Inflation in Pakistan,

its causes and its remedies.Introduction:

According to official statistics, price inflation in Pakistan, as measured by the consumer price index (CPI), remained on average 11.1% per annum between 1990-91 and 1995-96 but more than 20% as believed by most of the economists. Price inflation, defined as the persistent rise in general price level in a country, may be described as creeping, running or galloping depending on its pace of rise in a country. Inflation in Pakistan has entered into the regime of ‘running inflation’ intimating to the managers of the economy the seriousness of unmanageable feature of macro-economics variables in the country.

Several studies have been conducted to explore the causes of inflation during the 1990’s. Generally, monetary growth, public policy, administered prices, rise in the prices of imported goods, inflationary expectations and output growth are termed as the determinants of inflation in Pakistan. However, their actual contribution towards inflation is debatable. One group of economists considers inflation a monetary phenomenon, while the other assigns more weightage to rise in administered prices and increase in prices of imported goods as determinants of inflation. Overall, host of factors from both the demand and supply side are responsible for the recent price spiral in

Pakistan. The following is a brief review of the factors responsible for inflation during this period.

Causes of Inflation :

The GDP growth has a significant dampening effect on inflation. Pakistan’s GDP has grown at an average rate of more than 6% per annum during the last decade. During the first half of 1990, however, the growth rate remained at an average of 4% per annum which may be attributable to the transition of economy from greater government role to the private sector, inefficiency of public sector enterprises, lower production in large scale manufacturing, poor agriculture sector performance and distortionary public policies. Most public sector enterprises have become inefficient and have been incurring losses for several years. More than 4000 industrial units in the private sector are ‘sick’ due to which performance of the manufacturing sector is poor for the last few years and recorded a negative growth of 1.4% this year. The agricultural sector, which contributes 26% to the GDP also exhibited vulnerability during the last five years’ period. This sector recorded a meager growth of 2.5% per annum during last five years which is even lower than 3.0% population growth rate. The effect of poor agriculture growth is also evident from the fact that ‘food group (weight 49.35%), in CPI recorded 107% inflation from 1990-91 to May, 1997 as compared with overall inflation of 97.57% and non-food inflation of 88.0% during the same period. Furthermore, the country faced a severe wheat shortage this year due to lower than targeted production of wheat in the country, delay in its import and failure of responsible authorities in its prompt distribution in different areas of the country.

As far as administered prices are concerned the government increased the procurement price of wheat, gram, rice, sugarcane, e.t.c. This year in the range of 10% to 40% to give impetus to the production of these crops. Actual quantities of these crops will come into the market with the time lag of at least 6 months. Prices, however, increased soon after the government’s announcement. Distortionary public policy towards agriculture sector in the past has put us into the situation that, Pakistan, an agricultural country, is bound to import wheat, milk, cooking oil, pulses, meat e.t.c to the tune of $2.0 billion annually. Solution of half of trade deficit problem of the country hinges in self-sufficiency in agricultural production. Similarly, the index of fuel, lighting and lubricants in CPI, which comprises electricity gas and POL products increased 19% during the year from end June, 96 to May, 97 and 98.59% from 1990-91 to May 1997 which caused rise in cost of production and transportation cost. One reason for rise in the prices of POL products in the country is price-hike of POL in the international market determined by demand and supply forces. The other one is the frequent devaluation of domestic currency which is controllable by better economic management in the country. Almost every increase in administered prices adds more and more grieves, miseries and hardships to the consumer life.

Increases in the world price of imports in the world market and a 40% devaluation/depreciation in the Pakistani rupee from January 1991 to June 1997 fuelled inflation to unmanageable levels. Without removing the causes of devaluation , we are lowering the value of our currency to make our commodities competitive. As devaluation fuel inflation, it

becomes necessary to devalue further to keep our market competitiveness intact. This has put the Pakistani rupee in a devaluation spiral.

