A Simulation Analysis of the Debt Problem in Pakistan

Transcription

1 The Pakstan Development Revew 37 : 4 Part II (Wnter 1998) pp. 37:4, A Smulaton Analyss of the Debt Problem n Pakstan EATZAZ AHMAD and AAZ AHMED 1. INTRODUCTION The current debt stuaton n Pakstan and the resultng fnancal crss requre serous attempts to fnd a sustanable ndgenous soluton. As such t s essental to search ways and means to reduce dependence on external borrowng over medum to long run. 1 External debt s usually created to sustan a growth rate of the economy, whch s otherwse not feasble wth the gven state of domestc resources, technology, consumpton propensty and economc management practces. However, the success of economc growth fnanced by external borrowng depends on two factors, namely the domestc savng rate and productvty. A country wth lower savng rate needs to borrow more to fnance a gven rate of economc growth. In Pakstan the flow of external loans s lkely to have adversely affected the compulson for savngs. For example, no serous attempts have been made to mprove tax collecton or to control non-development government expendture unless forced by the donor agences. The adverse effect of borrowng on savngs has recently been observed n [Al et al. (1997)]. The evdence also does not support the proposton that hgher rate of economc growth results n hgher savng rate [see Al et al. (1997)]. The savng rate n the prvate sector of Pakstan has remaned low because of low real nterest rates and the lack of legtmate and safe nvestment opportuntes. Furthermore the poor and mddle-ncome classes have been burdened wth hgh nflaton tax and no serous efforts have been made to tax the rch. Savng rate n the government sector has been deteroratng due to exponental growth n the sze of ths sector and extraordnarly low productvty. Government has ventured n the terrtores where t had no busness n the frst place. The current rate of savngs n Pakstan s stubbornly as low as Eatzaz Ahmad and Ayaz Ahmed are respectvely Assocate Professor at the Quad--Azam Unversty, Islamabad and Staff Economst at the Pakstan Insttute of Development Economcs, Islamabad. Authors Note: We wsh to thank Professor Syed Nawab Hader Naqv for hs encouragement and useful comments on the paper. 1 Usng Neo-classcal growth framework, Ahmad and Paul (1994) and Crouch (1973) have shown that the benefts of foregn nvestment can only be temporary unless t ncreases natonal savngs rate and/or productvty.

2 37:4, 356 Ahmad and Ahmed t was many years ago. Thus the falure to ncrease the natonal savng rate alone explans why the need for external borrowng has contnued to rse over the years n Pakstan. A declne n productvty s somethng extra-ordnary because all the on-gong nnovatons n technology are meant to mprove productvty. New technologes that are nferor to the exstng technologes quckly dsappear from the scene. Nevertheless a recent study by Ahmad and Idress (1998) shows that total factor productvty n the manufacturng sector has declned by about one percent over the perod Ths loss n productvty can most plausbly be explaned by neffcency n the economy, especally n the publc sector. In the lght of above background ths study ams to suggest a polcy prescrpton that can provde a sustanable soluton to the present debt crses. The analyss s based on a three-gap model of resource flows. The model s stock-flow consstent as t consders both the current and captal accounts of the transactons takng place across the prvate and publc sectors and the rest of the world. A smlar model has recently been used n Ahmad (1997) to study the effects of varous fscal measures on the debt poston and n Ahmad (1996) to dscuss the role of foregn captal nflows n reducng the sze of debt. The present study consders a broader polcy prescrpton that ncludes both the fscal and monetary nstruments. 2 The paper s planned as follows. Secton 2 provdes a hstorc overvew of the resource defcency n Pakstan. A three-gap smulaton model s presented n Secton 3. Secton 4 provdes statstcal smulatons for varous ndcators of resource defcency over the next two decades and studes the effectveness of a polcy prescrpton n addressng the problem. 2. TRENDS IN RESOURCE DEFICIT, BORROWING, AND DEBT When Pakstan resorted to external borrowng n 1950s and 1960s, the objectve was to accelerate growth rate of the economy. Snce the domestc savng rate was too low to fnance economc growth through productve nvestment, Pakstan opted for external borrowng. The dea was that the ncreased growth rate n future would rase the savng rate and produce suffcent exportable surplus to retre the debt. However, presently we need to borrow n order to avod debt default and mprove our credt ratng so that we can mantan the supply lne of borrowng. The danger s that f the supply lnes are cut-off, Pakstan s economy wll collapse. At least n one respect the growth strategy of 1960s was successful n the sense that resources generated through external borrowngs resulted n hgh rate of economc growth. If the same pace of growth were sustaned, the adverse trend n debt accumulaton mght have reversed at some stage. The stuaton n 1970s was stll 2 All the earler studes on debt smulaton n Pakstan are based on two gap models. See, for example, Burney (1988); Chaudhary (1988); Naqv (1970) and Rahman (1967)

