The Politics of Economic Policy Reforms

by Ishrat Husain*

*Ishrat Husain is a former governor of the State Bank of Pakistan.

Abstract

The formulation and implementation of economic reforms generate winners and losers. The former are normally silent, the latter critically vociferous because the trickle-down benefits of growth come too late. The leader who ignores populist sentiments places himself in political peril and, at times, is tempted to adopt statist policies built upon nationalisation. The consequence is economic stagnation. To minimise the zero sum effect of economic reform a policy mix that ensures political stability through growth and social welfare has to be crafted. This entails: (i) an effective communications strategy that informs the public about the rationale and possible fallout of the reform; (ii) eliminates bureaucratic turf wars that impede reform implementation, (iii) ensures that policy objectives are responsive to domestic and external changes and; (iv) avoids over centralisation which can be counterproductive. Editor).

Development economists were long under the illusion that their elegant, technocratic, “first best” solutions to the problems faced by developing countries were so crystal clear that they would be readily implemented by policy makers. After suffering many retreats, reversals, set-backs and slippages through the decades in several countries, they have come to realize that economic reforms are integral to the politics of a country and cannot be designed, implemented or sustained in the absence of political consensus and political will. The content, timing, sequencing and phasing of reforms are critically dependent upon the quantum of political support provided by the decision makers. After all, if the economy falters, the neck of political leaders, will be on the noose at the time of elections, not that of economists, policy advisors and economic managers. The politicians have to face the consequences of the actions they may have taken on the advice of technocrats.

The linkage between economic reforms and politics is rooted in the truism that each economic policy action has trade-offs in terms of benefits and costs and creates a set of losers and winners. The losers are usually vocal, identifiable and homogeneous while the winners are diffused, differentiated and silent. The grievances of the former resonate in the inner sanctums of the decision making coterie.

In the case of Pakistan, the politics of economic reforms can be better understood in the historical context.¹ In the decades of the 1950s and 1960s, the government played a proactive role controlling the commanding heights in the economic space. The instruments used by the government in promoting industrial growth, – considered as the lynchpin of development strategy at that time, – were import licensing, foreign exchange allocations, approvals for industrial investment, subsidized credit, tax holidays, accelerated capital depreciation, preferred access to public utilities, high tariffs and quantitative restrictions to protect domestic producers. In every single case, entry into the industrial or commercial area was controlled by the government functionaries. They could either make or break an entrepreneur. The Pakistan Industrial Development Corporation (PIDC) set up a number of successful enterprises by using capital provided by the government and once these enterprises became profitable, they were sold to private entrepreneurs on non-competitive terms. Agricultural lands in new irrigated areas were allotted to a chosen few at less than the market price. Plots of urban land developed by the public sector authorities in prime locations were also disposed of through the discretionary powers of the political leaders.

In the 1970s the nationalization of industries, banks and the proliferation of government-owned and managed development financial institutions (DFIs) opened another major avenue of patronage. Debt capital was provided by the government-controlled financial institutions to the politically influential borrowers who never repaid the loans. Through over-invoicing, collusion with bank officials and manipulation of accounts these state–spawned industrialists financed their own equity share of the industry from these loans. Once the sponsors had recovered their capital several times over, the enterprises were abandoned as “sick industries” and left in the tender care of the creditors. By the end of the 1990s, more than half of the non-performing loans advanced by the Nationalized Commercial Banks (NCBs) and DFIs were blocked in these sick industries. The losses incurred by the banks and DFIs were borne by the tax payers through budgetary and extra-budgetary allocations.

The activities of these “private entrepreneurs” were not limited to borrowing capital and failing to repay it, but extended to large-scale evasion of taxes, duties, import tariffs, utility charges etc. In the absence of any obligatory requirement for documentation or any fear of penalty for non-compliance, the proportion of declared income got progressively smaller while the size of the concealed income increased. The tax revenues to the government became stagnant while the private concealed incomes of the tax payers and tax collectors kept swelling. Fiscal deficits and resort to borrowing – both domestic and external – were thus forced upon the government.

