Industrial slowdown: causes and remedies
By Sartaj Aziz
The World Bank President, Mr. James Wolfuson, when he met the Finance Minister, Mr. Shaukat Aziz, in Washington last week, expressed two major concerns, according to the official announcement: the slow growth rate and rising level of poverty. Both are interrelated and both need deeper analysis.
One of the most important factors in the disappointing performance of the Pakistan economy in the 1990s has been the industrial slowdown. The rate of growth in the manufacturing sector in the preceding three decades from 1960 to 1990, was 9.9 per cent, 5.5 per cent and 8.8 per cent respectively or an average of 8.1 per cent. As a result, the average GDP growth also slowed down from 6.1 per cent in 1960-90 to an average of 4.6 per cent in the decade of the 1990s. The agriculture sector, on the other hand, has maintained its impressive growth rate- 5.4 per cent per annum in the 1980s and 4.2 per cent in the 1990s.
There are at least four main causes of the industrial slowdown in the 1990s: reduction in protection as a result of the economic reform programme initiated in the early 1990s; higher cost of production in the industrial sector combined with low labour productivity; weaker demand for industrial products following overemphasis on the IMF-supported stabilization policies in the past 10 years; and declining investor confidence due to several economic and non-economic factors.
A key element of the economic reform programme launched in 1991 was the creation of a more open economy through lower tariffs. The average import tariff of 80 per cent (going as high as 150 per cent for some items) has been gradually reduced to 20 per cent by 1999. This naturally reduced the high level of protection that was available to certain industries in the expectation that these inefficient industries, requiring high protection will fade away and will be replaced by new investments in value-added industries like electronics, chemicals and engineering. As explained later, the climate for new investment was, however, affected adversely by several non-economic factors.
While industrial production from the existing industries thus began to decline, the expected expansion from value-added industries did not take place and the overall rate of industrial growth declined from 8.1 per cent in 1991-92 to 2.5 per cent in 1994-95, 0.1 per cent in 1996-97 and 1.5 per cent in 1999-00. Only in 1997-98 and 1999-2000, the growth rate recovered briefly to 6.9 percent and 7.6 per cent respectively, largely due to good sugar-cane and cotton crops.
High cost of production: The cost of production in various industries is determined by the relative cost of raw materials, the utility prices, the interest rate structures and productivity of labour. In Pakistan, all these elements have progressively become more negative:
* Textile and sugar industries benefited for many years from cheaper cotton and sugar-cane at the cost of growers. Under the liberal economic policies, farmer received prices comparable to international prices and these "concealed rents" available to our industries disappeared;
* price of electricity in Pakistan is almost double that of neighbouring countries because of leakages, theft of power and cross subsidization of different consumer groups at the cost of industrial and commercial consumers. The average industrial tariff is Rs6 per kwh, which is twice as high as in the mid-1990s;
*similarly, the cost of credit is higher than in other countries of South Asia mainly because the high proportion of defaulted loans add at least 4-5 per cent to the average interest rates charged by the nationalized commercial banks. the administrative costs of our banks are also higher than those in other countries. In my budget speech of 14th June 1993, I had announced a phased programme to reduce high rates on loans, enhance profits on savings and restrict the scope of concessional credit. In the next two years, the average rates did decline from 18-19 per cent to 15-16 per cent but in the past 5 years, the average interest rates have remained between 14 and 15 per cent. Since in the meanwhile, the inflation rate has declined to 4-5 per cent, this constitutes a high real interest rate of almost 10 per cent;
*labour productivity has been traditionally low partly because of the poor quality of human capital and partly because the industry itself has not invested in training and research to upgrade the level of skills and improve productivity;
*there are serious gaps in infrastructure like railways, ports and road networks and in the overall quality of services sector. That is why the industry is forced to maintain larger inventories equal to about 6 months requirements (compared to only 14 days in Japan). That also ultimately adds to the cost of production and adversely affects the competitive position of our industry in world markets;
*in January 1993, I had set up a committee under the Chief Economist, Planning Commission, to examine all the links in the service chain from the opening of LCs till the arrival of goods in the warehouse. It had done some useful work, but with the dismissal of our government in April 1993, the process was disrupted and has not received much attention on a systematic basis after that.
