Haq's Musings: Thirlwall

Pakistan's economy has grown at a compounded annual growth rate (CAGR) of about 5% since the 1960s. While Pakistan's average 5% annual economic growth rate is faster than the global average, it falls significantly short of its peer group in Asia. The key reason is that, unlike Pakistan's, the East Asian nation's growth has been fueled by rapid rise in exports. History shows that Pakistan has run into balance of payments (BOP) crises whenever its growth has accelerated above 5%. These crises have forced Pakistan to seek IMF bailouts 13 times in its 73 year history. Pakistan's current account deficits would be a lot worse without 23X growth in remittances from overseas Pakistanis since year 2000. What Pakistan has experienced is BOP-constrained growth as explained in 1979 by Thirlwall Law, a law of economics named after British economist Anthony Philip Thirlwall. Another reason why Pakistan has lagged its Asian peers in terms of economic growth is its lower savings and investment rates. Every time Pakistan has faced a balance of payments crisis, the result has been massive currency devaluation, high inflation and slower growth for a period pf multiple years. This is is exactly what Pakistan's current government led by Prime Minister Imran Khan is dealing with right now. This pain is the result of years of flat exports, soaring imports and excessive debt taken on during former Prime Minister Nawaz Sharif's PMLN government from 2013 to 2018. The best way for Pakistan to accelerate its growth beyond 5% in a sustainable manner is to boost its exports by investing in export-oriented industries, and by incentivizing higher savings and investments.

History of Pakistan's IMF Bailouts

Economic Growth Since 1960:

The World Bank report released in June, 2018 shows that Pakistan's GDP has grown from $3.7 billion in 1960 to $305 billion in 2017, or 82.4 times. In the same period, India's GDP grew from $37 billion in 1960 to $2,597 billion in 2017 or 71.15 times. Both South Asian nations have outpaced the world GDP growth of 60 times from 1960 to 2017.

While Pakistan's GDP growth of 82X from 1960 to 2017 is faster than India's 71X and it appears impressive, it pales in comparison to Malaysia's 157X, China's 205X and South Korea's 382X during the same period.

GDP Growth in Current US$ 1960-2017. Source: World Bank

Thrilwall's Model:

Thrilwall's BOP-constrained growth model says that no country can sustain long-term growth rates faster than the rate consistent with its current account balance, unless it can finance its growing deficits. Indeed, if imports grow faster than exports, the current account deficit has to be financed by borrowing from abroad, i.e., by the growth of capital inflows. But this cannot continue indefinitely. Here's how Jesus Felipe, J. S. L. McCombie, and Kaukab Naqvi describe it in their May 2009 paper titled "Is Pakistan’s Growth Rate Balance-of-Payments Constrained? Policies and Implications for Development and Growth" published by Asian Development Bank:

"The reason is straightforward. If the growth of financial flows is greater than the growth of GDP, then the net overseas debt to GDP ratio will rise inextricably. There is a limit to the size of this ratio before international financial markets become distinctly nervous about the risk of private and, especially in less developed countries, public default. If much of the borrowing is short-term, then there is danger of capital flight, precipitating the collapse of the exchange rate. Not only will this cause capital loses in terms of foreign currency (notably United States [US] dollars) of domestic assets owned by foreigners (the lenders), but it will also cause severe domestic liquidity problems. This is especially true of many developing countries as overseas borrowing by banks and firms is predominantly denominated in a foreign currency, normally US dollars. As the exchange rate plummets, so domestic firms have difficulty finding domestic funds to finance their debt and day-today operations, often with disastrous consequences."

Investment as Percentage of GDP Source: State Bank of Pakistan

Pakistan's Rising Current Account Deficit:

Pakistan's external debt has been rising rapidly in recent years to fund its ballooning twin deficits of domestic budget and external accounts. It pushed the external debt service cost to $12 billion in fiscal 2019-20, and added to the trade deficit of nearly $24 billion. Remittances of $21 billion from Pakistani diaspora reduced the current account deficit to $11 billion, but still forced the new PTI government to seek yet another IMF bailout with its stringent conditions to control both fiscal and current account deficits. These conditions resulted in dramatic slow-down in the country's GDP growth.