The other element in the modus operandi employed by the privileged private sector cabal of Pakistan was the manipulation of foreign trade flows for obtaining windfalls. By restricting imports, imposing differential tariffs and surcharges, securing specific exemptions and concessions through Statutory Regulatory Orders (SROs), misclassifying goods and claiming refunds and rebates for non-existent or fraudulent transactions in connivance with customs officials, a large number of private businessmen and customs officials became rich overnight at the expense of the consumers and the national exchequer.

The parasitic equation between the large private businesses, government officials and politicians propelled the country towards financial crisis by the end of the 1990s. A detailed factual analysis of this relationship can be found in an earlier work.² The situation was not helped by the nuclear tests of May 1998 or the sanctions imposed upon Pakistan as a consequence. The international financial institutions and bilateral western donors terminated all assistance while the freezing of foreign currency accounts eroded the confidence of resident and non-resident Pakistanis. Capital flight intensified and the exchange rate was almost in a free fall. Consequently, in October 1999 Pakistan was at the brink of massive default and had already defaulted on its Eurobonds.

It was at this stage that structural economic reforms were vigorously implemented in the country. An analysis of the content, impact and consequences of these reforms has been carried out elsewhere³ and is beyond the scope of this paper. The historical narrative briefly summarized above should, however, be kept in mind to understand why the politics of economic reforms is so difficult. There are some simple explanations offered to explain this phenomenon. The external donor agencies believe it is lack of “political will” that is the stumbling block between sound policy prescriptions and their implementation. But it should be remembered that in the last general elections the electorate of Andhra Pradesh threw out its able Chief Minister – a reformer of high calibre and a darling of the donor agencies – although he had demonstrated strong “political will” and implemented enormously sensible economic reforms. So if it is not political will then what is it that drives the politics of economic policy changes? The Pakistan case needs to be examined in a little more depth.

The economic policy agenda of deregulation, privatization, liberalization and market orientation was adopted in the early 1990s and was followed by successive governments. As these governments were frequently changed and were mainly preoccupied with their political survival, the implementation track record was not impressive. The pace picked up after 1999 when the continuity of the political regime provided a boost to the implementation of these reforms. The first observation is, therefore, that political stability is an indispensable prerequisite for continuity and consistency of economic policies and sustained implementation of reforms.

The reforms since 1999 have changed the economic landscape and reduced the enormous discretionary powers enjoyed by the bureaucrats and the political leadership. A large number of state-owned enterprises have been or are in the process of privatization depriving the politicians the powers to confer jobs. Except for two or three commercial banks all the domestic banks are now owned by the private sector or by international banks. Political loaning, import and export licensing, administered pricing of goods and state monopolies in trading have been abolished. Foreign exchange controls have been removed and a unified exchange rate exists that is determined by market forces. The differential between open market and official rate of exchange has almost disappeared. Tariff rates have been brought down significantly to the disadvantage of smugglers and tax evaders. Protection of domestic manufacturing industries is no longer encouraged. Duty slabs have been simplified and issuing of SROs to benefit individuals have been discontinued. A self-assessment system with random audit have been introduced for income and corporate taxes. Sales tax refunds and custom refunds are no longer a lucrative proposition. Petroleum and petroleum products are no longer imported by the government and the price is fixed by an independent regulatory agency. Competition among telecommunication companies has lowered prices, expanded access and sifarish (influence) or speed money bribery are no longer required for obtaining a phone connection. The liberal export and import of agricultural commodities by the private sector has reduced if not eliminated market manipulation and collusive practices. Loans are allocated by the banks and priced in accordance with the credit worthiness of the borrowers. No license is required to set up an industry. Despite this, there are still market inefficiencies, inequities in the distribution of income, privileged access to public goods and services and misuse of powers and authority. It is not being suggested that corruption or political influence have disappeared but the relative picture looks different at least in some areas such as – taxation, trade, banking, telecommunications, oil and gas, and agriculture. The police, judiciary, civil service as well as the land revenue and registration systems etc., are still badly in need of reforms.

