Why Pakistan will go to the IMF again, and again and again

Shahrukh WaniUpdated October 16, 2018 Facebook Count

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Pakistan’s formula for economic growth is as flawed as it gets: borrow foreign currency-denominated
loans, build some large-scale infrastructure, get a minor growth spurt in the process, and wait until this
growth spurt fades so we can repeat the process again.

This is what the previous government did. And, the one before that. It could have worked if, while
borrowing to build infrastructure, it did not ignore the underlying constraints to growth and
productivity.

Because they did not do that, Pakistan has ended up with an increasing level of debt, a balance of
payment crises, and a government struggling to keep the growth spurt going.

When these challenges become dire — Pakistan often ends up getting a loan by the International
Monetary Fund (IMF).

This time, if we’re successful in persuading them which looks to be the case, will be the 22nd occasion
we will be loaned capital by the fund since 1958.

And, if our public discourse and policies remain the same, we will without doubt keep knocking at IMF’s
door every few years (or some other lender for that matter).

Editorial: After IMF, govt must remember that focus on optics instead of reforms could derail exercise

The logical argument made by analysts in Pakistan here is that the government needs to bring
meaningful reforms to our economy.
So, in due course, we are in a fiscally sound enough condition that we not require bailouts like the ones
we get from the IMF.

This is a perfectly accurate demand. But, it often masks the political causes to our economic despair.

The problem with talking about the economy divorced from politics is that we end up with superficial
reforms.

This is because any meaningful reforms are impossible if the political structure does not allow them.

For this to change, our public discourse needs to take a holistic overview of our institutions. This is a
contribution to that end.

Digging deeper

Let me explain. Take the much talked about balance of payment crisis as an example.

The most direct culprits are lack of exports and the increasing cost of imports. Pakistan imports nearly
twice as many products and services than it exports.

In turn, there are many causes for low exports, some are macroeconomic determinants. The unsound
infatuation of the previous government with an appreciated rupee is an example of this.

Dig deeper, we are exposed to the fact that Pakistan has developed little comparative advantage over
the years. Which means that we mostly export basic textiles, cotton and rice and other related products.

Most of them are low-value items in the global value chain, so we earn little revenue from exporting
them, and are hence unable to cover our import bill.
Opinion: What lessons can PTI leadership learn after eating its words about approaching IMF?

Dig further, we find that even in products which we do export, we face structural problems  —  such as
lack of capital, whether it is human or financial.

Hence, exporters struggle to grow, move up the value chain, compete with foreign firms, and boost
productivity.

But, why is this? Why does Pakistan fail to provide an environment which is conducive to developing
globally competitive enterprises?

There are many explanations here — but one persuasive thought is that our institutions do not create
the set of incentives needed for the growth of a competitive market.

Instead, they encourage a reliance on state patronage even if it comes at the cost of the larger industrial
growth.

Now read: Negotiating with the IMF

Pakistan’s public discourse has been rather good at ignoring these underlying causes. The result of this
has been that, whenever Pakistan has found itself in such crises, it has been able to get loans to sail, or
crawl, through the crisis.

But, all those reasons why this crisis emerged in the first place will remain — waiting to fuel another
crisis down the road.

It is like putting the fire out but not fixing the leaking gas socket in the basement.
What are institutions?

A good place to start is understanding what institutions are, and how they influence our collective
behaviour.

Simply put, institutions are the ‘rules of the game’ as Douglas North popularly put it in his 1990 book.

Think about cricket — we have certain rules under which everyone plays the game. There has to be a
fixed number of players, they have a number of balls to play with, and everyone has a consensus on how
we determine which team wins.

Now, apply the intuition behind this analogy to the broader institutions which shape our daily life.

Like the rules which govern the game of cricket, we have humanly devised rules which govern our lives
in a more consequential manner.

Cure or curse: Our perpetual dependence on the IMF

They can be formal which are written down, such as the laws of the land often codified in the
constitution, or informal ones widely accepted by the population, such as kinship bonds.

These institutions are important because without them, society as we know it would collapse. But, these
institutions differ from country to country, and a persuasive strand of economic literature argues that
they are the key to understanding our development outcomes.

We can also split them between economic and political institutions. The former directly shape our
economic incentives, such as ownership rights of property, and the latter determine the political
structure, such as whether we’re a parliamentary democracy or not.
As a society, we decide which economic and political institutions to adopt, and these institutions shape
much of our behaviour through shaping our incentives.

Incentives, any economist can tell you, are fundamental to understanding any society’s prosperity or
lack thereof.

It’s not economics, stupid. It’s politics

The political institutions, I’d argue, are more important in determining our prosperity. As Acemoglu and
Robinson argue, those who control the political power determine economic institutions.

So, if political power (which in turn determines the political institutions) is controlled by a small,
extractive elite, they will set up economic institutions which benefit them, not the majority.