3 Smulaton Analyss of Debt 37:4, 357 manageable despte a reducton n growth rate of the economy, manly because the sze of external debt was small and the terms and condtons for external borrowng were favourable. In 1980s the Amercan ad to assst n the Afghan war helped postpone the crss. Durng ths perod, however, the composton of external debt changed gradually from long term debt to short term debt wth hgher rates of nterest. By the tme Amercan ad was dred up, Pakstan had accumulated suffcent amount of external debt to worry about. The successve governments not only opted to postpone the burden by rollng-over the exstng debt but also magnfed the problem by ndulgng n unrealstc adventures and gnorng the core ssue of management. As a result most of the efforts of economc polcy makers and cvl servants have been dverted to negotatng bgger and bgger loan agreements wth the donors, and tryng to meet the targets mposed by the donor agences. Not only dd we fal to desgn a sustanable development strategy, but we also managed to waste the hghly specalsed human resource on msdrected objectves. In the past two decades or so the debt poston has worsened very rapdly. Ths s evdent from the trends n varous ndcators as shown n Table 1. The table shows that the prmary budget defct has ncreased by almost 13 percent per annum over the perod to Thus even f debt servcng s gnored, the government s budget poston has deterorated over the years. The surplus n the prvate sector has also worsened qute sgnfcantly to the extent that n the recent years t has almost vanshed. Whle prmary budget defct has grown due to expanson n the sze of publc sector, the observed deteroraton n the prvate sector s surplus can be attrbuted to rsng consumpton propensty and over-nvocng of nvestment expendture to camouflage consumpton loans. The table also shows that prmary budget defct has outweghed the prvate sector s prmary surplus, wth the result that the prmary external defct has been postve and growng at the rate of more than 14 percent per annum. The nterest and prncpal payments on publc debt and rental payments on prvate foregn captal have been ncreasng even at faster rates. The extra-ordnary growth n debt servcng payments s manly due to the rsng publc debt and nflow of captal, and partally due to the rsng rates of nterest on external as well as nternal debt and the amortsaton rate of external debt. Wth ncreasng dffculty n arrangng longterm soft external loans, whch have also lead to declnng credt worthness of Pakstan, the composton of external debt has drfted towards short term commercal loans. Ths n turn has resulted n the rsng nterest and amortsaton rates and shortenng of the amortsaton perod as s evdent from the table. Lkewse the nterest rate on nternal borrowng has to be ncreased n order to compete n the domestc loanable funds market.

4 37:4, 358 Ahmad and Ahmed Table 1 Indcators of Resource Defcency (Bllon Rupees Per ear) Indcators of Resource Defcts Growth Rate Prmary Budget Defct Prmary Prvate Sector Defct Prmary External Defct Interest Payments on External Debt Rental Payments on Foregn Captal Prncpal Payments on External Debt External Debt Servcng Debt Servcng and Rental Payments Abroad Interest Payments on Internal Debt Total Debt Servcng Current External Defct Current Budget Defct Net Internal Borrowng Net External Borrowng Gross External Borrowng External Debt Internal Debt Interest Rate on Internal Debt Interest Rate on External Debt Amortsaton Rate of External Debt External Debt Servcng Rate Average Amortsaton Perod of Outstandng Debt Foregn Exchange Reserves Foregn Equty Investment Foregn Drect Investment Total Foregn Investment It s also evdent from the table that the current account external defct has been rsng qute fast due to the rsng prmary external defct and, especally the rsng nterest payments on external debt and rental payments on foregn captal. Lkewse the current account budget defct has been rsng almost at the same rate due to the rsng prmary budget defct and nterest payments on external and nternal debts. The statstcs n Table 1 also show that foregn captal nflow both n terms of equty and drect foregn nvestment has ncreased qute sgnfcantly, especally durng 1990s. Although the drect effect of captal nflows s that t helps control the need for external borrowng, yet the resultng ncrease n rental payments abroad adds to the burden on current account external balance and thereby ndrectly ncreases the need for external borrowng.

