relations with India deteriorated early on and the Kashmir dispute has continued to simmer between the two countries, a high level of defence spending has remained a key feature of state policy and strong competition between defence and development has been unavoidable. The only periods in Pakistan’s history when defence spending grew less rapidly than GDP were the first half of the 1960s and the second half of the 1990s. In the former period, it was the large US military assistance which made putting a lid on military expenditures possible. In the latter period, growing financial and fiscal crises led to an actual decline in defence outlays for a few years.

Between 1965 and 1990 there was an almost relentless growth in defence and related spending. Real defence expenditure almost doubled between 1960-65 and 1965-70 in the wake of the 1965 war. Under Bhutto defence outlays increased by a further 33 per cent even though the size of the country and the economy had shrunk substantially. Under Haq, real defence spending increased by 9 per cent per annum on an average during 1977-88 while development spending rose 3 per cent per annum; by 1987-88, defence spending had overtaken development spending. For the 1980s as a whole, defence spending averaged 6.5 per cent of GDP. Not only was this a peak but it also contributed strongly to large fiscal deficits and a rapid build up of public debt.

Public versus Private Sector

The notion that the state must be the leading agent in economic development was also embedded deeply in early economic thinking. An important achievement of the 1950s was the increase in the rate of domestic capital formation, in absolute terms fixed investment in then west Pakistan increased nearly fourfold in the 1950s. But there was a clear public sector bias. The result was an almost sevenfold increase in the real level of public investment in the 1950s and the share of public investment in total investment increased from less than 40 per cent to two-thirds over the decade.

The Khan era was an exceptionally successful period of economic management because it used planning institutions and processes effectively for economic policy coordination. The pace of economic decision-making was speeded up, implementation processes strengthened and sectoral planning substantially decentralised. But the public sector bias of the development policy of the 1950s continued and was compounded by the large availability of foreign assistance, which mainly financed public sector development.

Bhutto’s economic policies virtually halted the growth of the modern private industrial sector and reinforced the anti-export bias of the industrial strategy. Large public investments in industry focused on import substitution and the reform of the exchange rate system failed to remove the large wedge between the average effective exchange rates for imports and exports.

Even though the attitude towards the private sector improved during the Haq period and some privatised units were returned to the private sector, there was no attempt to tackle the overhang of major nationalisation of the Bhutto period. Even though major inefficiencies had already emerged in public sector enterprises, especially the nationalised commercial banks, not much thought was given to systemic solutions.

The early 1990s saw the emergence of liberal economic policies and a fuller realisation that the private sector should be allowed to play a greater role in the economy. But structural reforms including financial sector liberalisation and privatisation did not go far enough or remained in early stages. Only limited progress was made in privatisation in the financial, telecommunication and energy sectors. The delay in privatising large state-owned banks was particularly costly because credit allocation decisions became more susceptible to political pressures under democratically elected governments.

Paradoxical though it may seem, some of the liberalisation measures, though sound in themselves, had the impact of diluting the urgency of macroeconomic adjustment. First, the ease of financing the foreign exchange gap through foreign currency deposits and portfolio investments became an excuse for not facing the unsustainability of large balance of payments deficits. Second, large receipts from privatisation were used to bolster public spending rather than to retire debt.

III Pakistan at Threshold of 21st Century

As I have argued elsewhere, Pakistan, as it approached the 21st century was faced with not only a financial crisis but also an economic growth crisis because the per capita GDP growth had slowed down to 1 per cent per annum during the 1990s from an average of around 3 per cent per annum during 1960-85 [Hasan 1998].

