The Pakistan economy has been in a crisis for the last several years. Even the Supreme Court of Pakistan chose to justify its approval of the military takeover by referring to the crisis in the economy. Gen. Musharraf again cited the economic crisis to justify his support to the American military intervention in Afghanistan.

The Pakistani economy had experienced high rates of growth in the 80s, when we in India were stuck with our Hindu rate of growth. Pakistan’s per capita income in the early 1990s was about 25% higher than India (close to $500 per head compared to India’s $390). The average Pakistani was and is better fed and clothed than an Indian. While 52% of India’s population in 1992 was below $1 a day income only 11% of Pakistan's was below this poverty line. Pakistan has roughly 2 million migrant workers, roughly equal to the Indians working in the Middle East. What then is the cause of this crisis which has forced Pakistan to crawl before the IMF, not once but thrice during the last decade?

This paper looks at the evolution of Pakistan’s economic policies and growth record during the last 25 years. As the highest growth was attained during the Zia era, a considerable part of our analysis looks at the factors that lay behind this phenomenal growth record. The period after Zia’s death is analysed to understand the eruption of the balance of payments and fiscal crisis. The continuing crisis despite the better IMF medicine and its accentuation after the nuclear explosion, lie behind Musharraf’s justification for intervention. The concluding part looks at the possibility of mitigating the crisis after joining the American camp in the war against the Taliban.

Section I below looks at the economic policies during the Ziaul Haq regime and its growing dependence on foreign savings. Section II analyzes the crisis of the 1990s and the pressure from the IMF that forced the so-called democratic regimes to impose an unprecedented burden on the people of Pakistan in an era of declining foreign aid and remittances. The accentuation of the crisis after the nuclear explosion in 1998 is also delineated. The options before Gen. Musharraf and his finance minister Shaukat Aziz are discussed in Section III.

On the first impression the structure of the Pakistani economy looks disarmingly like India’s economy. The structure of its output is amazingly similar with the industrial sector in both the countries being 27% of GDP, and its service sector marginally larger than India’s. In both countries, the agricultural sector’s share in output has fallen below 30 per cent.

To understand this period of high growth followed by a decade long decline and re-current crisis, it is necessary to go back to the era of Ziaul Haq, who ruled Pakistan for a decade or more and fundamentally changed its economy and society. The islamisation of the society and the rise of fundamentalist social groups is well-known and partly explains the political and social crisis that has bedeviled Pakistan in the 1990s. What is less appreciated is how Ziaul Haq also changed the structure of the economy. He moved away from the populist policies of Bhutto, who stressed the importance of the state and the public sector in economic policy, and used foreign aid and remittances to make Pakistan heavily dependent on the continuous receipt of savings from abroad.

To appreciate the factors behind the current crisis, we need to go back to growth and development strategy under Ziaul Haq, when the Pakistani economy grew at rates far higher than India’s. While the Indian economy in the 1980s grew at 5.5% per annum the Pakistani economy grew at about 7% per annum. Its agriculture expanded at twice the rate in India, thanks to the completion of two large dams and irrigation projects.

Ziaul Haq came to power overthrowing Zulfikar Ali Bhutto in 1977 and imposed marshal law. The military intervention came after strong public protest against Bhutto, which started in the wake of alleged irregularities in the election held in March 1977. Zia’s takeover was with the declared purpose of resolving the impasse between Bhutto’s People’s Party and the combined opposition with a promise to hold free and fair elections within 90 days. Bhutto’s continuing popularity and the fear that his return to power through free elections could unleash a vendetta against the top military leadership, prompted Zia and his colleagues to postpone elections. Zia used the Lahore High Court judgement finding Bhutto guilty of complicity in the murder of a political opponent in March 1978 to imprison Bhutto and its endorsement by the Supreme Court helped Zia order his execution in April, 1979. This set the stage for a long military rule, which ended only with Zia’s sudden death in a mysterious air-crash in August 1988.

After Bhutto’s elimination, Zia’s legitimacy was at a low ebb and he was under pressure from the western governments to restore parliamentary democracy. However, the Soviet invasion of Afghanistan in December, 1979 gave a new lease of life to the Zia regime as it softened the internal and external pressure for broader political participation. Zia finally ordered elections on a non-party basis in March 1985, after amending the constitution that substantially increased the powers of the President. Following the elections, Zia picked Muhammad Khan Junejo as the prime minister. But Junejo’s assertion of authority led to a conflict with Zia and his government was dismissed in 1988.