Despite the structural reforms that have been brought about in the last several years, the perception about economic performance is characterized by two opposite views. Those in the government along with multilateral development banks, external rating agencies, fund managers, international investment banks, and research analysts believe that the reforms undertaken during the last seven years have turned around and stabilized the economy and stimulated growth. Independent economists, popular electronic and print media, politicians of all persuasions, large business organizations and many others, however, argue that these reforms have done nothing to improve the lives of the ordinary citizens and that the benefits have been concentrated upon the well-to-do segments of the population. The echoes of the Decade of Reforms of the 1960s and the 22 families are being heard once again.

Why does such a polarization exist in the perceptions about economic performance? How can these apparently paradoxical positions be reconciled? The empirical evidence of policy reforms from Pakistan and other developing countries indicates that: (i) there is considerable variation in the economic impact of policy reforms and that each set of reforms creates both winners and losers; (ii) there is a considerable time lag in the distribution of the benefits and initially the benefits are accrued to those who already possess resource endowment and; (iii) there is a disconnect between the expectations of the politicians and the objectives of the economic policy makers.

Economic policy formulators have to make tough choices and trade-offs and select ingredients of different policy options to meet the objectives they have set for the economy. These policies affect the economy as a whole in a beneficial manner over time but hurt many groups or individuals in the process. For example, the objective of aggregate GDP growth may be attained but the initial benefits of this growth may be captured by those who already own capital, land and financial assets, those who run their own businesses or those who are already employed. Thus the consequences of this policy will affect various segments and classes of the population in an uneven manner. It is the responsibility of the decision makers to keep the political leaders informed and to communicate to the general public as to what particular mix of instruments they are planning to use, with what intensity, magnitude and duration they will be using this particular mix and what the consequences of these actions are likely to be. A neglect to communicate creates its own momentum of uncertainty that hardly helps the reform process.

Predicting the consequences of various policy reforms is also fraught with difficulties. Economists are notorious for poor forecasting of outcomes as they usually build their models on historical trends of the variables and the underlying assumptions that these are also conditioned by the past behavioural relationships. Despite this, policy makers must not shy away from informing the public about their predictions for the future particularly in reference to who is going to gain or lose from these reforms.

The Annual Budget Statement, Annual Development Plan, Six Monthly Monetary Policy Statement, Annual Trade Policy and Price Support Policy for major crops are some of the systematic attempts made by policy makers in Pakistan to inform the general public about the likely course of fiscal, monetary, trade and agricultural policies of the country. But these instruments should be supplemented by interactive dialogue with the business community, civil society, think tanks, political leaders and media. The second observation is that an effective communication strategy to inform the public about the rationale and the consequences of the policies adopted is absolutely essential.

Even if an effective communication strategy is in place, it does not necessarily guarantee that the impact of apparently benign policy reforms will be felt, or even appreciated, by a substantial segment of the target population. The reason is that the implementation of such policies is often carried out inefficiently and the results are far from satisfactory. Internal consistency in various policies and coordination in their implementation are absolutely essential if the confidence of the private economic actors is to be generated. The turf battles, the silo-like vertical decision making process, the concealing of vital information and data from each other, one-upmanship, and feigned attempts to please the bosses at the expense of other competing ministries derail both policy formulation as well as implementation. The subsequent blame game and pass-the-buck syndrome for the failures due to this lack of coordination and these internal inconsistencies are neither acceptable to the public nor to the political bosses. The ministry or organization responsible for the policies shows up in a bad light and, in the process, the stakeholders which include the government of the day, the ruling party and the people suffer.

It is seldom realized by those engaged in these turf battles that it is the policy mix rather than the stand-alone, isolated or uncoordinated policies that will make the difference. To strike the right mix requires cooperation and collaboration among various ministries and agencies. Despite this obvious prerequisite, it is disconcerting that bureaucratic turf wars and personality clashes have become commonplace. This confrontational approach invariably results in poor policy formulation and even greater disasters in policy implementation. The expected benefits of reforms are thus dissipated creating nationwide disenchantment and disillusion. The third observation is that inter-ministerial turf battles and negative bureaucratic competition rather than coordination undermine the efficacy of policy reforms.