It is too simplistic to lay the blame for Pakistan’s economic and financial problems at the end of the 20th century mainly on the governance and economic policy failures of the 1990s. The fundamental governance and growth problems had long roots and had their origins in: (a) a level of defence spending that the country could ill afford; (b) inability of the government after the mid-1980s to collect enough revenues to cover current expenditures leading to borrowing partly for current outlays including defence and thus, a sharp build up of public debt; (c) a major neglect of human development outlays and quality of public education in face of rapid growth of population and rising needs for skills; (d) a weak industrial and export structure, dominated by cotton based exports resulting from both insufficient progress in education and trade policies which discouraged backward linkages, exports based on imported inputs and diversification;

(e) personalised rule, over-centralised decision-making, weakening public institutions and rule of law, increasing public corruption, and lack of accountability; and (f) a pattern of development which resulted in sharply increasing inequalities and only slow reduction in poverty because it rewarded rent seeking, discouraged genuine entrepreneurship, did not promote labour-intensive exports, and did not sufficiently tax the rich.

By the end of the 1990s, growth and governance problems had become intertwined. Because growth benefits were not widely shared, the quality of public services (especially education) was deteriorating and the pace of poverty reduction was slowing, the tensions in the society had begun to erupt with increasing frequency in ethnic, sectarian and random violence. The deteriorating law and order situation in turn had become a constraint on investment and growth.

Taking the second half of the 20th century as a whole, however, it is the governance failures in Pakistan that stand out much more than growth disappointments. Pakistan no doubt missed major economic opportunities, especially in exports of manufactured goods but its average GDP per capita growth rate of 2 per cent per annum over 1950-2000 was about the average for developing countries and about the same as India’s.2 Furthermore, Pakistan

Table 2: Key Fiscal Aggregates, Public and Private Investment

(as percentage of GDP)

Years Public Fixed Private Fixed Consolidated Public Defence Non-Interest, Non-Defence Fiscal Tax
Investment Investment Spending Spending Public Spending Deficits Revenue
1960s 1970s 8.210.3 8.8 5.6 NA 21.5 2.8 (1960-65) 4.0 (1965-70)5.6a NA 14.0 2.1 5.3 NA 13.8
1980s 9.2 7.8 24.9 6.5 14.5 7.1 13.4
1990s 7.5 9.1 24.1 5.6 11.7 6.9 14.0
1999-2000 6.0 8.4 23.6 4.9 10.5 6.6 12.9
New Revised National Account Series
1999-2000 5.6 10.4 18.7 4.0b 7.8 5.4 10.7
2000-01 5.7 10.2 17.2 3.2 8.0 4.3 10.6
2001-02 4.2 11.3 18.8 3.4 8.0 4.3 10.9
2002-03 4.0 11.3 18.6 3.3 9.2 3.7 11.5
2003-04 4.0 10.9 16.7 3.2 10.0 2.4 11.0
2004-05 4.4 12.1 18.2 3.2 11.8 3.3 10.0
2005-06 4.8 13.6 17.7 3.2 11.3 4.2 10.4

Notes: (a) Refers to the average in 1975-76 and 1976-77, last two years of Bhutto rule. (b)Including defence pensions which were excluded from defence budget 2000-01.

Economic and Political Weekly May 5, 2007

had to cope with a much higher growth rate of population of nearly 3 per cent per annum over 50 years. If governance had not deteriorated so much and the strength of public institutions not eroded over time, the resources mobilised through taxation would have been more adequate and the quality of public services (especially education) would not have declined so precipitously. Poor governance hurt the poor and low income groups especially as they depend relatively more on public services. The failure of the well-intentioned Social Action Programme in the 1990s, which aimed at the provision of basic education and health services and narrow the gaps in human development must basically be attributed to poor governance.

Why did governance decline so sharply over time? This is a big question, the answer to which is essentially beyond the scope of this paper. But one can point to some basic factors. I believe the very high population growth rate complicated, both financially and managerially, the delivery of basic public services. The responsibility for the weakening of the rule of law must be borne by the political leadership, both military and civilian. Some argue that extra-judicial interventions by the military and disregard of the constitution is a root cause of this problem. But in some respects Pakistan’s military regimes were less arbitrary than some democratically elected leaders starting with Bhutto. The weakening of bureaucracy, a decline in its competence, and increase in corruption are as much due to its steadily declining relative compensation as to the frequent political interventions in violation of rules and regulations.