5 Smulaton Analyss of Debt 37:4, 359 Table 2 shows the trends n defcts, borrowngs and debts as ratos to the nomnal GDP. Snce all the measures of resource defct are also gven n nomnal terms, the nflatonary factor s elmnated from these ratos. A rsng (declnng) rato would ndcate that the resource defct s growng n real sense faster (slower) than the real GDP. We observe that, whle the prmary budget and external defcts as proportons to the GDP have been more or less stable, the debt servcng and rental payments, and the current account defcts have been rsng faster that the nomnal GDP. That s, the burden of debt servcng and current account balances have deterorated n real terms as well. The same s the case wth net and gross external borrowng and external and nternal debt. On the other hand net nternal borrowng has not ncreased as fast as the nomnal GDP. Table 2 Indcators of Resource Defcency (Percentage of the GDP) Indcators of Resource Defcts Growth Rate Prmary Budget Defct Prmary Prvate Sector Defct Prmary External Defct Interest Payments on External Debt Rental Payments on Foregn Captal Prncpal Payments on External Debt External Debt Servcng Debt Servcng and Rental Payments Abroad Interest Payments on Internal Debt Total Debt Servcng Current External Defct Current Budget Defct Net Internal Borrowng Net External Borrowng Gross External Borrowng External Debt Internal Debt Foregn Exchange Reserves Foregn Equty Investment Foregn Drect Investment Total Foregn Investment

6 37:4, 360 Ahmad and Ahmed Another notable observaton s that contrary to the generally held percepton, durng 1990s the current account as well as prmary budget defcts have shown some mprovement n relaton to the GDP growth, whle the prmary and current account external defcts have been relatvely stable. Ths could partally be due to the dscplne mposed by the so-called IMF condtonaltes. Nevertheless t s evdent from the above observatons that the resource defcency and debt postons have severely worsened n Pakstan durng 1980s and 1990s. 3. THE MODEL The full three-gap model has been derved n Ahmad (1997). In ths paper we consder a varaton of the model to hghlght the role of monetary money supply, nflaton and exchange rate. However, to avod repetton, we gve only a bref descrpton of the model. Unless otherwse stated, all varables are measured n domestc currency at current prces. The parameters relate ether to real quanttes (at constant prces) or to nomnal values n foregn currency. The followng notatons are used n the paper: ED a = Amortsaton rate of external debt. BM = Base money. G C = Government consumpton expendture. P C = Prvate consumpton expendture. CBD = Current account budget defct. CED = Current account external defct. e = Rate of exchange rate deprecaton. ED = External debt. FDI = Prvate foregn drect nvestment. FDK = Stock of prvate foregn drect captal. FEI = Prvate foregn equty nvestment. FEK = Stock of prvate foregn equty captal. FER = Foregn exchange reserves. FDK G = Growth rate of foregn drect captal n real terms. FEK G = Growth rate of foregn equty captal n real terms. FER G = Growth rate of foregn exchange reserves n real terms. BM G = Growth rate of base money.

7 Smulaton Analyss of Debt 37:4, 361 G = Growth rate of real GDP. g = Margnal rate of government consumpton expendture. GEB = Gross external borrowng. G I = Government nvestment expendture. P I = Prvate nvestment expendture. ID = Internal debt. M = Imports. NEB = Net external borrowng. NIB = Net nternal borrowng. PBD = Prmary budget defct. PED = Prmary external defct. PPD = Prmary prvate sector s defct. R = Total rental payments on foregn captal. ED r = Rate of nterest on external debt. ID r = Real rate of nterest on nternal debt. G S = Government savngs. P S = Prvate savngs. s = Margnal prvate savng rate (out of prvate dsposable ncome). T = Tax and non-tax government revenues. t = Margnal tax rate. U = Unrequted transfers. u = Margnal rate of unrequted transfers. X = Exports. = Gross domestc product (GDP). δ = Deprecaton rate of prvate foregn drect captal. γ = Government s share n nvestment expendture. κ = Margnal captal-output rato. π = Domestc nflaton rate. FDK ρ = Rental rate on prvate foregn drect captal. FEK ρ = Rental rate on prvate foregn equty captal.

8 37:4, 362 Ahmad and Ahmed Accordng to three-gap model external defct s a mrror mage of the domestc resource defct, where the latter s splt nto ts prvate and publc counterparts. We can defne the prmary external, budget and prvate sector defcts and ther nterrelatonshp as follows. PED G P G P ( C + C + I + I ) ( U ) = M X U, = (1) G G G G PBD = C + I T = I S, (2) P P P P PPD = C + I + T U = I S, (3) PED = PGD + PPD, (4) It can be shown that the tme paths of the prmary resource defcts are gven by the followng equatons. The proof s avalable from the authors. PPD ( + ) ( 1+ G ) γ ( ) κ G+ 1 γ 1κ 1G π PPD (5) t g G = 1 ( 1 γ ) κ G ( 1+ G ) ( 1 γ ) ( ) PBD = 1+ π PBD (6) κ ( + ) 1G s 1 u t G ( 1+ G ) ( ) κ G+ 1 κ 1G PED = 1+ π PED (7) (( t ) + (1 + )) g s u t G In order to proceed further we need to trace the relatonshp between stock and flow components of varous varables. Snce the prmary resource defcts are measured n domestc currency, the nterest payments on external debt and the rental payments on prvate foregn captal must also be denomnated n domestc currency for aggregaton purposes. We assume that nterest rate on nternal debt and the rental rate on foregn equty captal are subject to full Fsher effects. 3 Therefore the two are adjusted one to one for nflaton. However, we assume that foregn drect captal s fully ndexed for nflaton and, therefore, the rental rate on foregn drect captal does not ncorporate 3 Accordng to the Fsher effect, under perfect foresght, wth flexble prces and n the absence of any unexpected shocks, nomnal nterest rate fully adjusts to the expected nflaton rate to yeld a constant real rate of nterest. Lkewse, f the foregn nflaton rate s constant, the nomnal exchange rate wll also adjust wth changes n the domestc nflaton to yeld a constant real exchange rate [see Tanz et al. (1988)]. Although the valdty of Fsher effects s an emprcal queston, there s no way one could predct the future course of dsparty from the neutral assumpton made above.