Well-thought-out and reasonable policies may still not produce the desired results if their sequencing, phasing and timing are off the mark. Just as a seasoned chef skilfully administers ingredients to produce gastronomic delights, so must the economic expert artfully formulate a correct policy mix.

How should the right policy mix be chosen? The starting point is the specification of the objective that the government wishes to achieve. As mentioned earlier, each economic policy action will create its own set of winners and losers in the short run while the long term impact may turn out to be quite benign. The popular adage “no gains without pain” seems to apply here. Unfortunately, the long term goal cannot be attained without a segment of the electorate undergoing the short term pains. This is the root cause of the continuing differences between politicians and economists worldwide. While politicians wish to please everyone, the economists are unable to design policies without some losers. Occasionally the latter are compensated and though this sounds good in policy articulation, it is difficult to implement.

These dilemmas that confront the policy makers can be illustrated with a few real world examples. In 2000-01 Pakistan, after almost a decade of stagnant per-capita incomes, low levels of new investment and rising unemployment and poverty, recorded a negative per-capita income growth. Inflation was, however, quite low. The policy makers were confronted with a situation in which they could either live with a low inflation, low growth scenario and allow the status quo to prevail or they could choose an option under which growth rate could be accelerated and taken to a higher trajectory to push the economy out of this low equilibrium trap. The two main policy instruments at the disposal of the government for kick starting the economy are fiscal and monetary policies. The fiscal policy lever could not be used at that time as the country was already trapped under an unsustainable debt burden and the assistance of the IMF was sought to obtain long term re-profiling of bilateral official debt. The only lever that could be relatively freely used to provide a stimulus to the economy was monetary policy and that too could only be used because of the prevailing favourable low inflationary environment. An expansionary monetary policy was, therefore, pursued for the next three years with the result that GDP growth rate recovered from 1.8 percent to 3.1 percent in FY 02, 4.8 percent in FY 03, 6.4 percent in FY 04 and 8.4 percent in FY 05. Consequently, unemployment rate fell from 8.3 percent in FY 02 to 6.2 percent in FY 05. Poverty naturally declined under this set of growth outcomes from 34 percent to 24 percent. What happened to inflation during this period? The inflation rate remained subdued at 3.5 percent in FY 02, 3.6 percent in FY 03 and 4.6 percent in FY 04. But beginning FY 05 a price in form of higher inflation had to be paid as it reached 9.3 percent and then 8.4 percent in FY 06. The unanticipated surge in the international prices of petroleum products from $ 25 per barrel to $ 75 per barrel did not help and actually accentuated the inflationary pressures.

Consequences of Policy Mix

What were the consequences of this chosen policy mix? Before 2000-01 declining per-capita income had made lives miserable for most segments and classes of society and the government. As incomes were declining government revenues could not rise to provide basic infrastructural and social services to the citizens. Investors – domestic and foreign – were reluctant to commit their funds in a situation where the rates of return were likely to be negative or only marginally positively. Stagnant private consumption was not able to transmit any positive signals to the manufacturing sector which was forced to cut down on hiring people. As services are directly and indirectly related to the volume of economic activity – domestic production, consumption and imports – the growth in this sector was also marginal. Most employment expansion takes place in services sector but the stagnant economy inhibited any significant job creation in this sector too. Fixed income earners – those on wages, salaries, pensions etc., were not affected much as the inflation rate was quite low.

What has happened since FY 04 in terms of the impact of higher growth and higher inflation on various income classes and the segments of the society? The businesses and self-employed services sectors were better off with this boom in aggregate demand as their earnings and profitability improved significantly. Government revenues grew by 20 percent annually allowing the public sector development expenditure to multiply four fold in less than three years but in the process, further pressures on the supply of goods and services in the economy were added. Middle class consumers benefited from liquidity surge in the banking sector and their enhanced purchasing power added to the demand for goods and services in the economy. Foreign direct investors saw such high income growth rate as the precursor for high corporate profits in an environment where the currency remained stable for a considerable period of time. Naturally, foreign investors brought in capital and consequently demand for labour rose and new employment opportunities were created.

