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Tuesday, March 30, 2010

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Economic growth revisited

Dr Ashfaque H Khan This article is written in response to Dr Meekal Aziz Ahmed's comments (March 27) on my article 'On economic growth' (March 23). Dr Ahmed is back again, "defending the indefensible" 'accomplished economists'. Like in the past, Dr Ahmed's comments are full of verbosity, personal attacks and political in tone, but unfortunately lacking substance. My response is limited to the essence of his comments. The main thesis of my article was that growth in developing countries including Pakistan would necessarily be consumption-led owing to the dominance of private consumption expenditure in GDP. There is, therefore, nothing wrong in consumption-led growth. If people don't consume why should someone produce? The very act of consumption would encourage private sector to produce, invest and hence propel growth. Dr Ahmed fully agrees with my main thesis and states that "there is nothing wrong with that. It is a welcome manifestation of a growing economy". But hastily he changes his gear and enters into policy arena, particularly in the domain of monetary policy. He finds fault with the policy of the State Bank of Pakistan (SBP) regarding cutting the interest rate sharply and flooding the economy with cheap money which, he thinks, is responsible for the surge in private consumption and a source of other economic problems the country faced thereafter. As the readers would see, Dr Ahmed dissociates himself from my main thesis and enters into a totally different territory. In so doing, he provided me an opportunity to dwell more on the subject and hence clear his misperception. I had covered the time period from 1999-2000 to 2006-07 in my article. Dr Ahmed would agree that the type of policy to be pursued by the government would depend on the prevailing economic conditions in the country. So, what were the prevailing economic conditions in 19992000 and 2000-01? It is a well-known fact that the economy of Pakistan had reached to an extremely fragile state by the end of the1990s. The economic growth averaged 2.8 per cent per annum, budget deficit and public debt averaged 6 per cent and 82 per cent of GDP, respectively and as such the annual debt servicing was consuming almost two-thirds of total revenues during the period. Inflation on the other hand, averaged 3.8 per cent. How to revive economic growth under the circumstances was the greatest challenge faced by the then policymakers. The economic growth could have been revived either by pursuing an expansionary fiscal policy or easy monetary policy. The former was not an option because budget deficit was high and the country was facing serious debt crisis. The only option left was to pursue an easy monetary policy to kick-start the economy as inflation was under control (3.8 per cent). Accordingly, the SBP gradually started reducing the discount rate from as high as 14.0 per cent on June 7, 2001 to 7.5 per cent by November 18, 2002 in five periodic interventions. In other words, an easy monetary policy was pursued for a limited period of less than three years (until April 13, 2005) to revive economic growth. During the period of low interest rate the real private consumption expenditure grew at an average rate of 0.8 per cent per annum. While investment-to-GDP ratio remained stagnant at around 16.7 per cent, real GDP growth moved up to 4.7 per cent in 2002-03 owing to the existence of excess capacity in the economy. The real private consumption expenditure grew by 10.1 per cent and 12.9 per cent in 2003-04 and 2004-05, respectively. In this period, investment rate also started rising sharply and economic growth surged to 7.5 per cent and 9.0 per cent, respectively with inflation moving upward to 9.3 per cent in 2004-05. What happened thereafter? Quite naturally, the SBP started tightening the monetary policy and the discount rate was raised to 9 per cent (an increase of

150 bps) on April 14, 2005 and further by 50 bps each on July 31, 2006 and August 1, 2007. What was the outcome? The real private consumption growth decelerated to a mere 1.0 per cent in 2005-06 but improved to 4.7 per cent in 2006-07. Investment continued to maintain its upward movement with investment rate rising gradually to a peak of 22.5 per cent in 2006-07. With deceleration in private consumption growth, the real GDP growth also moderated to 5.8 per cent and 6.8 per cent, respectively. Both exports and imports continued to grow at high double-digit rates. Imports grew at a relatively faster pace than exports on account of price effect. What is the morale of the story? Dr Ahmed agrees with my main thesis that growth in developing countries would necessarily be consumption-led. He then raised the issue of the domain of monetary policy. In answering his questions, I described the prevalent economic conditions during 1999/00-2000/01 and the policy options that were available. Given the prevailing conditions, the pursuance of an easy monetary policy was the only option available. The SBP pursued such a policy for a limited period of less than three years. This policy not only encouraged private sector to come forward but succeeded in reviving economic growth. Once growth accelerated, the SBP started tightening the monetary policy to check inflationary pressure. Both consumption and economic growth returned to moderation but investment continued to rise to meet the growing demand for goods and services. Dr Ahmed may disagree on the degree of tightening of monetary policy but I am sure he would agree with the choice of instrument and the direction of policy. What happened in 2007-08 requires another article and I promise that I would write on the subject as I am the eye-witness. Suffice it to say that unprecedented surge in food and fuel prices, deterioration in security environment, and run-up to the election resulting in policy paralysis are the root causes of macroeconomic difficulties in 2007-08.

The writer is director general and dean at NUST Business School, Islamabad. Email: ahkhan@nbs.edu.pk

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