9 Smulaton Analyss of Debt 37:4, 363 nflatonary factor. Fnally, assumng that the purchasng power party holds, the exchange rate deprecaton factor s equal to the rato of domestc nflaton factor to foregn nflaton factor. Ths means that external debt s also ndexed for domestc nflaton. It also follows that the nterest rate on external debt does not nclude nflatonary factor. Under the above assumptons we can wrte FDK ( 1+ π ) ( G + δ ) FDK 1 FEK [( 1+ π ) ( 1+ G ) 1] FEK 1 FER = [( 1+ π ) ( 1+ G ) ( 1+ e )] FER 1 FDI (8) = FEI (9) = FER (10) BM BM = G BM (11) 1 FDK ( 1+ π ) ( 1+ G ) FDK 1 FDK (12) = FEK ( 1+ π ) ( 1+ G ) FEK 1 FEK (13) = FER ( 1+ π ) ( 1+ G ) FER 1 BM ( 1+ G ) BM 1 FER (14) = BM (15) = The tme paths of current account external and budget defcts are as follows. CED = PED + + ED ( 1+ e ) r ED + ( 1+ π ) 1 1 FEK [( 1+ π ) ( 1+ ρ ) 1] FEK 1 ED ID + ( 1+ e ) r ED 1 + [( 1+ π )( 1+ r ) 1] ID 1 ρ FDK FDK = PBD (16) CBD (17) Net external borrowng s requred to fnance the part of current account defct whch s not covered by prvate captal nflow, and to ncrease foregn exchange reserves [see Cohen (1988)], whle gross external borrowng s equal to the net borrowng plus prncpal payments. That s, ( FDI + FEI ) + FER NEB = CED (18) ED ( 1+ e ) a ED 1 GEB = NEB + (19)

10 37:4, 364 Ahmad and Ahmed Budget defct s fnanced by three sources: nternal borrowng, external borrowng net of the ncrease n foregn exchange reserves, and monetary borrowng or the change n base money. Therefore the net nternal borrowng can be wrtten as ( NEB FER ) BM NIB = CBD (20) Fnally, external debt, measured n local currency, accumulates for two reasons: the local currency value of the exstng volume of external debt ncreases due to exchange rate deprecaton; and/or f the net external borrowng s postve durng the current perod. The nternal debt, on the other hand, accumulates only on account of net nternal borrowng. Therefore, ( + e ) ED NEB ED 1 + (21) = 1 ID = ID 1 + NIB (22) Ths completes the structure of our model, whch can now be used to smulate the tme paths of net external and nternal borrowngs and debts under alternatve parametrc assumptons. 4. PARAMETER ESTIMATES AND NUMERICAL SIMULATIONS We shall now use Equatons 5 22 to study the tme path of some of the key ndcators of resource defcency n Pakstan. The base perod for projectons s chosen to be whch was relatvely a normal year and for whch all the requred data are avalable n the fnal form. The tme paths are derved for the perod to Wth a few exceptons varous parameters requred for smulaton are estmated usng compound growth rates, averages, etc. over the past 10 years. Snce no separate nformaton s avalable on the rental payments on the foregn drect and equty captal, the rental rates are estmated as parameters from the followng non-lnear regressng equaton usng the past 20 years data. 4 FDK 1 ( 1 ) FEK + π ρ 1 + ( 1+ π )( 1+ ρ ) 1 FDK FEK 1 = R (23) The seres of foregn drect and equty captal stocks are estmated by accumulatng past nvestments for the perod and applyng 5 percent deprecaton rate on the foregn drect captal. 4 No serous econometrc problems such as autocorrelaton or multcollnearty are apparent from the results and the estmates of both the parameters ρ FDK and ρ FEK gven n Table 3 are statstcally sgnfcant.