Who benefited and who lost out in this changed economic environment? The beneficiaries were the self-employed, partnerships, individuals and businesses accounting for 80 to 90 percent of the work force of the country. These segments found their incomes rising as a result of this higher demand. The unemployed found jobs after a long period of search and the government was able to raise the development expenditure four fold. The main losers were the fixed income earners as their wages, salaries, savings, deposits and pensions did not keep up with rising inflation. Negative real returns on bank deposits and other saving instruments did not endear these policies to them. They are the most vocal and articulate people and their sound bytes are heard over all the TV channels and their written tirades adorn the pages of our newspapers. This influential and articulate segment of our society has been badly hurt by the policy mix and is understandably angry and justifiably upset. Those belonging to this group extrapolate their own experiences and of their cohorts and colleagues and paint the negative picture of the economy with a broad dismissive brush. They cannot be blamed for having any compunctions or pangs of guilt for lack of objectivity as they are suffering from the impact of these policies.

The policy mix has been altered since April 2005 through tightening of monetary policy and is beginning to show some demonstrable results. Inflation has edged down to 7.5 percent and is expected to run out of steam by early next year. It will take another year of monetary tightening to bring inflation down to 6 percent. But the losses this storm has left behind in terms of real income and purchasing power erosion during the last couple of years will be hard to compensate and the sour taste it has left in the mouths of the losers from these policies will not disappear. The popular perception that the high growth rates have benefited the rich and well-to-do segments of the population is therefore justified from the prism of those who have been losers from the policy mix adopted between 2000-01 and 2005. The irony is that those who are the beneficiaries of these policies remain silent spectators. The disconnect between the voices of the losers and the silence of the winners from economic reforms makes the task of policy makers highly difficult. The voices of the losers resonate in the National Assembly and Senate halls, seminars and conferences, electronic and print media and are magnified by those opposed to the government of the day. The cliché oft pronounced and repeated widely that “the common man has not benefited from these reforms” then becomes the brazen truth. The risk is that the political leadership may develop cold feet as they see their chances of getting elected at the next elections withering away. They may begin to adopt populist policies to appease their electorate – loose fiscal and monetary policies, subsidies of all kinds and financing losses of public utilities and enterprises, tax exemptions and concessions etc. If this happens the beneficial effects of reforms will be dissipated and the economy will be back to the crisis situation from which it was extricated. The fourth observation is that policy objectives do not remain static and as domestic and external conditions change the policy objectives have to be modified. The losers under one set of policies can become the winners under a different set. So there are no permanent winners or losers under changing economic policy environment.

Pakistan has also not lived up to Huntington’s⁴ hypothesis that “Centralization of Power is an essential pre-requisite for policy innovation and reform.” Mr. Z.A Bhutto followed this hypothesis and nationalized industry, banks, insurance, education etc., by a stroke of his pen. But this policy innovation did not sit well with most of the influential actors and the country went through a period of economic turmoil.⁵ The Devolution Reforms of 2001 have also met a lot of direct and indirect resistance by the provincial government politicians and the bureaucrats in general. The non-acceptance of the reforms imposed by the centre has been a major constraint in the sustainability of economic policies however sound or sensible they may be. A more participatory and consultative process in which the views of the provinces and local governments are assigned due weight would have a much better chance of success.

The fifth observation is that in the case of Pakistan a centralized approach to design and then push the reforms to the provinces and lower tiers of governments for implementation does not always work or is unlikely to produce the desired results.

