In South Asia, a reminder that poor economics can be poor politics

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By Sanjay Kathuria

On April 11, Shehbaz Sharif was sworn in as Pakistan’s new Prime Minister, following a no-confidence motion against the incumbent.  A month later, in neighbouring Sri Lanka, Ranil Wickremesinghe took oath as Prime Minister, for the sixth time, after the incumbent resigned.

While politics in these countries is volatile, the leadership changes arose directly from the economic mismanagement that is habitual in Pakistan, and getting to be habitual in Sri Lanka.

Sri Lanka’s people have been reeling under the impact of back-breaking inflation and shortages of fuel, power, food and medicines, and a currency that is depreciating at record speed. This economic hardship and growing distrust of the ruling Rajapaksa family’s style of leadership led to spontaneous and widespread protests, culminating in the eventual resignation of Prime Minister Mahinda Rajapaksa.

At the time of writing, his younger brother Gotabaya Rajapaksa remains in power, as the President of the republic.

Pakistan has a similar, if only slightly less dramatic, story. Its large headcount of poor and/or informal workers implies a high sensitivity to inflation, and a Gallup poll in January, 2022 found that most people considered inflation to be Pakistan’s biggest problem. A depreciating currency does not help.

To compound this, people have been grappling with power shortages, compounding the misery of the brutal heatwaves that hit Pakistan (as well as India). This economic mismanagement precipitated a successful no-confidence motion against Prime Minister Imran Khan and his government, paving the way for his successor.

How did Sri Lanka and Pakistan manage to dig themselves into such deep economic holes? It is telling that Pakistan has, so far, seen 23 ‘arrangements’ – more than any other country in South Asia – with the International Monetary Fund (IMF), a global lender of last resort. Sri Lanka has had 16 such arrangements.

Other South Asian countries have not needed the IMF as frequently: Bangladesh has had 12 arrangements, while Nepal has had eight and India, seven. In fact, India’s last trip to the IMF was in 1991, a result of its economic crisis.

The malaise runs deep in Sri Lanka and Pakistan

The seeds of Sri Lanka’s crisis were laid around 2005, when its government (led by then President Mahinda Rajapaksa) started binging on several mega infrastructure projects, often of dubious economic value. This trend accelerated after the end of the Civil War in 2009. Growth did increase for a few years, but the path was unsustainable.

In addition, since the early 2000s, an increasingly complicated and non-transparent labyrinth of tariffs and hidden tariffs have been levied on imports, increasing the policy bias against exports; with renewed impetus since 2019, when the Rajapaksas came back to power after a four-year hiatus.

Total trade as a share of Sri Lanka’s GDP fell from 89% in 2000 to 46% in 2010, a decline of perhaps unprecedented magnitude in a modern economy. In 2019, it was 52%.

The need to fund large trade deficits and the debt overhang meant that external debt kept growing and external reserves shrinking, leading eventually to the sovereign debt default announced on April 12. Moreover, high domestic spending, coupled with low tax collections, resulted in high fiscal deficits and borrowing needs, and a total debt stock as high as 119% of GDP in 2021, up from 70% in 2012.

To compound all this, the overall investment climate favours entrenched business, with negative implications for exports and economic growth. Finally, while the Easter bombings and COVID-19 did exacerbate the shortage of foreign currency earnings in an economy highly dependent on tourism, it should be noted that the economy was already on an unsustainable path prior to the onset of the pandemic.

Pakistanis are used to poor economic leadership. Several issues bedevil the economy, but the underlying problems are the dominance of the ‘moneyed elite’, another name for crony capitalism, which leads to an anti-competitive environment and reduces economic dynamism; the lack of persistent democracy; and the prevalence of extremism.

In turn, these help to create an environment of protection from foreign and domestic competition, poor tax collections and low investment. Pakistan’s economy is highly protected, with a mixture of tariffs and hidden tariffs, resulting in a stagnant export sector and recurring foreign exchange crises. The lack of any significant trading relationship with India costs the Pakistani economy dearly: its exports could be 80% higher if it traded with India to its full potential.

Tax collections are below that of peers and, combined with persistently large fiscal deficits, result in interest payments that are almost half of tax revenue. And investment is around half the South Asian average, resulting in growth that is well below Pakistan’s potential.

Since these underlying constraints have not been effectively addressed, Pakistan has seen repeated cycles of macroeconomic distress.

Bangladeshi contrasts

Compared to Pakistan and Sri Lanka, Bangladesh has many economic virtues, reflected, for example, in its steady and robust growth. Between 1997 and 2020, there have been only two years when Bangladesh had a lower GDP growth rate than Pakistan. In 2019, it overtook Pakistan to become the second largest economy in South Asia. How did this happen?