11 Smulaton Analyss of Debt 37:4, 365 All the requred data are taken from 50 ears of Statstcs n Pakstan, varous ssues of Economc Survey and Statstcal Supplements (Fnance Dvson, Government of Pakstan) and Annual Report (State Bank of Pakstan). The estmated parameters are gven n Table 3. Table 3 Estmates of the Parameters Parameter Estmate ED a = amortsaton rate of external debt 0.06 e = rate of exchange rate deprecaton 0.09 G = growth rate of real GDP 0.05 FER G = growth rate of the foregn exchange reserves 0.05 FEK G = growth rate of foregn equty captal 0.1 FDK G = growth rate of foregn drect captal 0.13 BM G = growth rate of base money 0.13 g = margnal rate of government consumpton expendture 0.13 ED r = dollar rate of nterest on external debt 0.04 ID r = real rate of nterest on nternal debt 0.02 s = margnal prvate savng rate (out of prvate dsposable ncome) 0.12 t = margnal tax rate 0.17 u = margnal rate of unrequted transfers 0.04 δ = deprecaton rate of prvate foregn drect captal 0.05 γ = government s share n nvestment expendture 0.48 κ = margnal captal-output rato 4 π = nflaton rate 0.1 FDK ρ = rental rate on prvate foregn drect captal 0.11 FEK ρ = rental rate on prvate foregn equty captal 0.07

12 37:4, 366 Ahmad and Ahmed The expected levels of prmary defcts, current external and budget defcts, the net and gross external borrowngs, net nternal borrowng and external and nternal debt for the perod to are reported n Table 4. These results show that the prmary budget defct s expected to rse by about 19 percent annually. The prmary prvate sector s defct, on the other hand, would grow at a lower rate, 9 percent per annum. Snce, however, the prvate sector s defct would reman qute low as compared to the budget defct, ts slow growth would have neglgble effect on the prmary external defct, whch s expected to grow at the rate of 18 percent per annum. The current account external defct s expected to grow at the rate of 20 percent per annum, faster than the growth n the budget defct (about 17 percent per annum). Snce the current account external defct s the sum of the budget defct and the prvate sector s defct, ths pattern ndcates deteroraton n the prvate sector s current account balance as well. The man reason for ths deteroraton and, hence a faster growth n current account external defct as compared to the current account budget defct, s the expected growth n rental payments on prvate foregn captal. If, however, the prvate foregn captal nflow contnues to grow at the present rate, t wll more than offset the shortfall n the prvate sector s balance. Ths also means that net external borrowng wll reman substantally below the current account external defct, so that the government wll rely heavly on nternal borrowng to cover the budget defct. Thus net nternal borrowng would grow at a faster rate (about 18 percent per annum) than the net external borrowng (about 16 percent per annum). On the other hand external debt s expected to grow faster than the nternal debt because external debt s ndexed for exchange rate deprecaton, and hence for nflaton as t s contracted n foregn currency, whle the nternal debt s not ndexed for nflaton. The above smulaton results nclude the effects of nflaton. In order to remove the nflatonary factor and to place the results n relaton to real growth n the growng economy, we now dvde all the varables by the nomnal GDP. Table 5 provdes the relevant nformaton. The table shows that the prmary budget and external defcts as percentages of the GDP are expected to grow by more than 2 percent per annum. Ths means that n real terms the two measures of defcts are expected to grow faster than real GDP. The prmary defct n the prvate sector, on the other hand, would grow n real terms much slower than the growth rate of real GDP Although the current account external defct, as a percentage of the GDP, s expected to grow at about of 4 percent per annum, the net external borrowng wll reman farly stable around 4 percent of GDP. The bass for ths expectaton s the assumpton that prvate captal nflow wll contnue to contrbute favourably to the captal account of the balance of payments. The current account budget defct as a percentage of the GDP s also expected to reman farly stable whle the net nternal borrowng would rse at around 2 percent per annum. These trends, n turn, translate nto an