But purely from an economic policy viewpoint, the picture at the end of the 1990s had some bright spots. By the sheer pressure on public resources, defence spending did not increase much in real terms in the 1990s. The gradual liberalisation of imports and reduction of tariffs had by reducing foreign trade taxation substantially, reduced the anti-export bias in policies, agricultural price distortions had become minimal, and the environment for the private sector had become much friendlier. There was a clear recognition in the privatisation efforts and seeking of private investments in power generation that the government had become overextended, financially as well as administratively.

IV State and Economy under Musharraf: Progress and Problems

So what has changed and by how much during the last seven years? Unfortunately the views on what has happened tend to be rather polarised. The government claims broad success in putting national finances on a sound footing, reviving strong growth, improving social indicators and beginning the difficult processes of improving governance and sharing of growth benefits more widely. The sceptics point to the continuance of serious issues in governance and quality of public services, narrow base of the prosperity, only modest progress in poverty reduction, and reemergence of heavy reliance on external flows.

As often, the reality is more complex. There have been some fundamental changes in macroeconomic policies, attitudes towards the private sector and the size and use of public resources which have revived strong growth and improved growth prospects enhanced the priority of social sectors including higher education, and accelerated pro-poor spending. But it also remains a very much open question whether reforms have so far put the economy on a sustainable, high growth path and improved the economic model and governance structures sufficiently to ensure more equitable growth. This section and the next explore both the progress and challenges that remain.

Macroeconomic Management: Reduction of Deficits and Debt Burden

The sharp turnaround in the public and external finances of Pakistan has been the singular economic policy success of recent years.

No doubt the improvement in external and domestic finances and the large build-up of foreign exchange reserves has been greatly helped by developments following 9/11 and realignment of Pakistan’s relationship with the US and other western countries. External grants, substantial concessionary assistance, Paris club rescheduling, payments for logistical support to the US, and somewhat better access to external markets, all contributed strongly to the remarkable build-up of external reserves over the last few years. But tough stabilisation policies aimed at restoring financial discipline, shrinking fiscal deficits, great restraint on non-concessionary external borrowing, and measures to promote exports laid the basic ground work for the much increased confidence in the stability and strength of the Pakistan rupee, which in turn resulted in the reversal of capital flight, large increase in worker remittances, and growing interest by foreign investors.

The external and public debt levels have come down very sharply since 2000. External debt, as a percentage of exports of goods, services, and transfers has dropped from around 250 per cent to 115 per cent over the period 2000-06.

The public debt to GDP ratio has declined from over 90 per cent (on new GDP numbers) in mid-2000 to 55 per cent in mid2006. As a proportion of government revenues, Pakistan’s public debt has also declined from nearly 600 per cent in mid-2000 to less than 400 per cent in 2005-06. Interest payments as a percentage of government revenue have come down from 33 per cent of public expenditure in the late 1990s to 17.5 per cent in 2005-06.

The sharp decline in interest payments in the budget from nearly 7 per cent of GDP in the financial year (FY) 2000 to 3.1 per cent (as well as containing defence spending as a percentage of GDP) has opened up fiscal space, defined as non-interest and nondefence spending, while at the same time making possible a reduction in fiscal deficits. Non-interest and non-defence spending has doubled over the last six years in real terms providing a strong momentum to both growth and social development.

The macroeconomic management in Pakistan is being challenged once again partly because of external shocks – the almost doubling of the international oil price between 2003-05 and in 2005-06, the devastating earthquake which will cost the economy $ 6 billion over five years and too accommodative a monetary policy in FYs 2005-06.

Notwithstanding major economic shocks, Pakistan has been able to avoid disruption to economic growth because of adequate level of foreign exchange reserves and large foreign investment flows partly related to rapid privatisation. However, the current account balance of payments deficits, after official transfers, was at $ 5 billion in 2005-06 and, as the July-October 2006 data suggest, could grow to $ 6.0 billion or over 4 per cent of GDP in 2006-07, if the recent decline in international oil price is not sustained. Meanwhile, inflation though stable at around 7-7.5 per cent is stubbornly high.

