The Effects Of Structural Reforms In Pakistan Economics Essay

Abstract

This paper analysed the impact of structural reform on firm exports. It is observed that structural reforms have a positive impact on exports of firms in Pakistan. The research tested this hypothesis with Pakistan exports data from the years 2002-2008 by regression of the data with reform indexes of trade liberalization, privatization and financial reforms.

1.0 Introduction

A lot of research has been undertaken to analyse the impact of structural reforms on the economy; poverty, current account deficits and GDP. Structural reform refers to a reduction of government restrictions and regulations on economic relationships and an improvement in governance (Williamson, 1990; Lora, 2001; Rodrik, 2006; Cazurra & Dau, 2008). Many developing countries have observed an improvement in their economy after the application of structural reforms while others still doubt its impact.

The aim of this paper is to see the benefits of structural reforms in particular by analyzing the impact of structural reform on Pakistani firms’ exports. The level of exports is taken to be an indicator of firm competitiveness in the global market.

In today’s competitive global arena, countries have to look deeper into economic development. For economic development, the firms in developing countries should increase their competitiveness by accessing foreign markets. Along with efforts a firm-level, the government can also play a vital role by adopting structural reforms. Hence, the question under research is:

What are the effects of structural reforms on firms’ exports in Pakistan?

The specific objective of this research is to analyze the effect of structural reforms on firm exports.

This study will be significant for the government in formulating or restructuring the structural reforms. The study will also be an inspirational tool for the firms hesitant to enter the global market. Further studies can be done on this subject analyzing the impact of structural reforms on other firms such as multinationals, foreign subsidiaries, or state-owned organizations.

1.1 Pakistan Exports

Pakistan is a member of the World Trade Organization, and has bilateral and multilateral trade agreements with many nations and international organizations. It is also a haven of rich resources and produces that can enable it to become one of the major players in the competitive world market. However, fluctuating world demand for its exports, domestic political uncertainty, and the impact of occasional droughts on its agricultural production have all contributed to variability in Pakistan’s trade deficit.

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In the six months to December 2003, Pakistan recorded a current account surplus of $1.761 billion, roughly 5% of GDP. Pakistan’s exports continue to be dominated by cotton textiles and apparel, despite government diversification efforts. Exports grew by 19.1% in FY 2002-03. (Export Promotion Bureau Statistics) Major imports include petroleum and petroleum products, edible oil, chemicals, fertilizer, capital goods, industrial raw materials, and consumer products.

Pakistan’s large foreign debt burden can be largely attributed to past external imbalances. Principal and interest payments in FY 1998-99 totalled $2.6 billion, more than double the amount paid in FY 1989-90. Annual debt service peaked at over 34% of export earnings before declining.

With a current account surplus in the recent past years, Pakistan’s hard currency reserves have grown rapidly. Improvements in fiscal management, greater transparency and other governance reforms have led to upgrades in Pakistan’s credit rating. Together with lower global interest rates, these factors have enabled Pakistan to prepay, refinance and reschedule its debts to its advantage. Despite the country’s current account surplus and increased exports in recent years, Pakistan still has a large merchandise-trade deficit. The budget deficit in fiscal year 1996-97 was 6.4% of GDP. The budget deficit in fiscal year 2003-04 is expected to be around 4% of GDP.

To aid the current account deficit, Pakistan has to rely on grants and loans from international organizations. In the late 1990s Pakistan received about $2.5 billion per year in loan/grant assistance from international financial institutions (e.g., the IMF and the World Bank) and bilateral donors. Increasingly, the composition of assistance to Pakistan shifted away from grants toward loans repayable in foreign exchange. All new U.S. economic assistance to Pakistan was suspended after October 1990, and additional sanctions were imposed after Pakistan’s May 1998 nuclear weapons tests. The sanctions were lifted by ex-president George W. Bush after Pakistani ex-president Musharraf allied Pakistan with the U.S. in its war on terror. Having improved its finances, the government refused further IMF assistance, and consequently the IMF program was ended. The government reduced tariff barriers with bilateral and multilateral agreements.

