Inflation, debt and ML-1 – Newspaper

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THE interim government is working hard in all economic areas. Resuscitation efforts include reviving the Karachi to Peshawar (ML-1) railway line, a project to be supplied and financed by China at a cost of $6.7 billion that will reduce travel time between these two cities to 6 p.m.

Assuming an interest rate of three percent, insurance costs of 2% and a payback period of twenty years, the annual payments amount to $530 million. The question our government must ask itself: can we afford such expenditure in foreign currency at this time? Shouldn’t we consider a cheaper solution by purchasing a $150 million new signaling system that will increase average train speed and track capacity by 20%?

(A digression: our railway ministry, like PIA, is akin to a black hole where all the money poured in is lost forever and we never get anything back. But that is not the argument I am developing here).

A mistake our governments have made over the years is not to determine foreign exchange or the external viability of projects and policies. So, for example, we build power plants or bridges with foreign loans, but without examining whether that particular project is feasible only in terms of rupees or will also generate (directly or indirectly) enough foreign exchange to service the debt. Or if we implement a policy that, for example, gives a tax exemption to a sector, we do not take into account what effect that policy will have on the foreign exchange. Ignoring external viability has led us to pursue policies and projects over the years that have resulted in foreign debt and liabilities of $125 billion, with little to show for it in terms of foreign revenues.

Can we afford such expenditure for a new railway at this time?

For example, the amnesty granted to the real estate sector in 2020 allowed real estate magnates to park their tax-evaded billions in real estate and construction. However, the government never analyzed what would happen to the current account deficit, as money going to real estate and construction would lead to more imports and have a negative impact on exports. The impact on tax revenues or on the manufacturing sector that exports and pays higher taxes was also not taken into account. The government wanted to stimulate growth at all costs and has pushed our imports to unsustainable levels by 2021.

Also consider: between 2013 and 2018, when we doubled our electricity production capacity, did we examine whether these projects were externally viable, given that an overwhelming part of our electricity is used in homes and little for industrial production? Or have we implemented policies that made them viable? Due to a fixed exchange rate policy in those years, our exports fell from 13.8% of total national production to 8.9%, our import bill skyrocketed and today we face difficulties paying for those factories.

Similar mistakes have been made throughout history, with successive governments failing to consider the long-term consequences of policies, and these ill-conceived policies have come back to haunt us again and again. Today our government is struggling with enormous domestic and foreign debts. Since the passage of the seventh NFC Award, another misguided policy, the federal government’s deficits have increased exponentially and this year the federal government’s net revenue, after paying the provinces, will be less than the interest we have to pay on the debts. So we even borrow to pay the interest.

Because of this unfavorable situation, our governments must scramble to borrow dollars to pay off our foreign debts and the State Bank must create new money, by purchasing bank securities, to finance the federal government’s insatiable appetite for debt.

This money creation is of course the main reason we have experienced so much inflation and devaluation. To add to our misery, we are also seeing virtually no growth in an economy where more than 2.5 million new people enter the workforce every year.

The current government is aware of these problems. However, it appears that the country is trying to stimulate growth as a way out of these problems. This, I think, is a mistake – a mistake we have often made as a solution to our problems.

The current situation does not call for pursuing rapid growth, but first reducing inflation. The most effective monetary tool the State Bank has to reduce inflation is to increase the policy rate – the interest rate at which it lends money to banks. An increase in the policy rate forces a decrease in demand for goods and services, which reduces inflation. The high policy rates we have today have largely suppressed private sector demand, dampening inflation.

But our dilemma is that today all new credit goes to the federal government, while credit to the private sector is actually shrinking. When the State Bank increases interest rates, it also increases the cost of servicing the federal government’s debt. But instead of cutting spending or increasing revenues – which is not possible in the short term – the government just borrows more, forcing the State Bank to print more money. The resulting increase in the money supply causes more inflation.

The economy is in a Catch-22 situation where the tightening monetary policy of the State Bank is swamped by the expansionary fiscal policy of the federal government, caused by the large budget deficit.

While there are no easy solutions, in my opinion the best course for administrators is to reduce expenditures on the Public Sector Development Program and the Provincial Annual Development Program on an emergency basis to reduce the overall federal and provincial deficit. Once the deficit is reduced, monetary policy will become more effective and inflation will come under control.

However, until we consolidate our fiscal position, we should only pursue growth through investments that result in exports. For the time being, we should not pursue investments aimed at selling to domestic consumers.

That’s why we have to postpone the ML-1 project for a few years. Right now it would be like buying a corporate jet for the CEO of a loss-making company with a lot of debt. The airplane may be convenient for business managers, but it is not a luxury the company can afford. In the same way, we can’t afford the new railway.

The writer is a former finance minister.

Published in Dawn, November 5, 2023

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