Maintaining macro stability would require further strengthening the structural position of both external and internal finances not only through fiscal and monetary policy adjustments but also through export push in non-traditional exports. Having said that Pakistan has much greater freedom of financial options than ever before as typified by its successful long term bond placement in the international market, the continuing strong interest from foreign investors especially from west Asia, and continued strong support from international organisations especially the World Bank and the Asian Development Bank.

Defence Spending

The analysis of defence spending since 2000 is complicated by two facts. First, as is the custom in many countries including India, the defence pensions were moved to the civilian budget from 2000-01. Second, the national income figures were revised substantially upwards and a new series was introduced starting with 1999-2000. This makes historical comparisons somewhat difficult. Since 2000-01, defence spending, excluding pensions, has risen in real terms roughly in line with the growth in GDP. It actually fell in the stabilisation years 2000-02 but has increased by 23 per cent during the last three years (2003-06).

Currently defence spending is around 3.2 per cent of GDP and appears to be lower than the level in the 1990s even after making rough adjustments for comparability of data. Two points need to be noted, however. First the defence budget is still absorbing nearly one-third of government revenue. Secondly, the current military outlays are being supported partly by payments from the US government for the fight against terrorism. The issue of an appropriate level of defence spending, i e, the choice between guns and butter remains very much alive.

Private Sector Development and Privatisation

Another important success of the Musharraf regime, not unrelated to the strengthening of the financial position and increased confidence in the currency, has been the further energising of the private sector through accelerated privatisation and improvement of the investment climate. Induction of foreign investment has becoming a promising source of future growth.

During the last five years, 2001-06, direct foreign private investment has totalled $ 7.3 billion, rising from $ 500 million in 2001-02 to $ 3.5 billion in 2005-06. Privatisation receipts at $ 2.4 billion have accounted for over one-third of direct foreign investment. The privatisation sales to the foreigner have been concentrated in banking, telecommunications and thermal power while other important foreign investment flows have been in oil and gas and telecommunications.

The opening up of the financial and telecommunications sectors partly with the help of foreign sectors is transforming and modernising the economy in a fundamental fashion. The growth in cellular phones in Pakistan has been nothing short of phenomenal and the competition in the telecommunications sectors has pushed down prices very sharply, essentially reducing the cost of information and doing business.

The liberalisation, privatisation and reforms of the financial system, a process that was started in the 1990s, is providing a strong base for healthy private sector development. The largely publicly owned banking system was greatly misused by vested interests both to earn economic rents and thwart genuine entrepreneurial activity. In a very short time, the control of the banking system has moved into private hands. Regulatory capacity of the central bank has been greatly enhanced and its autonomy increased.3

Financial reforms have improved resource allocation by making lending follow sound economic and financial criteria. It has also improved governance by closing avenues for corrupt practices and political influence paddling. There is also evidence of financial deepening as the ratio of monetary assets to GDP has risen from 40 to 44 per cent over the last five years after having been stagnant for a long period. The increased financial intermediation also generally augurs well for economic efficiency.

There is also broad evidence that the investment climate for the private sector is improving and the cost of doing business is decreasing. According to the World Bank, Pakistan was one of the top reformers in terms of doing business in 2004.4 It ranked 60th out of 154 countries in 2006 (India was 116th) and 74th out of 175 countries in 2007. According to World Economic Forum global competitiveness reports, Pakistan’s ranking improved from 75th out of 102 in 2003 to 66th out of 116 in 2005. However, Malaysia, Thailand, India, China, and Turkey were substantially ahead of Pakistan in these rankings.

The growing importance of the private sector in Pakistan is also evident from its share in fixed investment. The share of private investment which exceeded 50 per cent of total investment in the 1990s is now approaching 75 per cent.

Still, there are three major problem areas. First, in the power sector which is largely in public hands, the inefficiencies and frequent breakdowns in supplies not only increase the costs for the private sector by requiring alternative generating capacity but also result in large losses for public entities which are a significant drain on public resources. It is not clear that large scale privatisation of the Water and Power Development Authority’s energy corporations is a quick and fully feasible answer, at least in the short run.