While the country has a current account surplus and both imports and exports have grown rapidly in recent years, it still has a large merchandise-trade deficit. The budget deficit in fiscal year 2004-2005 was 3.4% of GDP. The budget deficit in fiscal year 2005-06 is expected to be over 4% of GDP. Economists believe that the soaring trade deficit would have an adverse impact on Pakistani rupee by depreciating its value against dollar (1 US $ = 60 Rupees (March 2006) and 1 US $ = 85 Rupees (January 2010)).

An increase in trade deficit was largely contributed to by the increased imports of earthquake relief related items, especially tents, tarpaulin and plastic sheets to provide temporary shelter to the survivors of earthquake of October 8, 2005 in Pakistan Occupied Jammu and Kashmir and parts of the NWFP, an official said. The rise in the trade gap was also fuelled by high oil import prices, food items, machinery and automobiles. The Petroleum Ministry claimed that the increase in bill of oil imports would be sharp and steep, which is the main reason behind the all-time high trade deficit.

Pakistan’s exports increased more than 100% from $7.5 billion in 1999 to $18 billion in the fiscal year 2007-2008. Pakistan exports rice, furniture, cotton fibre, cement, tiles, marble, textiles, clothing, leather goods, sports goods (renowned for footballs), surgical instruments, electrical appliances, software, carpets, and rugs, ice cream, livestock meat, chicken, powdered milk, wheat, seafood, vegetables, processed food items, Pakistani assembled Suzukis (to Afghanistan and other countries), defence equipment (submarines, tanks, radars), salt, marble, onyx, engineering goods, and many other items. Pakistan now is being very well recognized for producing and exporting cements in Asia and Mid-East to satisfy the global building boom. (See Table 1.1)

1.2 Structural Reforms

Structural Reforms are defined as transformations of institutional frameworks and regulations for markets to function properly. (IMF, 2004:105) A key aspect of structural reforms is the retrenchment of government from the economic arena as an active participant to allow firms and individuals to conduct market relationships. The role of the government therefore becomes one to provide basic infrastructure, law and order, and rules needed by firms to undertake economic activities and limit market imperfections at the same time. (World Bank, 1997) Furthermore, Structural Reforms typically apply conventional prescriptions for improving growth by removing policy-related distortions and impediments to a well-functioning market economy. (Banks, 2005)

IMF and World Bank publish their own structural reform indexes for many developed and developing countries, unfortunately for Pakistan they only provide banking reform index. The wider criteria of structural reform include:

Fiscal discipline

Financial reforms

Public expenditure priorities,

Tax reform,

Liberalizing interest rates

Competitive exchange rates

Trade liberalization

Liberalization of inward foreign direct investment,

Privatization

Property rights

(Williamson’s (1990) original text includes ten areas of reform)

Governance was later added to this list (Rodrik 2006)

These are taken into account for Pakistan by neither IMF nor World Bank. Therefore researchers formulated structural reform indexes by themselves in order to study the impact of these on firm export. In this research, three variables to represent structural reforms were taken into consideration; namely trade liberalization, privatization and financial reforms.

1.3 Structural Reforms in Pakistan

Pakistan underwent colossal changes after ex-president Musharaf came to power in 1999. The country was at the brink of many problems at that time including bankruptcy and target of terrorism. The initial period was devoted by the economic team of the new government in managing the crisis and making sure that the country avoided default. A comprehensive programme of reform was designed and implemented so as to put the economy on the path of recovery and revival. The military government took some initially unpopular decisions such as imposing general sales tax, raising prices of petroleum, utilities and removing subsidies so badly needed to bring about fiscal discipline and reduce the debt burden. The IMF and the World Bank were invited to enter into negotiations on new stand-by structural adjustment programmes.

Brining macroeconomic stability to Pakistan was the focus point of the reform system. Although corrective action required on a number of fronts, there was a conscious effort to focus on achieving macroeconomic stability, on certain key priority structural reforms and improving economic governance. The structural reforms included privatization, financial sector restructuring, trade liberalization, towards deregulation of the economy and generally moving towards a market-led economy instead of a government regulated one. A stand-by IMF programme was put in place in November 2000, which was successfully implemented followed by a three-year Poverty Reduction and Growth Facility (PRGF), which was successfully completed in December 2004. It was due to this successful completion that Pakistan decided not to draw down the last two tranches although it was eligible to do so. The IMF has also decided that Pakistan will not be subject to the usual post-program monitoring due to its good economic standing.