Weaker demand: The main thrust of the economic policies since 1988 has been to pursue the IMF-supported stabilization programme through a contractionary fiscal policy including cuts in development expenditure and a tight monetary policy to reduce the current account deficit. These policies, which included regular increases in utility charges and elimination of all subsidies, not only contributed directly to increased unemployment and poverty but also curtailed purchasing power and the demand for industrial products. When fiscal deficits are high at -8.9 per cent of GDP, their reduction deserves high priority but once these have brought down to a level below 6 per cent, then a more gradual reduction can allow more fiscal space for expanding public sector development expenditures and social sector spending. Such a policy can in turn stimulate industrial growth partly by increasing the demand for industrial products through larger purchasing power in the hands of the consumers. That is the only way to ensure that the benefits of reform reach the poor, as also emphasized by Mr. Wolfensen.
Investor confidence: Investor confidence has been affected by both economic and non-economic factors and overall investment has fallen from the peak of over 20 per cent of GDP in 1991-93 to less than 14 per cent in 2001-02.
After the initial policy reforms, recurrent political instability did not permit a sustained process of reform, under which inevitable distortions could be systematically removed. For example, while the overall tariff rates were reduced, the distortions created by special tariffs previously introduced to provide location-driven incentives or energy-relative incentives, created new complications for potential investors. Similarly, as duties on finished goods were reduced, the margin of protection left for semi-finished components or raw material became negative in some cases, particularly because duties on certain raw materials like steel, polyester and tin-plate could not be reduced below 35 per cent to provide minimum necessary protection to items produced by the Pakistan Steel Mills, new polyester plants and plants producing tin-plates. These anomalies and the selective changes that were necessitated created a climate of uncertainty.
Non-economic factors that adversely affected the investment climate included political instability caused by the removal of elected governments every two or three years, economic sanctions imposed by USA from October 1990 and by all major donors after the nuclear tests of May 1998, the impact of the 1997 Asian economic crisis and more recently harassment of businessmen by tax and accountability authorities and tensions with India.
The law and order situation has been difficult for many years but the fall-out of the Afghanistan crisis, after September 11, has totally vitiated the climate for foreign investment. Most foreign airlines have suspended their flights to Pakistan making travel to Pakistan even more difficult.
In 1992, Pakistan was included for the first time in the World Competitiveness Report published annually by the World Economic Forum in Geneva since it had crossed the qualifying threshold. But two years later, Pakistan fell below the threshold based on 8 sets of indicators and was eliminated from the Report.
There has been some new investment in the past three years for the balancing and modernization of the textile sector, largely because of the first year depreciation allowance of 90 per cent allowed in the 1998 Investment Policy, but in terms of investment in new value-added industries, it has been minimal. In the past six years, for example, only 7 new companies have been registered on the stock market against 198 companies listed in the two years from 1991 to 1993.
Remedies: Unless these causes of industrial slowdown are carefully analyzed and remedied through a combination of structural and policy measures, it will be difficult to move towards the paramount objective of economic recovery or accelerating the overall growth of the economy to at least 5 per cent per annum on a sustained basis.
These remedies can be divided into two broad categories: remedies that lie in the domain of economic policies and those that are influenced by non-economic factors.
Remedies in the first category would include the following priority tasks:
* removing all the tariff distortions and anomalies that create disincentives for value added sectors; * systematic review of all the elements of cost of production that affect the competitive position of our industries. This would include lowering the electricity and gas tariff for industrial consumers, at least during non-peak hours, special arrangements to remove the burden of non-performing loans from the portfolio of nationalized commercial banks so that future borrowers do not have to pay for the sins of past borrowers; * significant improvements in the services sectors by examining all the elements of the services chain, from the opening of LCs to the arrival of goods in a warehouse, and improving the weak links in the chain;* systematic review of the problems faced by different industrial sub-sectors, like smuggling or those created by special incentives for competing industries.