Large and persistent levels of trade and current account deficits due to stagnant exports and high level of imports is posting several implication for inflation. More than 60% of our exports consist of cotton and cotton-based products which are facing cut throat competition in the world market. Our major imports are machinery, chemicals and oil which registered a faster growth in price in international market due to the monopolies created by the developed countries.

The tax to GDP ratio in Pakistan is only 13 to 14%, leaving the government short of funds to run the machinery of the government. The government has to resort to debt financing, money financing and financing from external sources which put upward pressures of different magnitudes on the price level.

The ratio of indirect to total tax revenues in Pakistan is more than 70%. It has been the practice of all governments from past to present to tap revenues from indirect taxes, due to which inflation in the country has reached a very high level. The debt burden of Pakistan is almost equal to GDP, which has made budget making a very unpleasant task for the government every year. The government has to borrow to service the existing debt. Due to this, the debt pool is inflating day by day. As getting unlimited funds from abroad is not possible (although least inflationary in nature) the government has to resort to note printing which fuels inflation severely.

Borrowing from the banking and non-banking sector also has its limitations. The government has to compete with the private sector and offer attractive rates of return on its securities. The government is offering more than a 17% rate of return on its securities leaving banks in a liquidity crunch and putting upward pressure on the lending rate to the private sector. In the wake of a high lending rate the revival of the economy is looking difficult.

Consequences Of Inflation: During an Inflationary period it becomes very difficult for the government to fulfill its commitments of achieving macro economics targets. Almost all targets, such as GDP growth, price inflation, bank borrowing, trade deficit and budget deficit are violated. This hurts the credibility of the government. Costs of development project and non-development expenditure increase due to which the government needs more funds next year by the amount of inflation to keep economic activity at the level of previous year.

A low saying rate in the country is also one of the causes of rising inflation. In the wake of 14% inflation and an average 10% deposit rates, depositors are getting negative real rates of return on their deposits. Income of the individuals is being diverted from saving to consumption and non-productive channels like purchase of real estate and conspicuous consumption leaving saving at a very low level of 11% in the country.

Redistribution of income takes place during an inflationary regime. Resources are moving from lender to borrower. As in the case of Pakistan, lenders are small deposit holders and borrowers the rich elite. Double digit inflation is aggravating the already high inequality between the rich and the poor.

A kind of rent seeking culture develops due to inflation where the businessman earns lucrative profits by trading existing production. This provides a disincentive for him to be involved in the production process. An entrepreneurial culture cannot develop in this situation. Trading further raises the price level by manipulation of the market through hoarding and black-marketing by the rent seekers while production eases the upward pressure on price level in an economy.

As inflation is a regressive tax on fixed and low income groups, it can cause anxiety, unrest and many other social problems in the country.

Dollarisation; as defined by the ratio of foreign currency deposits to total monetary assets (M2), takes place due to the decline in the value of domestic currency. This process never reverses until or unless the value of the local currency is not restored as is evident from the study of transitional economics of the socialist block and other developing countries. Foreign currency deposits in Pakistan have reached the $9.4 billion mark since their inception in 1992 to date acting as a hanging sword on the head of the government. Inflation expedites this trend further.

Devaluation is also one of the consequences of inflation. Due to double digit inflation

Pakistan has been caught in the vicious circle of devaluation (devaluation inflation loss of competitiveness again devaluation).

As a result of inflation real money balances (M/P) decline and we need more money to exchange the same quantity of goods and services. This puts pressure on the printing press to print more and more currency notes to meet the requirement. This is the extra cost attached to inflation.

Inflation Pressure On The EconomyThere has been a significant rise in inflation mainly caused by supply shocks of essential food items and higher crude oil prices in the international market. Some essential items like wheat and meat has witnessed considerable increase during the outgoing fiscal year (2003-2004) mainly spearheaded by supply shocks caused by misadministration and hoarding (rather than actual supply shocks). Even after the stabilization of food items supply, the inflation caused 4% ending with 4.6% surge in price level during 2003-2004. Some prophets of doom and gloom gave an impression that price level is sky rocketing, and the economy would crumble in near future. However, that’s not the case. Some analysts were also of the opinion that inflation would accentuate macroeconomic imbalance and will hurt the poor and the fixed income groups. Some went to the extent of linking recent surge in inflation to imminent rise in the poverty level.