Pakistan’s economic turnaround during the latter part of the decade was even more impressive because the country was faced with a critical and fragile regional and domestic environment with constant threats to security (a result of playing key role as a frontline state in the war against terrorism) a prolonged and severe drought, tensions with India and high oil prices.

1.4 Structural Reforms – Privatization, Deregulation, Liberalization

The previous government, whose era is under observation for this study, actively pursued an aggressive and transparent privatization plan whose thrust was sale of assets in the oil and gas industry as well as in the banking, telecommunications and energy sectors, to strategic investors, with foreign investors encouraged to participate in the privatization process.

1.4.1 Trade Liberalization

Trade liberalization is a system under which traders are free to export and import without government restrictions. Under a liberal trade policy, prices are a reflection of supply and demand. Interventions include subsidies, taxes and tariffs, non-tariff barriers, such as regulatory legislation and quotas. Inter-government managed trade agreements and any governmental market intervention which may result in artificial prices that do not reflect the principles of supply and demand also are evidence of trade restrictions.

Through time, Trade Liberalization has been a measure to increase economic growth, as well as promote investment and exports. The adoption of trade liberalization measures in Sub-Saharan Africa were aimed at reducing anti-export bias and making exports (especially non-traditional ones) more competitive in international markets, mainly by reducing trade policy barriers, exchange rate distortions and export duties (Babatunde, 2009).

1.4.1.1 The effect of trade liberalization on export growth

The export performance of a country may be expected to depend primarily on competitiveness and the level of ‘world’ demand which determines shifts in the demand curve for a country’s goods. There are many studies based on the orthodox supply tradition which explain the impact of trade liberalization on export growth in developing countries. Some such investigations confirm that the countries that embarked on liberalization programs have improved their export performance (Thomas et al, 1991; Weiss, 1992; Joshi and Little; 1996; Helleiner, 1994; and Ahmed, 2000).

1.4.1.2 Trade Liberalization in Pakistan

Substantial trade liberalization has taken place in Pakistan since the late 1980s, at an accelerating pace over time. Import taxes have been reduced, the Statutory Regulatory Orders (SROs) have now been mostly withdrawn and Non-Tariff Barriers (NTBs) have been largely dismantled. In particular, the average tariff rate has declined sharply from 77 percent in 1985 to about 17 percent in 2005.

Trade liberalization has been undertaken in Pakistan for the last 15 years and the maximum tariff rate which was as high as 250-300 percent has been brought down to 25 percent while the average tariff rate is about 9 percent. Non-tariff barriers have been eliminated and the culture of providing selective concessions, exemptions and privileges to individual firms has given way to an across-the-board uniform rules and regulations. Protection to domestic industry is no longer a policy objective as in the globalized world efficiency can improve only under a competitive environment. The breaking down of these artificial barriers has led to significant productivity gains and manufactured exports now account for 90 percent of the total exports. Imports of all kinds of goods – capital, consumer, raw materials – are freely allowed into the country at negligible import duty rates.

To attract foreign direct investment, the foreign investment regime in Pakistan has been kept highly open and liberal. There are no restrictions or ceilings or prior approvals required for foreign investors to set up their business in Pakistan for many sector of the economy – agriculture, real estate, retail trade, manufacturing, services, banking, insurance and other financial services. It is a pre-requisite to and register the initial foreign investment with the Central Bank, then the foreign investors are free to repatriate their profits, dividends, royalties, technical fees, debt servicing, etc. through their bankers without any prior approval. Foreign companies are allowed to raise funds from domestic sources, including bank loans, without any restrictions. They are treated equally with national firms in all respect and can bring in and out expatriate staff to run their businesses.

1.4.1.3 Trade Liberalization under SAFTA

Pakistan is a member of SAARC among six other countries. A treaty, South Asian Free Trade Area (SAFTA), was signed among the seven SAARC member countries including Pakistan and India on January 6, 2004 at Islamabad to allow free trade among member countries by eliminating trade barriers and scale down their tariffs to 0-5 percent that came in force on January 1, 2006, and will be fully implemented by December 31, 2015. SAFTA has replaced SAPTA, which was established in 1993 to liberalize trade among the SAARC countries. The SAFTA treaty, which was signed by India, Pakistan, Bangladesh, Nepal, Bhutan, Sri Lanka and Maldives, seeks to allow free cross-border movement of goods within the region, with the provision for a list of sensitive items for member countries to safeguard national interests.