Zia’s long rule fundamentally changed the Pakistan economy and society. Firstly, Zia used his efforts to Islamize society to broaden his political support. Secondly, the Soviet occupation of Afghanistan and Zia’s highly successful efforts to mobilise and coordinate large external assistance for the mujahedins from diverse sources such as the USA and Saudi Arabia, increased his political standing and control after 1980. Third, Zia extended the role of the army in governance through extensive use of military intelligence, appointment of senior officers to key positions in public administration and dispensation of patronage to the armed forces, thus creating a strong vested interest for the army in continuation of his regime. But all these would have been insufficient to hold power for more than a decade, specially since the Pakistani army stood accused of atrocities in East Pakistan and the ultimate creation of Bangladesh as a independent nation. What helped him most was a period of high and sustained rate of economic growth and a dramatic fall in absolute poverty. The economy expanded by nearly 6.6% per annum with moderate inflation. This growth was broadly shared amongst different segments of the population with increases in real wages in urban and rural areas, which resulted in a decline in poverty.

The Pakistani economy under Zia benefited from a number of special factors, both domestic and external. The completion of the long gestation period Indus Basin Tarbela Dam helped unleash an unprecedented agricultural growth, while fertilizer and cement investments undertaken under Bhutto contributed to the industrial growth. Yet this would not have been sufficient for the high rates of growth or reduced the pressure on Zia to raise resources for investment. A tremendous boost to economic activity was provided by rising worker remittances, which rose to a peak of US $3 billion in 1982-83. In 1982-83, these remittances were equivalent to 10% of the gross national product of Pakistan. Zia also successfully negotiated with USA for larger external assistance, unprecedented in the history of Pakistan. In addition to direct assistance to Pakistan, the United States and allies funneled about US $5-7 billion to the Afghan Mujahedins through Pakistan, providing further boost to the local economy. Similarly, the narcotic trade which gathered momentum in the 1980s strongly supported the service sector of the economy.

Unlike Ayub, Zia did not have a clear long-term vision about the economic future nor a long-term strategy. He left the day-to-day management of the economy to his Finance Minister Ghulam Ishaq Khan. Khan abandoned Bhutto’s strategy of increasing state intervention and public sector investment. The economic policies became market oriented. Buoyant remittances and aid eased the foreign exchange constraints on the economy. This helped Zia-Khan to move to a flexible exchange rate regime, improving the incentives for exports. The loosening of the controls also led to a surge in private investments (which had fallen sharply during Bhutto) both for agriculture and industry.

In 1977, Pakistan’s GDP was only US $15 billion. The increase in remittances to $2-3 billion over the next few years served as a powerful source of economic expansion, providing strong support to the balance of payments. In the first half of the 1980s workers remittances exceeded the total earnings from merchandise exports.

Unfortunately, the workers' remittances boom did not translate into higher rates of national savings and investments. Most of the remittances were directed to consumption and this played a major role in reducing poverty.

Not withstanding the substantial additional taxation imposed in 1979-80 and 1986-87, fiscal policy had only limited success in increasing the proportion of GDP mobilised through tax revenue from 11.9% in 1976-77 to 13.3% in 1987-88. As a result, public savings remained negative and fiscal deficits persisted at a high level.

Agricultural growth increased to 4 per cent per annum from a dismal 2 per cent during 1972-77, and played an important role in accelerating GDP growth in the Zia era. Many factors contributed to this. Production during the Bhutto years had been adversely affected by exceptionally poor weather, both droughts and floods. The additional water availability from Tarbela Dam after 1976 of nearly 10 million acres feet augmented irrigation water supply by more than 10 per cent. Domestic fertilizer production of nitrogenous fertilizer nearly trebled during the first half of 1980s. The use of fertilizer per hectare increased from 30 kg. in the mid 1970s to 80 kg. by the mid 80s. The increase in support prices for wheat and cotton improved agriculture incentives. Livestock sector too expanded and grew by more than 5.5 per cent in 1980s, thanks to the increasing demand for milk, meat and poultry. The share of livestock in total agricultural sector increased from 26% in 1980-81 to 32 per cent in 1994-95.