The recent surge in inflation is a global phenomenon and cannot be viewed in isolation. Normally inflation is the by product of economic growth and economist term it as greasing factor that is necessary for

economy to move at a brisk pace. There are always some sort of trade-offs between employment and inflation. The inflation is an integral part of economic activity and it is unavoidable. Higher growth is essentially associated with higher inflation. The economic policy can only influence one part of the inflation while other part is out of the purview of such a policy. For example higher oil prices in the international market are out of the purview of the economic policy making and food supplies are driven by the performance of volatile agriculture sector. The government can hardly influence the performance of the agriculture sector. Core inflation is the true representative of the influence of the economic policy on inflation.

As far as inflation is concerned, Pakistan is comfortably placed in the camp of developing countries since the last three years. It is a misconception that the statistics released by the government do not fully translate the on ground realities (although it is true that inflation in real terms is much higher in the economy than reported by the government). Generally, people take decrease in inflation rate as decrease in prices of most items but in fact it might represent the declaration of the pace of increase in price level.

It is common to criticize statistics provided by the government without going into proper analytical assessment. As a matter of fact the government statistics are based on internationally recognized methodology of collection and processing of information. These methods, in fact are being practiced in both the developed and developing world in general.

In Pakistan, like most of world economies, the term inflation is generally referred to the upward movement in Consumer Price Index (CPI). The CPI index in Pakistan is based on a basket of 374 consumer items selected on the basis of a Family Budget Survey conducted by Federal Bureau of statistics in 2000-2001. Its objective is to measure the change in cost of living due to changing prices of consumer items. The consumer items are distributed in 10 groups of basket of goods and services. The weight of an item represents the share of expenditure of an average family on the specific item. The CPI is compiled by FBS (Family Budget Survey) on the basis of monthly surveys. Its coverage includes 35 major cities/urban centres across the country. While, all the urban centres have been categorized into four groups by size of population ranging from mega cities to urban areas with less than fifty thousand population. The selection of these urban centres has been made in such a way that ensures geographical and regional representation of all the areas of the country. Each month, more than 100,000 prices are collected on the basis of a stratified random sample covering four markets in these 35 cities. Price quotations are collected for each of the 375 items from different shops in each market.

TABLE-1: INFLATION (HISTORICAL TREND) Year Inflation (%) 1950s 3.0 1960s 3.2 1970s 12.5 1980s 7.2 1990-97 11.4 1997-2002 7.8 2002-03 3.1 2003-04 4.6

The stereotype thinking about statistics provided by the government has a historical background. Pakistanis are traditionally accustomed to low inflation (see table-1). Only twice in the country’s history of five decades we touched double-digit inflation as far as average for decades is concerned. The inflationary pressure persisted in the early 1990s due to monetary overhang combined with shortage of essential commodities continued until 1996-97 and the average for the first seven years (1990-97) of the 1990s averaged at 11.4 % but continued its declining trend thereafter. It declined to 7.8 % in 1997-98 and further to 5.7 % in 1998-99. In 2002-03 it reached to 3.1 %, which is lowest ever since 1969. Improved availability of agriculture and food products has kept a firm check on the prices of milk, wheat, rice, beef, mutton and poultry meat. The trend of declaration could not sustain during the outgoing fiscal year and during 2003-04 CPI.

Moved up by 4.6 % against a target of 4.0% and actual achievement of 3.1 % last year. The main reason was the shortage of wheat in some parts of the country.

Another important contributor to the inflation was higher oil prices in the international market. The Oil Advisory Committee has already passed on major portion of the oil price-hike to the consumers. The oil price-hike is an international phenomenon beyond the control of the government.