Second, though much progress has been made the private sector still looks too much to the government for solving its competitiveness problems by seeking tax, credit and other concessions. A Rs 50 billion package demanded recently by the textile industry to cope with competitive pressures in the post multi-fibre agreement era is a case in point. The government on its part has not been able to resist the urge to control prices as inflationary pressures reemerged and the consumers complained. Rent seeking behaviour has not entirely disappeared and genuine entrepreneurship is still hampered, though medium and small industries are faring better than before.

Third, while large foreign investment flows are providing a more balanced source of external finance, the bulk of foreign investments are taking place in areas like energy, telecommunications, financial and other services which do not contribute directly to export development. Since, as discussed below, export growth remains critical for Pakistan’s development, a lop-sided pattern of foreign investment could prove costly in the long run.

In other areas where state interventions required improvement, resource mobilisation, distribution of growth benefits, human development, and last but not least governance, progress has been more mixed.


The structure of taxation has improved, the burden of several taxes has been reduced, the move away from reliance on foreign trade taxation has continued, and serious efforts are under way to improve tax administration. It is too early to say, however, whether improvements undertaken or proposed would result in an elastic system of taxation which will automatically capture a reasonable share of GDP growth as government revenues. Also, the tax system is regressive because the rich and the well-to-do do not pay sufficient taxes and the individual income tax receipts remain very small. Finally, the present tax to GDP ratio at 10.4 per cent remains very low both in relation to needs and international

Economic and Political Weekly May 5, 2007

norms. It should be stressed, however, that the stagnation in the tax to GDP ratio, indeed a small decline compared to 1990s, is entirely due to the liberalisation measures which have reduced import duties. It has been estimated that if the import tax reductions had not occurred and if sales tax had not been increased in partial compensation, the government revenues would have been about 11 per cent higher than otherwise in FY 2005.5

Income Distribution, Poverty, and Employment

The revival of strong growth, and doubling of real public spending over the last six years, after the stagnating for a decade, has expanded employment, resulted in some increase in real wages, and reduced poverty incidence. The extent of reduction in poverty incidence over 2001-05 is a matter of some debate6 but there is little disagreement that poverty has declined in recent years. Still, rural poverty and growing differences in income between rural and urban areas are a matter of growing concern. According to government numbers, the rural poverty incidence in 2004-05 was at 28 per cent, almost double the rate of urban poverty. Surely the high incidence of rural poverty in a bumper crop year cannot be the basis of much satisfaction.

Government pro-poor spending, though still low, has increased in recent years to 4.5 per cent of GDP as fiscal space has opened up and progress on some rural programmes such as rural electrification and girls’ education is impressive. Increased pace of social spending has improved gross enrolment ratios and reduced gender differences. But net primary enrolment rate of 60 per cent in 2004-05 means that 40 per cent of the primary school cohort were not in school. The overall education spending is only about 2 per cent of GDP and quality and governance issues in public education remain huge. At the same time, the government must be given credit for turning its urgent attention to higher education and skills gap and developing cogent plans.

Reducing poverty incidence and increasing the access of the poor to basic public services in the rural areas is, however, only one dimension of Pakistan’s distribution problems which are reflected in growing income inequalities and regional differences.

Containing income and consumption disparities as well as steady reduction in poverty especially rural poverty, needs to be built in more explicitly as an integral part of future economic strategy because clearly, the issue of the distribution of growth benefits has assumed more urgency with economic liberalisation and a greater role for the private sector. The distribution problems have distinct dimensions in rural and urban areas, with poverty being much more of a problem in rural areas and growing income disparities much more of a problem in urban areas. In rural areas the share of consumption of the highest quintile to the lowest quintile was only 2.2 in 2004-05 and had changed little since 2000-01.7 But as mentioned above, rural poverty is widespread and nearly 80 per cent of Pakistan’s poor live in rural areas. In contrast, urban areas account for little over 20 per cent of the poor. But in urban areas consumption disparities are huge and growing. In 2004-05 the share of consumption of the highest quintile to the lowest quintile in urban areas was over 12 times and had grown from 10.4 in a short period of four years.8