If the elite benefit from an economy underpinned by clientelism and patronage rather than a well-
functioning competitive economy, they will choose the former.

It is important to remember that there is plenty of profit in poverty. It just happens to be controlled by
few.

Now, look at Pakistan. Our political economy is defined by an embedded culture of rent-seeking and
patronage.

A leaf from history: Shariat Court strikes down land reforms as ‘un-Islamic’

This means we have a system which grants profits to certain players in our economy unfairly, hence
undermining the central principle of efficient market allocation — fair competition — and creating a
wrong set of incentives for businesses.
Our manufacturing sector is rife with examples of rent-seeking practices. For example, Pakistan’s
automobile sector is dominated by a handful of Japanese manufacturers known for selling low-value
cars while making a considerable profit.

Despite this, Pakistan provides them with extensive trade barriers to protect them from foreign
competition. The recent finance bill (since amended) further shows the extent of their political
patronage.

This is not by accident. Because Pakistan’s political power is controlled by an extractive elite, it has
allowed for such political institutions to emerge which permit its government to provide these rents to
certain car manufactures with immunity, even if this negatively impacts our shared prosperity.

Direct evidence of our political structure influencing economic outcomes comes from a paper by Asim
Ijaz Khwaja and Atif Mian.

They show that politically connected firms in Pakistan receive loans from government banks in Pakistan
at lower rates despite defaulting more than non-politically connected firms.

This is evidence of unaccountable political power translating into inefficient economic allocation.

Look at this from another angle. A large amount of economic history literature argues that one of the
many reasons why some East Asian countries prospered in the second half of the 20th century was
because of land reforms.

By undertaking substantial land reforms, these countries were not only to increase agricultural output
but also raise living standards for their surplus labour, which, in the long run, subsidised their move
towards industrialisation.

If land reforms are important for growth, would Pakistan ever adopt them in any meaningful way?
Read next: What Pakistan can learn about tax reforms from developing countries

Despite attempts to do so, Pakistan has not gone through significant land reforms and over 10 million
acres of land still remains under tenancy, while one estimate puts the average farm size in Pakistan at
about six acres.

In South Korea, despite a significant increase in average farm size over the recent past, it still averages at
about 3.5 acres (as of 2005).

Without making a deep dive into the history or merits of land reforms, if we agree for the sake of
argument that more radical land reforms are needed in Pakistan — can we undertake such reforms
when political power and institutions are so highly influenced by those who control large farm holdings?

In other words, if feudal lords control the political institutions, it shouldn’t be a surprise that economic
outcomes will favour them.

To fix the economy, focus on the political discourse

What may seem to a passerby as a country which continues to choose poorly thought-out economic
policies, sees rampant corruption and a failure to establish a productive industrial base, are in fact
symptoms of the political institutional structure which benefits a narrow extractive governing elite at
the cost of everyone else.

Our economic failure is a symptom of our collective political choices. Once we can allocate political
power more fairly, we can make better economic outcomes.

Tweaking institutions at the margins does have some impact. Hence, the IMF’s stabilisation programme
will provide some macroeconomic stability.

Up next: Pakistan will be going to the IMF for the 13th time. Will PTI’s Asad Umar fare better than past
ministers?
The stock market might recover, the fiscal deficit might get narrower. Taxes might increase a bit, so will
inflation.

And, in due course, we will issue a statement saying goodbye to the IMF for few years. Before repeating
the process again and again.

But, if the new government wants to break this cycle and make a sincere attempt at reforming Pakistan
into some sort of an egalitarian, prosperous nation, it needs to start by looking at political power and
the political institutions which rise from them, as they are the real constraints to our growth.

Even if it can make marginal changes on the economic front, they would not unlock the kind of
transformative shift we need for widespread prosperity.

Cure or curse: Our perpetual dependence on the IMF

Danish Hyder | Mushtaq Khan

Updated Jan 17, 2017 08:11pm

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Photo courtesy: dawn.com

Moral of the story first: prolonged interaction breeds complacency and self-interest.

The latest International Monetary Fund (IMF) loan programme for Pakistan concluded in September
2016. It was deemed a success: the country’s economy is doing reasonably well after three years under
it.

The state of the economy, however, may not have much to do with the programme. There is, in fact, a
strong expectation that Pakistan may again seek help from the IMF if its finances become insufficient to
meet its external trade and debt repayment needs.
Our relationship with the Fund (that is, dependency) can be better understood by looking at our past.
The IMF is generally approached for help when a country faces a balance of payments problem.
Although this remains the main reason for Pakistan requesting money from the Fund, the IMF
programmes in Pakistan (and in other countries) since the 1990s have focused more on introducing
comprehensive changes in the structure of the economy than just providing support for hard currency
needs.