The expansion of the industrial sector under Zia was equally impressive. Manufacturing sector growth during 1977-88 was over 9% per annum (Table-1) and compared very favourably with a growth of 3.7% during 1972-77. Several factors explain this rapid industrial expansion. First, the large public sector investment, which started under Bhutto and continued in the early Zia period, resulted in major increase in steel, cement, fertilizer and vehicle production. The public sector steel mill started production in 1982 and reached a high capacity utilization by 1984-85. Second, incentives for manufactures goods exports were strengthened by the introduction of a flexible exchange rate policy in 1982, and by increasing the rebates of custom duty and sales tax for exports by the introduction of direct export subsidies in 1978-79. Manufactured export grew by 13 per cent per annum in the 1980s. Third, the investment climate for the private sector was improved by providing guarantees against future nationalisation and tax concessions. Few enterprises nationalized by Bhutto were handed back to the former owners and licensing and investment controls were relaxed by raising the limit for units not requiring any sanction from Rs. 60 million to Rs. 300 million in 1984 and further to Rs. 500 million in 1987. As a result of this the private sector investment in manufacturing grew by 9.5 percent per annum during 1978-83 and accelerated further in the last five years of Zia regime. The private sector share in the new industrial investment by 1988 had risen to over 90 per cent in contrast to about 25 per cent in 1976-77.

The revival of the private industrial investment helped to expand the capacity in the traditional industries like cotton textiles and cement. The rapid growth of raw cotton production, thanks to the improved irrigation, gave fresh impetus to textile production specially cotton yarn production. Like India, the cloth production was moving out of the large mill sector towards decentralised power looms. Pakistan soon emerged as a major exporter of cotton yarn, with the 1989-90 yarn exports exceeding the cloth by more than 50 per cent. Export of cotton goods fuelled the manufacture export boom of the 1980s with over 60 per cent of the increase in the value of exports attributable to cotton, cotton textiles and garment export. The share of cotton and cotton goods export in the total export of Pakistan increased sharply from 40 per cent in 1979-80 to 60 per cent in 1989-90. The gradual depreciation of the Pakistani rupee from Rs. 9.9 per dollar in 1981 to Rs. 18 per dollar by 1988 provided valuable incentive to the exporter.

Despite the boom in manufacturing and exports the industrial sector in Pakistan suffered from many weaknesses. The industrial development was constrained by the small size of the home market, particularly after the creation of Bangladesh. The industrial sector in Pakistan remained rather narrow and undiversified. Even in 1990-91, more than 40 per cent of the industrial value added was contributed by food and textiles. The share of industries which were exclusively based on indigenous raw materials, still accounted for 60 per cent of value added. The removal of quantitative restrictions on imports along with the reduction in import tariff on raw materials and intermediate goods during the 1980s led to some diversification of manufacturing output. However, the reduction in import barriers undermined the import substitution strategy of industrialisation in Pakistan.

The high economic growth during the Zia period was not accompanied by a rapid rise in investment. Gross fixed capital formation as a percentage of GDP was about 17 per cent during 1977-88, marginally below the level of Bhutto era. How was it possible to obtain a growth of 7 per cent per annum with a relatively modest investment rate? Was Pakistan extraordinarily efficient in the use of capital resources?

To some extent the pattern of growth in Pakistan, specially the expansion in the service sector which requires lower investment levels, lowered the capital-output ratios and pushed up the growth rate. Some argue that the shift in the industrial investment from public to private also may have contributed to some gain in efficiency (Hasan; 1998). However, Zia also reaped the fruits of large investment in long gestation projects made by Bhutto. Despite all these, there is no doubt that the investment level under Zia was inadequate in relation to both current needs and future requirements. Serious shortages of infrastructure, specially energy, transport and urban development had already developed by the mid 1980s. Unlike Bhutto Zia left no large-scale project under implementation.