13 Smulaton Analyss of Debt 37:4, 367 Table 4

14 37:4, 368 Ahmad and Ahmed Table 5

15 Smulaton Analyss of Debt 37:4, 369 exponentally rsng tme path for the external debt and a relatvely stable U-shaped tme path of nternal debt. The above results show that Pakstan s external debt poston s expected to become worse n future whle the poston of nternal debt wll not mprove. The burden of external debt servcng wll rse to more than 8 percent of GDP and the current account external and budget defcts wll rse beyond the acceptable lmts. We can now study the effects of changes n parameters of the system on the smulated tme paths of resource defcts. Usng a model smlar to the one presented here, Ahmad (1997) has performed such smulaton exercses and has suggested two mxed polces to reduce the debt burden. These polces are manly focussed on fscal measures such as changes n tax rate, government consumpton rate and the share of publc sector n nvestment expendture. Although the present study s based on updated estmates of the parameters, there s not much pont n repeatng the entre smulaton exercse, whch n any case s llustratve only. In ths paper we shall consder a broader polcy mx that also ncludes monetary polcy to control nflaton and thereby the rate of exchange rate devaluaton. The polcy mx s desgned wth the multple objectves of reducng the debt burden, mantanng a hgh and steady growth rate of GDP, producng stablty n the economy and mnmsng the fnancal rsk due to low foregn exchange reserves. After a number of experments we have come up wth the followng polcy mx that has a balanced effect on all accounts. (a) The tax rate s ncreased by 1 percent n each year startng from the year tll t s ncreased from 17 percent to 20 percent n the year (b) The rate of government consumpton expendture s reduced by 1 percent startng from tll t settles at 10 percent n the (c) The share of publc sector n nvestment expendture s reduced by 2 percent n each year startng from tll t s reduced from the present 48 percent to 40 percent n (d) GDP growth rate s ncreased from the present 5 percent per annum to 6 percent per annum gradually over a perod of 10 years from to (e) The annual growth rate of foregn exchange reserves s set at 20 percent for to tll the foregn exchange reserves reach at about 5 percent of GDP. From the year onwards the growth rate s set equal to the target GDP growth rate of 6 percent so that the foregn exchange reserves reman around 5 percent of GDP n the subsequent years. (f) The growth rate of money supply s reduced from the current 13 percent by 1 percent per annum over the perod to when t reaches to 6 percent. Assumng full Fsher effects, t s expected that nflaton rate and the

16 37:4, 370 Ahmad and Ahmed rate of exchange rate deprecaton wll declne by the same magntudes and settle at 3 percent and 2 percent respectvely wth a lag of one year. (g) Wth the resultng stablty n prce level and exchange rate, a better budget poston and the declnng role of publc sector, t s expected that real nterest rates on domestc savng nstruments wll rse and the prvate sector wll gan confdence. These factors along wth other polcy measures are expected to rase the prvate savng rate by 1 percent per annum over the perod to tll t reaches to 15 percent. (h) Fnally, we assume that wth more stablty and the expandng prvate sector, productvty wll rse and as a result captal-output rato wll declne gradually to 3.5 over the perod to Although the space does not allow a separate treatment of each of the above polcy measure, we can nevertheless dscuss brefly the qualtatve mplcatons of each. The ncrease n tax rate produces favourable effects on all accounts; but the decrease n external defct s smaller than the decrease n budget defct because the resultng decrease n the overall resource defcency, whch determnes the sze of the external defct, s partally offset by reduced prvate savngs. Despte ths, however, the favourable effects on external borrowng and external debt would be greater than the effects on nternal borrowng and nternal debt. The reason s that the government would reduce nternal borrowng only to the extent that the reducton n the budget defct s not fully matched by the reducton n external borrowng. A cut n government consumpton expendture leaves the prvate sector s resource balance unchanged. Therefore the reducton n the prmary external defct must be equal to the reducton n prmary budget defct. It also follows that the reducton n current account budget defct would be equal to the reducton n current account external defct, and to the reducton n net external borrowng, wth the net nternal borrowng remanng unchanged. The share of publc sector n nvestment expendture s reduced gradually keepng n vew the poltcal dffcultes attached wth prvatsaton. Snce a decrease n the government s share n nvestment mples an equal ncrease n the prvate sector s share, the overall nvestment and resource defcency n the country remans unaffected. Therefore, the external balance remans unchanged. 5 Wth the nvestment n publc sector decreasng, the budget defct mproves. Furthermore, government must fully crowd out n terms of reduced borrowng from the domestc captal market n order to make room for the prvate-sector nvestment. Thus both net nternal borrowng and nternal debt would decrease. 5 These results rest on the assumpton that all the dsnvested busnesses are purchased by domestc resdents. If some of these purchases come from foregn resdents, the resultng net captal nflow would have some favourable effect on the external borrowng and external debt as well. See Ahmad (1996, 1998).