1.4.2 Financial Sector Reforms in Pakistan

State Bank of Pakistan defines Financial Sector Reform as “A market based financial sector owned and managed mainly by the private sector but operating under a strong regulatory environment.” Financial Reforms in Pakistan have several characteristics:

Restructuring and Privatization of public sector financial institutions – a number of banks have been provatized and there have been improvements in their governance and transparency

Corporate Governance Reforms- strong internal audits and business practices according to code of ethics

Capital Adequacy

Risk Management

Technology Upgradation

Product Diversification and  Innovation

Increased Disclosure and  Transparency

Dealing with non-performing loans

Strengthening Regulatory and Supervisory Capacity

Legal and Regulatory Infrastructure

Liberalization of foreign exchange regime

The financial sector too, has been restructured and opened up to competition. Foreign and domestic private banks currently operating in Pakistan have been able to increase their market share to more than 80 percent of assets and deposits. The interest rate structure has been deregulated and monetary policy uses indirect tools such as open market operations, discount rates etc. Domestic interest rates on lending have dropped to as low as 5 percent from 20 percent substantially reducing financial costs of businesses.

Pakistan possesses a wide range of financial institutions, ranging from commercial banks, specialized banks, national savings schemes, insurance companies, investment banks, stock exchanges, leasing companies, micro-finance institutions and Islamic banks. They offer a whole range of products and services both on the assets and liabilities side.

Among the commercial banks, 12 foreign and 20 domestic banks together hold 80 percent of the banking system assets. Foreign banks enjoy the same facilities and same access as the domestic banks and there is no preferential treatment for domestic institutions. Unlike many countries, foreign banks can have 100 percent ownership, can open their branches or establish local subsidiary with full ownership. The above mentioned structure of banking system has resulted from a number of deep-rooted reforms that have taken place in the past five years.

Along with strong regulation, supervision and enforcement, a number of measures have

been taken to put best corporate governance practices in the system by prescribing ‘fit

and proper’ criteria for Chief Executives, members of the Boards of Directors and top

management positions. Accounting and audit standards have been brought to the

International Accounting Standards (IAS) and the International Audit Codes. External

audit firms are rated according to their performance and track record and those falling

short of the acceptable standards are blacklisted. These practices were put in place in

Pakistan long before the scandals of Enron, World Call and Pramalat had shaken the

corporate world.

1.4.3 Privatization

Privatisation is the most effective tool for the developing nations to achieve economic efficiency and to move out of the slow growth mode. Privatisation as one of the pillars of the strategic economic reforms agenda of the Government goes hand in hand with the broader policy direction of deregulation and liberalization of the economy. Its scope includes all public assets that can be transferred to or can be managed by the private sector. Only strategic industries or industries which the private sector is unable or unwilling to own or manage are exceptions. Government’s privatization program is flexible and keeps adjusting according to ground realities while keeping the overall direction intact. Privatization of public enterprises has continued over the years despite changes in the government. This has ensured continuity of policy with only minor adjustments in the program. The Privatization has been helpful in liberating the Government from micro‐management of the economy. This in turn has freed substantial public funds which were being used as subsidies for loss making public enterprises. The privatisation policy also aims to provide a vehicle for potential investors to invest in Pakistan through their participation in the privatization process. In this respect efforts are continuously being made to harness the resources of the expatriate Pakistani and domestic private sector investors. Simultaneously it is ensured to prevent the concentration of resources in a few hands by promoting privatization through competitive bidding. Side by side promulgation and strengthening of regulatory frameworks is being ensured to protect the genuine interests of the investors, consumers, taxpayers and the Government. The interests of the employees of enterprises proposed to be privatized are protected through enforcement of agreement between the Privatisation Commission and All Pakistan State Enterprises Workers Action Committee (APSEWAC).

Central to the economic reforms process has been a clear progression towards deregulation of the economy. Prices of petroleum products, gas, energy, agricultural commodities and other key inputs are determined by market.

Imports and domestic marketing of petroleum products have been deregulated and opened up to the private sector. The markets do not always function effectively. Independent regulatory agencies have been set up to protect the interests of consumers and end-users of utilities and public services.