While there are many reasons (including human development and social mobilization) for Bangladesh’s striking development in the last three decades, it is interesting, for our purposes, to focus on three differences with Pakistan and/or Sri Lanka.

First, while Bangladesh’s policies are also biased against trade, it has managed to provide a special regime for its world-class readymade garments sector, insulating it against the inefficiencies faced by other sectors of the economy.

Second, Bangladesh lives within its means, as seen in the low shares of external debt to gross national income (20% in 2020, versus 72% for Sri Lanka) and total interest payments to government revenue (estimated at 21% in FY21 versus 76% for Sri Lanka, according to World Bank data).

Third, it has a robust and growing trade and investment relationship with its giant neighbour, India, – India-Bangladesh trade is the highest among all bilateral partnerships in South Asia – getting access to cheap inputs and consumer goods for exports and domestic consumption, and, increasingly, India’s huge market.

The inflation tax on the poor

One of the most politically sensitive economic indicators in South Asia is consumer price inflation, given the high level of informality in work and the precarious existence of even those who have managed to surmount extreme poverty. In such a context, a low inflation strategy is critical to reducing poverty; otherwise, in a situation where most wages are not linked to prices, high inflation can quickly erode the hard-won gains from improvements in household income.  

A rise in prices quickly brings protesting people on to the streets, as witnessed in Sri Lanka and Pakistan in recent months. Bangladesh, too, has had its fair share of anti-inflation protests in the past, but protests over recent inflation have been relatively muted, at least so far.

In April 2022, consumer price inflation in Bangladesh was 6.3%, versus 29.8%in Sri Lanka, and 13.4% in Pakistan. India’s was 7.8%, while inflation in Nepal was 7.3%.

To be sure, shocks such as COVID-19 and Russia’s invasion of Ukraine have a lot to do with the globally elevated level of prices, termed by the IMF as a “clear and present danger for many countries”.  And yet, countries can mitigate at least part of the price shock, depending on their overall economic capacity, fiscal headroom, level of flexibility in the economy, and some luck – as can be seen in the significant differences in inflation rates amongst South Asian countries.

A striking example of fiscal headroom in addressing inflation can be seen in tax-related actions in Pakistan and India in recent weeks. Pakistan, which is seeking to renew its stalled arrangement with the IMF, had no choice but to raise prices of petroleum products in May and June 2022, in order to reduce budgetary losses and move towards fiscal consolidation, a core goal under the IMF’s Extended Fund Facility. Unfortunately for Pakistan – and this is the bind that it finds itself in – this action will raise prices even further.

Meanwhile, to reduce inflationary pressures, India, in May 2022 (following similar measures in November 2021), took a significant fiscal hit and reduced excise duties on petrol and diesel.

Lessons for South Asia

The contrasting economic stories of Pakistan, Sri Lanka and Bangladesh offer several lessons for South Asia and for emerging markets, more broadly. These lessons are not new, but have acquired a contemporary relevance, even for those countries that are not facing an immediate economic crisis.

First, crony capitalism can endanger sustainable growth and economic dynamism. Every country in the region is susceptible to some form of ‘insider-outsider’ policies, and this hurts not only those who are on the outside, but the economy as a whole.

Second, trade diffidence and a policy bias against exports, endemic in many countries in South Asia, not only reflects the power of entrenched business interests, but also exacerbates its negative impact by restricting international competition. On the other hand, low trade barriers are unambiguously good for consumers, especially the poor, because unimpeded imports help to check domestic prices and provide a wider range of consumption options. Import competition and availability of globally competitive inputs can also improve productivity and enhance economic diversification.

Third, the lack of deep economic relations with neighbours penalises trade, growth and employment, and implies that regional buffers against global economic volatility are inadequate.

Fourth, a conservative approach to domestic and external debt is a core element of a sound long-term economic strategy, since it is associated with economic stability – a sine qua non of private sector led-growth. In turn, a sound debt strategy involves adequate, broad-based tax collections and sustainable fiscal deficits; a competitive economy that helps the external deficit stays within reasonable limits; and prudent external financing focusing on foreign direct investment and productive, long-term borrowing.

The fate of Pakistani and Sri Lankan leaders is a timely reminder that while good economics may not always be enough to get leaders re-elected, poor economics can hasten their political exit, at least temporarily, even if they have illustrious surnames. To stay in power, following sensible economic strategies is a good starting point.

-Sanjay Kathuria is a Senior Visiting Fellow at the Centre for Policy Research, India; Fellow at the Wilson Centre, Washington, DC; Non-Resident Senior Fellow at the Institute of South Asian Studies, Singapore, and Visiting Professor at Georgetown University and Ashoka University. This article was originally featured on thewire.in

 

 

 

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