The table-2 clearly implies that the inflation in Pakistan is modest as compared to other developing countries. Pakistan’s inflation rate of 4.6% during the outgoing fiscal year is far below that 1998-99 level. No government in the world can be comfortable with soaring prices but in modern growth centric economic policy making, inflation is unprecedented and any forceful containment of inflation often caused slowdown in growth and rise in unemployment. The government of Pakistan is applying stringent and prudent policy measures to keep a check on inflation.

TABLE-2: INFLATION (A COMPARISON) Countries CPI inflation (%) 2003-04 Bangladesh 5.1 India 5.0 Egypt 5.2 Mexico 4.3 Philippines 3.9 Iran 16.0 Turkey 12.0 Sri Lanka 6.0 Pakistan 4.6 India 5.0

The government must tolerate around 5% inflation to reach above 6.5% growth during 2004-2005. The government should be vigilant about food supplies and restrict State Bank Of Pakistan from doing any unreasonable like upward adjustment of interest rates. This might hamper the current growth momentum in the economy.

Remedies: A persistent high level of monetary growth should never be compromised to maintain stability in the external value of currency and to control inflation effectively. The major factor towards excessive monetary growth in the case of Pakistan is high government borrowing as compared to the stipulated credit allocation in the credit plan. This leaves less room for the private sector which is considered more productive as compared to public sector. The Central Bank should not act as the printing press for the government’s finance ministry. For example during 1996-97 the government of Pakistan has taken more than Rs. 80 billion in credit as compared to revised target of Rs. 61 billion from the total domestic credit expansion of Rs. 136 billion. Unlimited injection of credit into the economy will aggravate the already uncontrollable inflation in the country. Quick and transparent privatization of government sector enterprises and use of privatization proceeds towards debt retirement will ease the government’s position by reducing the amount of debt servicing. It will also lower the government’s budget deficit by the amount of losses incurred by these units.

Down-sizing the budget deficit by cutting administrative expenditures and through increases in revenues by broadening the tax base. The government should consult that group of privileged people who is not contributing to government exchequer currently so that it does not have to resort to increasing administered prices to get extra revenue.

Inflation in Pakistan is hard to control efficiently and quickly without enhancement of agricultural production. There is need to provide credit to small farmers. His weak financial position and skill level prevent him from employing modern equipment and inputs to his farm. It is no easy task for small farmers in Pakistan to obtain credit. It is possible only after several visits to the bank and after paying some percentage of the loan to mobile credit officer (MCO) or to other officials. This increases the effective rate of return and multiplies his miseries.

Banks are unable to offer a positive real rate of return to depositors in Pakistan due to huge intermediation costs and stuck up loans. Implementation of recently approved laws by the parliament will help cure this situation. Process of privatization of the nationalized commercial banks (NCBs) should be speeded up keeping in view the transparency of this process.

As a long-term policy measure , human capital must be equipped with skill and knowledge to enhance its productivity and efficiency and ultimately tame inflation. The standard of living and the level of education has a strong bearing on population growth and other matters of social and economic well-being. Autonomy granted to State Bank Of Pakistan is also a right step towards financial soundness and the restoration of the value of currency. Performance of the State Bank Of Pakistan hinges on the success of recovery drive , controlling monetary expansion to public sector for budgetary support and reducing the lending rate by lowering the intermediation cost of the banking system.

Conclusion: Consensus has developed among the economists that the inflation and output growth are negatively correlated specially at the level of double-digit inflation. An unclear trade-off between inflation and unemployment at a very low level of inflation of 3 to 4% is also identified. On the basis of these findings a low inflation of 2 to 3% is desirable. It can be achieved through curtailment of monetary expansion, lowering budget deficit, promoting efficiency by education and skill, enhancing agriculture production through research and credit availability, promoting national savings by offering positive rate of return on deposits and identifying profitable avenues of investment and revival of the economy by solving the problems of sick industrial units and quick and transparent privatization of public sector enterprises.

The End