Governance is a very broad area which encompasses the delivery and effectiveness of all public services. Here again the record of the last several years is very mixed. The opening of fiscal space has certainly made possible a very sharp expansion in public spending on economic and social development including more adequate pay for civil servants. But the quality of many services including law and order and justice including enforcement of property rights remains extremely problematic. The lack of definite progress on governance issues shows, the intractability of issues of institution building and lags in obtaining visible results as shown by the tax administration reform.

The biggest achievement of the Musharraf government has been the creation of a political structure consisting of 6,400 new indirectly-elected governments with significant participation of women. The devolution to Nazim as an elected head of district government could prove to be a revolutionary change provided other political interests do not undercut the reforms, the initiative is properly funded and is fully supported by measures to enhance local governments’ capacities.

The biggest disappointment is the stalling of the civil service reform. While merit now plays a greater role in recruitment and promotion, and there is an important initiative to upgrade skills of civil servants through foreign training, the restructuring of processes and incentives to attract the best and the brightest to the top layers of governments at all levels of government are lacking. Civil service reform must go hand-in-hand with effective devolution and should include improved compensation at higher levels as well more competition for these positions including hiring from the private sector.

V Looking Ahead

Pakistan’s development and modernisation have suffered in the past either because there was not a very clear vision of the future or there were conflicting views about national identity and priorities. One hopes that that main political parties and the military leadership have learnt their lesson from history and would strive to unite the country around a broad emerging consensus about future directions. This consensus must have both economic and non-economic dimensions because social and political shocks can easily derail the economy.

Some of the elements of the non-economic consensus that appear to be falling in place are: (i) need for an enlightened moderation in which narrow interpretations of Islam are not allowed to drive the societal and state agenda; (ii) resolution of conflicts with India, containment of military establishment and a gradual reduction of defence spending as a percentage of GDP and public spending; and (iii) a determined attempt to reduce the centralisation of decision-making by empowering the provinces in the spirit of the federation.

Decisive progress on the non-economic issues is a necessary but perhaps not a sufficient condition for releasing the creative energies of the country to meet its aspiration of high growth rates to match those that are being achieved by China and India. For that, a better articulation of an economic vision is necessary which encompasses concern with growth as well as broadening of the growth benefits, reducing income, regional, gender disparities, and modernisation of attitudes towards work and thrift.

Export Development

Despite early promise, export growth has lagged in Pakistan. Even after the substantial export expansion of the last few years, the ratio of exports to GDP remains at 13 per cent, very much below the range of 30-50 per cent of GDP in successful east Asian economies. The failure of Pakistan to develop a large and diversified base of exports is one of the fundamental reasons for why it has not matched the growth and poverty reduction performance of not only the first generation of Asian tigers, South Korea, Hong Kong and Singapore but also relative late comers to the field, Thailand, Malaysia and above all China.

Future development strategy needs to emphasise exports sufficiently and help remove the trade policy distortions that remain. Special policy support might be needed to diversify the export base and to develop information technology exports. Recent weakness in exports is particularly worrisome.

Revenue Mobilisation and Size of Government

Improvements in governance and further economic reforms will depend critically on the management of public service personnel. But I doubt that improved governance, better delivery of public services, and a vibrant civil service can be delivered without expanding the base of government revenues.

The over-extension of government in terms of its functions should not obscure the woeful inadequacy of its financial capacity. In Pakistan, non-interest non-defence public spending, a key indicator of the size of government is only a little over 11 per cent of GDP, much lower than almost all developing countries (Table 3).

Raising tax revenue is both a moral and a practical imperative. One cannot run an effective government, however circumscribed its functions, on a shoestring. But the expansion in real spending in support of social and economic development must focus on decentralised programmes supporting the important devolution initiative which remains seriously underfunded. Taxation effort and authority also need to be devolved in parallel.