The low rate of investment during 1980s was due to the failure to mobilise sufficient domestic resources in the public sector. Despite the massive increase in the workers’ remittances, the national saving rate only moved up marginally to about 14 per cent of GDP (Table 3). It appears that while private savings increased, public savings declined during the Zia era. The domestic savings (excluding workers’ remittances) declined to about 6 per cent of GNP by 1980 or financed only about 40 per cent of gross domestic investment.

The fiscal crisis that gripped the economy in the latter half of Zia era can be largely explained by the surge in military expenditure. In nominal terms, the military expenditure rose from Rs. 8 billion (or 5.4 per cent of GDP) in 1976-77 to Rs. 47 billion by 1987-88 (7 per cent of GDP). Combined with the major increase in the size of the economy, this meant a growth in real defence spending of over 160 per cent or more than 9 per cent per annum. This rate of growth in military spending was faster than any other period in Pakistan history.

* Defined as current account balances before official transfers
** National savings are derived as residue

Table 4: Pakistan: Pattern of Public Expenditures (selected years)
Rs. in billion (Figures in parenthesis give percentage of GDP at market prices)

Zia justified this increase in military spending on the ground of the Soviet occupation of Afghanistan. He also increased the salaries and privileges of the armed forces that emerged as an important constituency of support to his regime. Combined with an increase in debt burden and increasing interest, the outlay on development was squeezed. This militarisation of the economy disturbed the balance between defence and public sector development outlay, which increased only at 3-3.2 per cent per annum as a percentage of GDP. Public development expenditure declined from about 10 per cent in 1976-77 to 6.9 per cent by 1987-88. At the beginning of Zia’s rule, the public sector development outlay had been nearly double the level of defence spending. A decade later the defence spending was as large as development outlay. A part of the increase in military spending was related to liberal benefits and amenities for military personnel. Similarly, the enormous increase in domestic debt which rose from Rs. 58 billion in 1981 to Rs. 290 billion in 1988 and further to Rs. 900 billion in 1996, led to a sharp increase a interest payments. During the Zia era the interest payments from the government budget increased eight times (Rs. 4 billion to Rs. 32 billion).

Ghulam Ishaq’s efforts to impose heavy taxation in 1979 met strong public resistance and were soon abandoned. The government shifted to large-scale borrowing at the end of the Zia regime. The unsustainability of large fiscal deficits and growing domestic debt undermined future growth and monetary stability.

Despite the shortcomings, rising incomes and increasing transfer payments, thanks to the remittances from workers, led to a sharp reduction in poverty. Real wages in agricultural industry rose rapidly and outward migration helped urban wages to rise.

As a strategy of emphasis on Islamic values and code of conduct, Zia announced a plan for an Islamic economic system in 1980. He institutionalised zakat and introduced interest-free banking. Zakat is one of the pillars of Islam according to which well-to-do muslims are required to distribute two and half per cent of their wealth annually. Under Zia’s zakat ordinance, the financial assets in the banking system and saving instruments were subject to 2.5 per cent deduction annually. By 1988, this provided Rs. 2.5 billion and was diverted by Zia to the poverty alleviation programmes for the vulnerable groups.

II
Economic Management under Benazir Bhutto and Nawaz Sharif.

The period after Zia’s death has been marked by a great deal of political instability, slow economic growth and recurring foreign exchange crises. Pakistan had to go to the IMF for bail-out packages thrice. The successive elections following the frequent dismissal of governments did not provide for strong and clear mandate or stability. The elected governments were not only politically weak but also dominated by strong vested interests.

Benazir Bhutto was elected in December, 1988 and dismissed by president Ghulam Ishaq Khan in August, 1990. Nawaz Sharif became the prime minister after another election in 1990 and was dismissed in April, 1993, but restored to his office by the supreme court ruling. Both Nawaz Sharif and Ishaq Khan resigned in 1993 and after a weak caretaker government for three months Benazir became the prime minister till she was dismissed by President Leghari in November, 1996. In 1997 Nawaz Sharif again won with a large majority till he was overthrown in the military coup led by General Musharraf.

Under these circumstances, the serious economic and social problems inherited from the Zia period have deepened. The period after 1988 witnessed a sharp decline in the growth rate of the economy, acceleration in inflation, worsening income distribution and increasing poverty. The most serious manifestation of this worsening situation were the crises of 1993 and 1996 in the foreign exchange position and coincided with the problems between the president and the prime minister. Frustration with the economic policies of the elected governments contributed to the exercise of extraordinary constitutional powers by president Ishaq Khan. Unfortunately, both Benazir and Nawaz were either unwilling or unable to halt the decline.