There is, in fact, a strong expectation that Pakistan may again seek help from the IMF if its finances
become insufficient.

Since December 1988, Pakistan has had nine separate engagements with the IMF — three of them were
double programmes. That means there have been 12 IMF programmes in Pakistan in the last 28 years.
Only four of them – all initiated in the 2000s and 2010s – were completed successfully; all the rest were
abandoned halfway in the 1990s.

The turning point came in 2000 when Pakistan was facing the possibility of defaulting on its foreign
debts by the end of the year. One should recall that Pakistan had fallen out of favour with the West in
May 1998 (when it conducted nuclear tests) and subsequently in 1999 (due to Pervez Musharraf’s
military coup). Seeking help from the IMF was the only option available to Islamabad in those
circumstances.

This constraint put the government in a situation where it had to accept and abide by the terms and
conditions attached to the loan agreement with the IMF (signed in November 2000 and completed in
September 2001).

Also read: Is Pakistan heading towards a serious debt problem?

A close look at the three remaining completed programmes reveals that two of them were clearly linked
to positive external developments (positive shocks). The three-year programme that started in
December 2001, for instance, was supported by debt rescheduling/write-offs and generous grants by
the United States after 9/11; the three-year Extended Fund Facility programme initiated in November
2013 became irrelevant after the collapse of world oil prices in mid-2014.
The successful completion of an IMF programme, thus, clearly depends on political will within the
government, as well as helpful external developments. This raises a question: what exactly does the IMF
do to ensure the success of its programmes?

Doctor-patient parable

By the IMF’s own acknowledgement in 2002, Pakistan was third in a list of 51 countries described as
“prolonged users” of its financial support. Our peers were the Philippines (#1), Panama (#2), Kenya (#7)
and Argentina (#16). Pakistan continues to rank high on that list.

A parable may help illustrate Pakistan’s complicated relationship with the IMF.

The incentive for a doctor (IMF in this case) to maintain a relationship with a patient (the country
receiving an IMF loan) is pretty straightforward. If the patient fully recovers, the doctor may feel
professionally satisfied but he will also lose a customer.

The IMF was created as a lender of last resort for governments that cannot get a loan from any other
source.

A ‘well-intentioned’ doctor will prescribe bitter medicine and demand behavioural changes – he will not
allow the patient an easy way out – irrespective of the fact that this will lose him a client. A ‘self-serving’
doctor, on the other hand, will yield to the patient’s reluctance to change bad habits and prescribe
milder medication; the doctor will also schedule regular visits to keep administering the palliative.

But after remaining bedridden for almost a decade, why doesn’t the patient (Pakistan) insist on a course
of treatment that actually cures him? In our view, this is because the patient is under the charge of his
aunt (the government). As with the doctor, we also assume the aunt is either well-intentioned (she
wants the patient to recover) or self-serving (she wants to keep the patient weak so that she can
continue living in his house).
Any doctor should be able to see through the motivation of the aunt. But it is not that simple — the
doctor reports to a board which insists that the aunt has the final say (as the guardian of the patient).
The issue is this: why does the doctor continue to treat the patient after eight failed treatments that
have focused on the same illness? Why does the doctor not adopt a tough-love approach? Why does the
aunt not demand a more effective treatment that will show results?

Game theory

Illustration by Essa Malik

Another way to look at this question is using a simplified game theory approach.

In this game, the doctor (the IMF) represents the board while the aunt (the government) represents the
patient (the country). For a regular patient, the game is repeated; the ‘payoffs’ shown are what the two
players (the aunt and the doctor) receive.

Quadrant 1 shows both the doctor and the aunt working for the betterment of the patient. In doing so,
the doctor works himself out of the job.

In Quadrant 2, the doctor is well-intentioned but the aunt refuses a treatment that works. The patient
suffers terribly (call it sovereign default) and the doctor is punished by his board. Both players are
individually hurt in this worst-case scenario.

By the IMF’s own acknowledgement in 2002, Pakistan was third in a list of 51 countries described as
“prolonged users” of its financial support.

Quadrant 3 shows a well-intentioned aunt and a self-serving doctor. The treatment fails but the doctor
is assured of more work. The aunt is disappointed and hurt and the patient continues to suffer.

In Quadrant 4, both the doctor and the aunt are self-serving. The treatment obviously does not work but
this serves the interests of the doctor and the aunt, as both know that another round of treatment will
soon begin.
If the game is repeated and the doctor’s ‘dominant strategy’ is to be self-serving, irrespective of how the
aunt behaves, he is better off playing selfish. If the aunt knows that the doctor will always be self-
serving, she too will gain more from being self-serving. Hence, Quadrant 4 presents a stable equilibrium.