Distribution of Growth Benefits

Sustained growth and political stability do require a better distribution of growth benefits than in the past. Income distribution issues are not peculiar to Pakistan. Even rapidly growing economies like China have major income distribution issues notably growing rural and urban income gaps and widening regional disparities.

Some of these issues arise from structural factors like concentration of labour force in agriculture and rural areas while the non-rural economy grows much faster. In the long-run only increased education and out-migration from rural areas can provide a durable solution to rural poverty in Pakistan. But much more can and should be done in the medium term to alleviate both rural and urban poverty and to contain income disparities.

Table 3: Non-Interest and Non-Defence Expenditure for Selected Countries

(Per cent of GDP)

1990 1995 2000
ArgentinaBangladesh Chile 9.0 15.1 16.2 13.2 12.6 17.4 12.7 11.8 21.1
EgyptIndia 20.4 21.0 24.3 17.8 19.4 19.8
Indonesia 14.7 12.1 13.0
Malaysia NepalPakistan 20.5 NA 14.5 15.9 14.3 11.7 17.5 13.8 10.3
Philippines Sri Lanka 11.2 20.9 12.9 19.3 14.3 15.9
Thailand 9.8 13.2 15.5
Turkey 12.2 17.3 22.2

Source: World Bank, Pakistan Public Expenditure Management, 2004.

First, the rather obvious but sometimes overlooked point, the trend in population growth would remain a major determinant of poverty. Since fertility rates are much higher in rural areas, present efforts to increase the levels of female education must be combined with making family planning services available widely and cheaply.

Unlike earlier periods rural poverty is now more deeply grounded among the landless poor and non-farm households: 60 per cent of the rural poor are landless agricultural labourers and nonagricultural households. For them public infrastructure and other spending are critical.

A healthy agricultural growth rate of say 4-4.5 per cent per annum remains essential for the high growth rate of the economy. The expansion of agricultural productivity can help bring real prices of wheat, which is so important for poor households. Agricultural diversification to higher value crops can assist in export development as well as job creation. Unfortunately, the trend growth rate of agriculture since 1999-2000 has fallen to less than 3 per cent per annum compared to a rate of 4.5 per cent in the previous two decades. Unless this trend is reversed, growth and equity problems will intensify. .

Fiscal policy must play a role in not only in supporting public interventions to reduce poverty but also to moderate income disparities.

Last but not least, the issue of urban income disparities must be addressed by examining the access of land for the middle classes which are in growing danger of being locked out of the housing and real estate boom.

VI Conclusion

Notwithstanding the strong revival of the private sector, the agenda for the role of the state in the Pakistan economy remains both large and challenging. No agenda can be implemented without a vision, a national consensus, and a government structure that can deliver public services on a priority basis. There has been a great deal of talk about second generation reforms but in Pakistan a lot of the basics of governance have yet to be put fully in place.




1 For reservation about the policy of privatisation, see, Kaiser ‘Bengali

Politics of Privatisation’, Dawn, July 11, 2005. 2 India’s growth per capita was, however, much higher than Pakistan’s

during 1985-2000 thus, offsetting its very slow growth till the 1980s

compared with Pakistan. 3 See Ishrat Hussain, ‘Banking System Reform In Pakistan’, The Business

People’s Magazine, January 2005. 4 World Bank, ‘Doing Business in 2006’, Table1.1 page 2, World Bank,

Doing Business Report: Pakistan Highlights. 5 Social Policy Development Centre , Annual Report 2006, Chapter 2, p 62. 6 The government estimates that poverty incidence reduced from 34.5 per

cent in 2000-01 to 23.9 per cent in 2004-05 – a more than 10 percentage

point drop. The World Bank estimates the reduction in incidence at only

5 percentage points. 7 Economic Survey 2005-06, p 58. 8 Op cit, p 58.


Hasan, P (1998): Pakistan’s Economy at the Crossroads: Past Policies and Present Imperatives, Oxford University Press, Karachi.

Economic and Political Weekly May 5, 2007

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