When Benazir Bhutto came to power, the macro-economic imbalances in the Pakistan economy were large. The fiscal deficit had risen to a new peak of 8.5 per cent of GDP and the current account deficit in balance of payments was growing. Investment rate had stagnated for more than ten years and spending on social development had fallen. With growing interest payments, the room for manoeuvre in public finance was limited. The agreement with the IMF negotiated by the transitional government of president Ghulam Ishaq, and which had fiscal deficit reduction as a key target were not seriously implemented by the elected government.

When Nawaz Sharif came to power in 1990 he set upon a fundamental liberalisation of the foreign exchange regime, relaxation of investment controls, privatization of public assets and increased incentives for domestic and foreign investment.

The latter half of the 1980s had seen a gradual decline in the workers’ remittances. In addition interest payment on foreign debt continued to rise. In 1992 the government also allowed Pakistani residents to hold foreign exchange in designated accounts if the funds were received from overseas. An increasing part of monetary assets came to be held in the form of foreign currency deposits. The exemption of these deposits from zakat and other taxes, attractive interest rates compared to those available on foreign currency deposits abroad and above all quick erosion in the value of domestic monetary assets through inflation encouraged the dollarization of the economy.

The elected government of Pakistan inherited an economy in deep fiscal crisis. The fiscal deficit was as large as 8.5 per cent of the GNP. In addition, the decline of remittances and widening trade deficit had worsened the balance of payments position. Pakistan approached the IMF for the structural adjustment facility in 1988 and accepted the target of reducing the fiscal deficit to 4.8 per cent by 1990-91. However, the deficit continued and reached a new peak of 8.7 per cent in 1990-91 despite the disbursement of $900 million by the IMF. Pakistan negotiated a new agreement with IMF and agreed to reduce the fiscal deficit to 4 per cent in 1994-95 and 3 per cent in 1995-96. However, Pakistan could achieve a deficit of 5.8 per cent in 1994-95.

Under pressure from the IMF the elected governments made serious efforts to raise the tax revenue. Heavy taxes were imposed during the 1991 to 1998 period. The level of additional taxation ranged from a high of 2.4 per cent of GDP in 1994-95 to a low of 0.6 per cent in 1995-96. Altogether, the additional taxation proposed amounted to an extraordinary 8.2 per cent of GDP in a relatively brief period of six years. The increasing tax burden and declining social spending added greatly to the unpopularity of the governments. The continuing pressure from the IMF and the rising debt forced the governments to accept such expropriatory taxation as a lesser evil than reducing non-development spending or military expenditure. Despite this heavy taxation, the tax revenue did not increase and undermined the credibility of the government. There are few parallels where additional taxation of this magnitude has been successfully introduced year after year under a democratic regime. As the fiscal crises grew, the defence spending declined from 7 per cent of GDP in 1988 to 5.5 per cent in 1996, but development expenditure drifted even more sharply from 7 per cent to 4.3 per cent of GDP. The civilian governments were thus unable to restore the balance between military and development seriously upset during the Zia years.

However, the liberalisation of the foreign exchange regime and opening of foreign currency accounts changed the balance of payments position. Foreign ‘aid’ declined, as the governments continuously failed to meet the targets set by IMF.

The situation was partly mitigated by the increasing deposits in the foreign currency deposits. The workers’ remittances were diverted to these foreign exchange accounts with the total deposit rising to $4 billion by 1996 and to $7 billion by 1998.

The rates of GDP growth declined sharply in 1990s as political instability and declining public expenditure on development eroded the stimulus to growth, resistance to new irrigation project put a limit to the expansion of agriculture. Despite varying weather condition, agricultural output still expanded by 4 per cent per annum during the 1990s, a remarkable rate of growth. However, the industrial growth declined from 8.2 per cent in 1980s to 4.6 per cent in 1990s with the large-scale manufacturing showing a more acute decline in growth rates. Overall the entire GDP growth rate declined from 6.5 per cent achieved in 1980s to 4.5 per cent in 1990s.