Deregulation of oil and gas, telecommunication and civil aviation sectors have also brought about significant positive results. Oil and gas exploration activity has stepped up in recent years and constant discovery and production from new gas fields operated by private sector companies have added new capacity to meet the growing energy needs of the country. Independent power producers – both domestic and foreign private companies – have played a critical role in filling in electricity generation requirements of Pakistan.

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Telecommunication has witnessed a boom since the private sector companies were allowed licenses to operate cellular phones. One million new cellular phone connections are being added every month and the number of phones has already reached about 15 million. Long distance international and local loop monopoly of Pakistan Telecommunications Corporation has been broken and new licenses including for wireless local loop have been issued. The customers are reaping rich dividends as the prices of phone calls – local, long distance, international – are currently only a fraction of the previous rates. Since the government recently announced the policy of allowing the private operators to fly on international routes, there has been a big uptake in the aviation business. Domestic airfares have been cut by PIA which had almost a monopoly and seat load factor has reached an all time high. PIA and the private airlines are all scrambling for new planes to meet the pent up demand for air travel.

Structural Reforms’ Impact on Firm Exports

Pakistan’s exports stood at a stagnant $8 billion in 1999; however, the average annual growth of Pakistani exports was at the spectacular rate of 11.03 per cent during 1999 to 2004-05 as compared with 2.65 per cent in 1998-99. [1] This leads us to question what changes in government policies led to this increase; more importantly, was the effect positive on domestic private-owned firms if it was on foreign subsidiaries? We base our research on the recent model of Cazurra and Dau (2008), in which the researchers analyze the effects of structural reforms on firm exports. They find that structural reforms generate new opportunities and induce firms to export. However, these positive effects are more vivid for foreign subsidiaries and domestic private-owned firms as compared to state-owned firms. (Cazurra & Dau, 2008)

The literature available so far has had very little focus on structural reforms as a whole and their impact on firm exports. Several studies find that developing capitalist countries that undertook structural reforms achieved macro-economic stability and growth, although not in all cases and not to the same extent. (Knack & Keefer 1995, Katz 2004, Rodrik, Subramanian & Trebbi 2004) Also, research by Arbache (2004) concludes that structural reforms may contribute to growth if accompanied by microeconomic policies tailor-made to address the country’s needs, and by appropriate macroeconomic, institutional and political environments, as structural reforms in the case of Brazil have not resulted in increase economic growth. There must be other factors at play as well as each firm’s individual interpretation of the structural reform.

This study will investigate the positive effect that structural reforms have on firm exports, through economic liberalization and governance improvements. Economic liberalization allows firms the freedom to allocate their resources according to the optimal productivity levels, while better governance reduces transactions costs and makes market relationships more efficient. This develops our hypothesis:

H1: Structural Reforms will have a positive effect on the export of firms in Pakistan.

Methodology

Research Design

The study design is longitudinal in nature, designed to identify whether there exists a relation between structural reforms and exports in Pakistan. Pakistan underwent government change in 1999; hence structural reforms were also altered. For this purpose, export data from the year 2005 to 2008 is collected to analyse the impact of structural reforms.

Data Collection

First of all, secondary data is gathered of the government policies regarding trade liberalization, privatization and financial reforms that will be considered for the study. Export statistics are gathered from publications of the Export Promotion Bureau. It is examined what overall contribution have structural reforms made to the firm exports. All data are calculated in Pak Rupees, using the prevalent exchange rate at the time of secondary data present.

The following variables are examined:

Dependent variables are exports.

Independent variables are structural reforms: trade liberalization, privatization and financial reforms

Data Analysis

The data are gathered from secondary sources such as government publications, earlier research and mass media. Structural Reforms positively influence Firm Exports. As a result, the dependent variable is Exports and the independent variables are trade liberalization, privatization and financial reforms. The study employs the Pearson correlation model to determine the correlation between the variables. The following model is used to test our hypothesis:

Exports = α0 + α1*trade liberalization + α2*privatization + α3* financial reforms

Nature and Form of Results:

The results will be the positive coefficient α1, i.e. the impact of structural reforms for each year to determine the strength of the relation between the variables. A pattern will be observed and displayed in the form of graphs and bar charts.