17 Smulaton Analyss of Debt 37:4, 371 The above polces are desgned to reduce the pressure on nternal and external borrowng. For further relef, t s also essental that the rate of prvate savngs and productvty rse. For ths purpose t s essental to promote stablty, effcency and confdence n the economy. The reducton n borrowng pressure and the ncreasng role of prvate sector as mpled by the above polces can partally serve the purpose. However, t s also necessary to sustan a better GDP growth rate n the long run. However, snce external borrowngs are hghly senstve to the growth target and the economy s lkely to reman under strct fnancal constrants, the growth objectve s postponed and the GDP growth rate s ncreased only gradually. When the GDP growth rate s ncreased, both the publc and prvate sectors would have to nvest more accordng to the prevously gven shares of the two sectors. Therefore, both the publc and prvate sector s balances would deterorate. The requred ncrease n prvate nvestment can be realsed only when the domestc captal market s releved of government borrowng. Therefore, n spte of an ncrease n the budget defct, net nternal borrowng must decrease. Thus the government has to ncrease external borrowng not only to fnance addtonal nvestment n publc sector but also to dvert borrowng from nternal to external sources. 6 To reduce uncertanty and produce stablty n the economy, t s suggested that nflaton and devaluaton of rupee be controlled by a consstent decrease n the growth rate of money supply. These polces would affect drectly the nternal and external balances to the extent that some of the stock varables are ndexed for nflaton (external debt and foregn drect captal) whle the nflatonary factor s ncluded n the nterest payments on some other stocks (nternal debt and foregn equty captal). Furthermore the results show that apart from the ncrease n nternal borrowng to replace defct fnancng by monetary expanson, the drect effects of ths polcy are relatvely small. The ncrease n nternal borrowng s, however, expected to be more than offset by the sale of publc assets. It s expected that the ant-nflatonary measure would rase real nterest rates on domestc savng nstruments and coupled wth the other measures dscussed above, better prospects for ganful nvestment would promote prvate savngs. Ths n turn wll further mprove external balance and releve the pressure for external borrowng. Fnally, most of the above polces are lkely to promote effcency and productvty n the economy. It s further suggested for the sake of optmal resource allocaton that resources are drected towards those sectors where the margnal productvty of nvestment s relatvely better. Thus we assume that captal-output rato declnes gradually from 4 to 3.5. Ths mprovement n productvty mproves nternal as well as external balances. However nternal borrowng would rse to absorb the surplus generated n the prvate sector. 6 In other words, snce domestc savngs are already fully used for nvestment, the addtonal nvestment requred to fnance an ncrease n the GDP growth rate has to be funded by external borrowng, rrespectve of the shares of the addtonal nvestment undertaken n the publc and prvate sectors.

18 37:4, 372 Ahmad and Ahmed The effects of the above polcy mx on varous ndcators of resource gap are presented n Tables 6 and 7. The results n Table 6 show that the polcy mx has favourable effects on all accounts. The prmary budget defct s expected to declne sharply and from the year onwards the defct turns nto surplus. The ncrease n the prvate sector s prmary defct results manly from ncrease n taxaton and prvate nvestment expendture and the GDP growth rate as requred by the polcy mx, though these effects are partally offset by the reduced captal output rato. The prmary external defct also shows a remarkable mprovement and t declnes by almost 3 percent per annum as aganst the expected 18 percent ncrease n the absence of any polcy. The current account external and budget defcts also show substantal mprovements, though the expected reducton n the former s sgnfcantly more than the reducton n the latter. The current account budget defct s expected to become almost stable. The mproved current account balances n turn translate nto decrease n expected borrowngs. The net external borrowng s expected to become negatve by the year whle the gross external borrowng wll decrease by 8 percent per annum. The net nternal borrowng would, on the other hand, contnue to rse, though at a reduced rate. The substantal decrease n external borrowng despte a much smaller mprovement n current account external defct can be explaned by the stablty of exchange rate resultng from the reducton n the growth rate of money. On the other hand, nternal borrowng s expected to ncrease, though at a lower rate than expected wthout the polcy mx, despte a stable current account budget defct. Ths s manly because, gven the net external borrowng, wth a decrease n the growth rate of base money, government would have to replace monetary borrowng by drect nternal borrowng. Fnally, the nternal and external debt postons are also expected to mprove sgnfcantly after the mplementaton of the polcy. The mprovement n external debt poston s expected to be more promnent because wth the stablty produced n the exchange rate, the exstng external debt would not grow as fast due to deprecatng rupee as was expected n the lght of present nflaton rate. Table 7 shows the tme profles of the expected ndcators of resource defcts after the mplementaton of the polcy mx. We observe that, except for the prvate sector s prmary defct, all the ndcators show declnng trends. For example the current account defct s expected to reman stable at about 6 percent of GDP whle the current account budget defct would declne to below 5 percent from the year onwards and by the year t wll declne to about 1 percent of GDP. The nternal and gross external borrowngs as percentages of the GDP wll declne steadly. The net nternal borrowng wll also declne, though towards the end of smulaton perod, t wll show a rsng trend.