What is even more alarming, there was a sharp increase in the incidence of poverty in Pakistan. It is not very clear what led to this sharp increase in the incidence of poverty from a low 17 per cent in 1988 to a doubling of the head count ratio to 33 per cent in 1999. Declining public expenditure, IMF-prompted fiscal adjustment as well as poor harvests and declining remittances, all played a part.

A most serious problem was developing on the export front. Pakistan’s exports were stagnant during the 1990-95 period at about $6.5 billion and rose to $8.2 billion in 1995-96 and again declined to $6.4 billion by 1999-2000. Similarly, imports rose from $7.6 billion in 1990 to about $12 billion in 1996-97 to decline to $8 billion in 2000.

When Pakistan exploded a nuclear bomb in 1998, its trade and balance of payments were in disarray. Workers’ remittances have stagnated around the $1 billion mark and the current account deficit was $2.5 billion. As the Western countries imposed sanctions on Pakistan and the IMF cut off its assistance, the crises in the balance of payments deepened. The government of Nawaz Sharif faced difficult choices. As depositors tried to withdraw deposits from the foreign currency accounts, the government hit the panic bottom and froze these accounts. This single act of the government undermined its credibility and accentuated the capital flight from Pakistan.

The official statistics of Pakistan show the declining level of foreign trade and workers’ remittances which fell to as low as $700 million in 1999-2000. It is likely that many of the transactions moved to unofficial channels. Indeed, the current finance minister of Pakistan Mr. Shaukat Aziz estimates that the total remittances of workers to Pakistan are approximately $6.5 billion of which only $1.5 billion move through official banking network.

The military government that seized power tried to grapple with the worsening economic situation. The economy has been plagued by imbalances in the balance of payments and in the fiscal situation. Pakistan’s total budgetary resources were 15 per cent of the GDP. Out of this, 5 per cent goes into civil administration, 4 per cent to defence and the rest to debt servicing. And therefore nothing is left for development purposes. A poor harvest due to a severe drought in 2000-01 led to a decline in agricultural production by 2.5 % and brought the GDP growth down to 2.2 per cent, the lowest in 25 years. The exports of Pakistan are stagnant for a decade and today less than the peak of 1995 by $2 billion. The fiscal correction promised by the military regime is yet to be realised.

General Musharraf has justified joining the American campaign in Afghanistan on these economic crises confronting the country. He had promised the people that liberal ‘aid’ from international agencies like the World Bank and IMF as well as from other western governments will help to turn around the Pak economy. Like his predecessors he has made efforts to impose the general sales tax and used military courts to speed up collection and check evasion. As promised by the western countries ‘aid’ has once again begun to flow into Pakistan. IMF has sanctioned a short-term facility of $300 million while the ‘aid’ Pakistan consortium has rescheduled Pakistan’s debt of $28 billion. In addition, ‘aid’ from the Asian Development Bank, World Bank and the governments of Japan and United States have been resumed. It is likely that in the current year Pakistan will be able to ease its balance of payments and resume imports to speed up growth.

However, serious problems still remain to be tackled. With IMF-induced trade liberalization the large-scale manufacturing industry is in doldrums. The dispute with the Hub Power Company and the worsening climate for foreign investment has led to a reduction in portfolio investments. The fiscal deficit continued to be large and despite the use of force the government has failed to meet its target of tax collection. Without more radical changes in the structure of the economy and resumption of export growth Pakistan is unlikely to be able to stablise its economy.

Will the military regime succeed in putting an end to this prolonged crisis, where the elected regimes have failed? Will Musharraf and his team of technocrats be able to restore stability and confidence? It is very unlikely. The coming elections are likely to be held against the background of a worsening social situation and a polarized social divide.

A lot depends on the restoration of confidence in the government to bring forth private investment, both indigenous and foreign, as well as check capital flight. The military regime has tried to pass a law to make future seizure of foreign currency accounts illegal. But then, past governments have not hesitated to ignore such restraints. It is unlikely that without the full restoration of parliamentary democracy, an end to the militarisation of society and a cut in military expenditure, Pakistan can hope to resolve the economic crisis let alone halt and reverse the growing impoverishment of the masses.

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