In a Federation with one Federating Unit dominating numerically, politically and economically over all other units; if most decision makers – civil servants, military officers etc., also originate from that dominant unit the forces opposed to centralization of power are likely to be intense. The limited success in the reforms on distribution of water and distribution of tax revenues through the National Finance Commission can be ascribed to this in-built tension and mistrust. Under these circumstances it does not make much sense to have a centralized authority pushing for reforms. Consensus building among all affected stakeholders, striking compromises and safeguarding the interests of all those adversely affected by the reforms are better tools in a set up like Pakistan. But the reality is that the Pakistani leaders – whether elected or military – have demonstrated a patrimonial leadership style. To them unfettered personal discretion rather than institutional checks and balances has been the norm of leadership. These leaders believed in favouring and benefiting those loyal to them personally and carried out their command and wishes without raising any question. Those who opposed them were severely punished in one way or the other. Heeger⁶ described Bhutto’s leadership as patrimonial but this description is quite apt for most who held high office in Pakistan. Under this style of leadership where patronage, discretionary favours and personal hegemony are considered the main instruments of political dispensation resistance to rule-based transparent policy reforms that curtail discretion and create a level playing field and competition is natural.

Conclusion

The above analysis makes a modest contribution to our understanding as to why sensible economic policy reforms are not implemented in a linear, smooth and uninterrupted manner. The five key lessons drawn from the specific case study of Pakistan show:

There is tension between the politicians’ instincts to remain popular with the electorate and the economic managers’ objective to maintain fiscal prudence, monetary discipline and stimulate overall growth. Economic policies do create losers and winners in the short term which is also the time horizon of the politicians for getting themselves elected. The politicians will thus resist such reforms that give rise to vocal losers.

Political stability is a precondition for continuity and consistency in economic policy implementation.

An effective communication strategy to keep the politicians and the public informed about the consequences of the reforms is essential to build consensus and mobilize support.

A centralized approach to design reforms in which the provinces and the local tiers of government do not play a significant role is unlikely to succeed during actual implementation.

Even well conceived policy reform packages do not always produce the desired results because of the bureaucratic infighting and turf battles between different government ministries and agencies.

In democratic societies, regime changes at the time of elections can threaten the implementation of economic reforms that were originally designed by the previous ruling party. As continuity and consistency are the key ingredients for the success and subsequent sustainability of policy reforms, the government and opposition parties should agree on the broad direction and the contents of the reform packages. The pace, sequence and timing will, of course, differ according to the preferences of the political party in power. Losers from the reforms in that event will be unable to get the policies reversed when the opposition party displaces the ruling party as both parties have agreement on the substance of the reforms although the modalities may differ. International and domestic investors will then have confidence that the country’s economic policies are immune from political changes.

Development policy economists are learning from the experiences of the past. They are beginning to take into account the political, social and cultural factors in the design of policy reforms and recognizing the capacity constraints and bureaucratic dynamics in their implementation.

The paradox of economic policies is that the politicians will not allow the introduction of the reforms that create negative vibes in the society. But if these reforms are not initiated on time and sustained, the economy may get into serious trouble at some point in the future. The discredit for the financial and economic crisis will go to the politicians in power at that time. It is, therefore, in the larger interest of the country as well as the collective political interests of the ruling and opposition parties that they should swallow the bitter pill sooner than later to make the economy healthy.

Reference

For the history of economic developments in Pakistan see Hasan, Parvez Pakistani Economy at the Cross Roads (Oxford University Press 1998) Zaidi, Akbar Issues in Pakistani economy (Oxford University Press 2006) Burki S.J. Pakistan: Fifty years of Nationhood Westview Press, 2001)
Husain Ishrat, Pakistan: The Economy of an elitist state (Oxford University Press 1999)
Husain Ishrat, Economic Management in Pakistan 1999-2002 (Oxford University Press 2003)
Huntington, Samuel F. Political Order in changing Societies (Yale University Press, 1968)
For an excellent analysis of Bhutto reforms see Saeed, Shafqat, Civil – Military Relations in Pakistan (Westview Press 1997)
Heeger, Gerald, “Socialism in Pakistan” in H. Desofosses and J. Levesque (eds) Socialism in the Third World (Praeger Publishers, 1975)