19 Smulaton Analyss of Debt 37:4, 373 Table 6

20 37:4, 374 Ahmad and Ahmed Table 7

21 Smulaton Analyss of Debt 37:4, 375 The nternal and external debts as percentages of the GDP would declne to about 20 percent of the GDP as aganst the expected fgures of 69 percent and 33 percent respectvely n the absence of the polcy mx. Before closng ths secton, t s to be noted that the above tme paths of resource defcts have been derved from smulaton exercses and cannot be taken as the estmated tme profles. In other words, the results are relevant n qualtatve, rather than quanttatve, sense. 5. SUMMAR AND CONCLUSION Ths paper has been an attempt to study the nature of present debt crss n Pakstan wth the help of a stock-flow consstent three-gap smulaton model. The paper shows that f the nterest/rental rates on debt and foregn captal, growth rates of real GDP, foregn captal, foregn exchange reserves, money supply, prce level and exchange rate, and the parameters charactersng natonal savng rate and productvty reman unchanged then the debt crss n Pakstan wll worsen. In partcular, the current account as well as prmary budget and external defcts, nternal and external borrowngs and publc debt wll grow to unmanageable magntudes. The study consders the effectveness of varous polcy nstruments n controllng the sze of publc debt. Keepng n vew that a sngle polcy nstrument s unlkely to produce desrable results on all accounts, the paper recommends a polcy mx that s desgned to have balanced effects on all the key ndcators of resource defcency. The polcy mx s based on a number of measures ncludng an ncrease n tax rate, a cut s government consumpton expendture, prvatsaton, ncrease n the growth rates of GDP and foregn exchange reserves and a decrease n the growth rate of monetary base. It s assumed that the resultng mprovements n the budget and external balances, reduced nflaton rate, stablty n exchange rate and the encouragement of the prvate sector, the prvate savngs and productvty wll also rse, whch further mprove the poston of resource balances. The polcy mx s shown to result n sgnfcant favourable effects on many accounts n the long run, especally n terms of a reduced need for nternal and external borrowng, better growth performance, economc stablty and a reduced rsk of default. Although the study s based on smulaton experments, t provdes useful nsghts n the complex nature of the current debt problem n Pakstan. In partcular, we learn that external and nternal debt postons should be studed n the context of overall macroeconomc pcture. A meanngful soluton to the problem les n addressng smultaneously the core ssues of poor savng performance, low productvty, unchecked monetary expanson, unrealstcally large publc sector and sluggsh economc growth.

22 37:4, 376 Ahmad and Ahmed REFERENCES Ahamd, E. (1996) Captal Inflows and Natonal Debt. The Pakstan Development Revew 35: Ahamd, E. (1997) Dynamcs of Foregn and Domestc Borrowngs and Debts. Journal of Economc Cooperaton 18: Ahmad, E. (1998) Retrng Publc Debt through Prvatsaton. Unpublshed paper. Ahmad, E., and M. Idress (1998) The Tme Profle of Cost Structure n Pakstan s Manufacturng Sector. Unpublshed. Ahmad, E., and S. Paul (1998) Foregn Investment and the Neo-classcal Growth Model. Chapter 6, p In S. Paul (ed) Trade and Growth: New Theory and the Australan Experence. Allen & Unwn, Sydney. Forthcomng. Al, N., E. Ahmad, and R. Butt (1997) Dependency Burden and Savngs Rates n Pakstan A New Strategc Study. Pakstan Economc and Socal Revew 25: Burney, N. (1988) Determnants of Debt Problem n Pakstan and ts Debt Servcng Capacty. The Pakstan Development Revew 27: Chaudhary, M. A. (1988) Internatonal Debt and Foregn Dependency: Polcy Optons for Pakstan. The Pakstan Development Revew 27: Cohen, D. (1988) The Management of the Developng Countres Debt: Gudelnes and Applcatons to Brazl. The World Bank Economc Revew 2:1. Crouch, R. L. (1973) Economc Development, Foregn Ad, and Neo-classcal Growth. Journal of Development Studes 9: Naqv, S. N. H. (1970) The Foregn Captal Requrements and External Indebtedness of a Developng Country: A Case Study of Pakstan. In E. A. G. Robnson (ed) Economc Development n South Asa. London: M. Stockton, Rahman, M. A. (1967) The Pakstan s Perspectve Plan and the Objectve of Elmnaton of Dependence on Foregn Assstance. The Pakstan Development Revew 7: Tanz, V., M. I. Blejer, and M. O. Tejero (1988) The Effects of Inflaton on the Measurement of Fscal Defcts. In M. I. Blejer and C. Ke-oung (eds) Measurement of Fscal Impact: Methodologcal Issues. Internatonal Monetary Fund, Washngton, D. C. (Occasonal Paper 59.)