The IMF’s mandate

The IMF was created as a lender of last resort for governments that cannot get a loan from any other
source — they are either on the verge of a sovereign default or have already defaulted. Since Pakistan
often has insufficient dollar reserves, its ongoing relationship with the IMF is not surprising.

Broadly speaking, the reason for failed IMF programmes may be ‘exogenous shocks’ (for example,
unanticipated floods, a sharp increase in oil prices, civil war etc), or a lack of ‘political will’ to make
structural changes in the economy (meaning the unwillingness of the government to implement certain
tax policies), or a combination of the two. As self-serving governments are more common than negative
‘exogenous shocks’, prolonged IMF user countries are highly likely to have governments that lack
political will to change their economic systems.

International Monetary Fund Managing Director Christine Lagarde meets Prime Minister Nawaz Sharif at
PM House | dawn.com

The IMF’s willingness to accept half-hearted implementation of economic changes/reforms creates an

incentive for the governments to show bad faith (that is, to promise changes/reforms they have no
intention, or ability, to implement). Since bad faith (read bad behaviour) makes it more likely that the
country will face a balance of payments problem in the future (which allows the IMF to offer another
loan package), the Fund has to state that the previous programmes failed because of bad luck — which
is to say that the reasons for failure were beyond the control of both the IMF and its client government.
The failure cannot be ascribed to poor programme design/monitoring (by the IMF) or to bad faith
(shown by the government).

The IMF’s inability to learn from the past is rooted in its bureaucratic structure that operates with its
own internal incentives. If the IMF makes future engagement contingent with past performance, it risks
losing its regular clients (prolonged users of its loans). This will reduce the IMF’s workload and a reduced
workload will require a reduced workforce — all this goes against the mindset of a well-entrenched
bureaucracy.
The IMF is, therefore, willing to return to countries even if they engineer their own problems. It cannot
cite the lack of political will (by the government) as a reason for the failure of a loan programme, as an
admission of bad faith will reveal poor operational practices within the IMF as well. The Fund, thus,
remains ‘apolitical’, even though the hindrances to real economic reforms are always political.

Keen observers of the IMF are of the view that the institution is also a source of foreign policy leverage
for the United States of America (which is the only member of its Executive Board with a veto). Having
the final say on whether a country defaults on its external payments is a powerful position to be in.

The IMF’s willingness to accept half-hearted implementation of economic changes/reforms creates an

incentive for the governments to show bad faith.

America does, at times, use its leverage to influence a country’s policy decisions. For instance, the IMF
was very eager to support Pakistan’s economy immediately after 9/11; local media characterised the
December 2001 IMF loan package – known as the Poverty Reduction and Growth Facility (PRGF) – as a
reward for Pakistan’s joining of the American War on Terror. Although this programme became
irrelevant after positive financial conditions prevailed for Pakistan post-9/11, the IMF was still
enthusiastic about its ‘successful’ completion in late 2004 when Pakistan was in the midst of a credit-led
consumer boom.

Pakistan’s outlook

Despite misgivings about falling exports and a slowdown in remittances, the outlook for Pakistan’s
economy is upbeat. Even while direct tax collection perpetually misses its annual target, low interest
rates have eased the cost of domestic debt servicing for the government, which has kept its fiscal
accounts manageable. The financial space created by low oil prices is also likely to continue till 2020,
which should keep annual inflation in the range of 4-6 per cent.

Another positive is the China-Pakistan Economic Corridor (CPEC). Although it raises many unanswered
questions, the CPEC factors prominently in the bullish sentiments that many businessmen in Pakistan
express. The booming stock market should help attract portfolio inflows in Fiscal Year 2016-17 and the
foreign direct investment for CPEC-related projects should also help the external sector.
As we have discussed in a previous note (CPEC: The devil is not in the details), the CPEC cannot be
allowed to fail — its failure would undermine China’s economic strategy for the 21st century. Just
partnering with China, in this scenario, appears to be sufficient to promise a sustainable economic
growth trajectory for Pakistan.

The Chinese flag flies next to Pakistan's flag on a sign along a road towards Gwadar | Syed Raza Hassan,
Reuters

Conclusion Reforming a country’s economy is not just about changing policies or issuing official circulars.
It is not even about securing parliamentary approval for sensitive policy change. Structural reforms are
about changing people’s behaviour, especially the behaviour of those who feel political power gives
them a licence to extract resources for personal gain. Changing such behaviour is not easy and this is
why structural reforms are notoriously difficult to implement.

As we have argued, prolonged interaction between a government and the IMF can lead to second-best
outcomes. Pakistan must now approach economic reforms with a completely different mindset if it
wants to end its decades-long relationship with the IMF.

The CPEC may be a new character in our doctor-patient parable. If the CPEC is a no-nonsense ‘doctor’
who is able to help the patient become healthy enough to partner with China, the IMF programme that
ended in late 2016 may be the last that Pakistan has.