Pakistan's External Debt. Source: Wall Street Journal

Pakistan's Exports:

Pakistan’s exports have continued to lag behind that of its South Asian competitors since the early 1990s. Bangladesh’s exports have increased by 6.2 times compared to Pakistan’s, measured in terms of exports per capita, and that of India by 6.8 times, according to Princeton's Pakistani-American economist Atif Mian.

Exports Per Capita in South Asia. Source: Dawn

Balance of Payments Crises:

Every time Pakistan has faced a balance of payments crisis, the result has been massive currency devaluation, high inflation and slower growth for a period of multiple years. This is is exactly what Pakistan's current government led by Prime Minister Imran Khan is dealing with right now. This pain is the result of years of flat exports, soaring imports and excessive debt taken on during former Prime Minister Nawaz Sharif's PMLN government from 2013 to 2018.

Export Growth in South Asia. Source: WSJ

Savings and Investment:

The second reason why Pakistan lagged its Asian peers in terms of economic growth is its lower savings and investment rates. There's a strong relationship between investment levels and gross domestic product. The more a country saves and invests, the higher its economic growth. A State Bank of Pakistan report explains it as below:

"National savings (in Pakistan) as percent of GDP were around 10 percent during 1960s, which increased to above 15 percent in 2000s, but declined afterward. Pakistan’s saving rate also compares unfavorably with that in neighboring countries: last five years average saving rate in India was 31.9 percent, Bangladesh 29.7 percent, and Sri Lanka 24.5 percent..... Similarly, domestic savings (measured as national savings less net factor income from abroad) also declined from about 15 percent of GDP in 2000s, to less than 9 percent in recent years. Domestic savings are imperative for sustainable growth, because inflow of income from abroad (remittances and other factor income) is uncertain due to cyclical movements in world economies, exchange rates, and external shocks".

Net Foreign Direct Investment Source: State Bank of Pakistan

21X Remittance Growth Since Year 2000:

Remittance inflows from Pakistani diaspora have jumped 21-fold from about $1 billion in year 2000 to $24 billion in 2020, according to the World Bank. In terms of GDP, these inflows have soared nearly 7X from about 1% in year 2000 to 6.9% of GDP in 2018.

Pakistan Remittances in Millions of US Dollars. Source: World Bank

Meanwhile, Pakistan's exports have declined from 13.5% of GDP in year 2000 to 8.24% of GDP in 2017. At the same time, the country's import bill has increased from 14.69% in year 2000 to 17.55% of GDP in 2017. This growing trade imbalance has forced Pakistan to seek IMF bailouts four times since the year 2000. It is further complicated by external debt service cost of over $6 billion (about 2% of GDP) in 2017. Foreign investment in the country has declined from a peak of $5.59 billion (about 4% of GDP) in 2007 to a mere $2.82 billion (less than 1% of GDP) in 2017. While the current account imbalance situation is bad, it would be far worse if Pakistani diaspora did not come to the rescue.

Summary:

Pakistan's average economic growth of 5% a year has been faster than the global average since the 1960s, it has been slower than that that of its peers in East Asia. It has essentially been constrained by Pakistan recurring balance of payment (BOP) crises as explained by Thirlwall's Law. Pakistan has been forced to seek IMF bailouts 13 times in the last 70 years to deal with its BOP crises. This has happened in spite of the fact that remittances from overseas Pakistanis have grown 24X since year 2000. Every time Pakistan has faced a balance of payments crisis, the result has been massive currency devaluation, high inflation and slower growth for a period pf multiple years. This is is exactly what Pakistan's current government led by Prime Minister Imran Khan is dealing with right now. This pain is the result of years of flat exports, soaring imports and excessive debt taken on during former Prime Minister Nawaz Sharif's PMLN government from 2013 to 2018. The best way for Pakistan to accelerate its growth beyond 5% is to boost its exports by investing in export-oriented industries, and by incentivizing higher savings and investments.

Haq's Musings

Saturday, September 12, 2020

Thirlwall Law: Why Hasn't Pakistan's GDP Grown Faster Than 5% Average Since 1960s?

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