Pakistan and the Wrong Road

Seemingly against the odds, Pakistan's stock market has continued to defy expectations, outperforming the rest of Asia outside Japan for the past 18 months and all of the emerging markets since last March.

Since January 2009, the average annual return for the MSCI Pakistan Index has been 31 percent, beating MSCI Emerging at 19 percent, and Frontier markets by 3 percent. Its equities market has consistently outperformed India since 2002 despite the latter's superior economic performance over the period.

But that stellar market performance has masked an economy with deep, deep problems, according to a new report by Sharmila Whelan, an economist writing for the Hong Kong-based financial analysis firm Asianomics.

Getting a handle on those problems, and doing something about them, is something that has preoccupied a growing number of western powers, given that an unstable, nuclear-tipped country, threatened by a myriad of Islamist and other violent sectarian strains, poses serious problems not just for the region but for the world.

Pakistan, Whelan writes, is a country going in the wrong direction. There was plenty of evidence of that on show when suicide bombers killed at least 115 people on Thursday and wounded more than 270.

It didn't have to be this way. In 2001, Pakistan was identified as one of the BRICS plus 11 countries that would economically dominate the 21st century. That hasn't happened and, according to Whelan's analysis, it isn't likely to. Both annual GDP and domestic demand growth, on a five year moving average, have moved down, not up as was predicted by the BRICS analysis. Average annual GDP growth has gone from 6 percent plus in the 1960s to around 3.5 percent in the last five years.

"In 2001, rural employment stood at 71 percent, suggesting that there was plenty of scope to boost GDP growth by redeploying labor from the relatively low growth, low productivity agricultural sector to a growing manufacturing sector," Whelan writes. "The view is that as labor is employed in more productive sectors, household incomes would rise and with them, consumption and savings. That in turn would finance higher investment, creating a virtuous cycle of rising growth and prosperity.

However, more than a decade later, 70 percent of employment remains in the countryside. Urbanization is 36 percent. Investment (and savings) as a share of GDP stand at a dismal 13 percent.

"Pakistan has failed to diversify, innovate and specialize," she writes. "It has consistently lost global export market share and its economic structure is changed little since 2001. Manufacturing accounts for just 17 percent of GDP and agriculture at over 20 percent is not much different from in 2001."

Pakistan, she continues, has failed to create good institutions and that failure to realize the country's economic potential largely reflects its failure to build the kind of good institutions that encourage and protect the economic incentives for growth. Poor institutions have in fact resulted in growth-impeding governance and a poor regulatory environment.

"Pakistan for decades has been a hornet's nest of vested interests and competing political and social interests. And it is not getting any better," she continues. "The secular decline in GDP growth is a case in point. A rent-seeking culture has characterized most of Pakistan's history."

The two competing parties for political and economic power are the military and the elite, traditionally the land-owning class, although an n industrialist class has arisen as well.

The country's major political parties are feudal in nature, dominating provincial governments and more than two thirds of the National Assembly.

Some 300 elite families own 45 percent of Pakistan's cultivated land and have transformed their control over land, tenants and customary loyalties into political power.

"In the 1950s and 1960s the feudal families exercised their control over national affairs through the bureaucracy. In the 1970s they migrated into politics to assume direct control. Land-owning families in southern Punjab and northern Sindh especially have been able to dominate local and regional politics and extend their dominance to the national level."

Almost all political parties today are extensions of the dominance of these powerful families. In 2009, Whelan writes, 82 percent of local district heads were scions of families who have traditionally been in politics and have had representation in national and provisional assemblies of past.

The current president, Asif Ali Zardari, for instance, has two sisters and one brother-in-law in the National Assembly. There have been only two instances in the past when established families have been defeated in elections, 1970 and 2002.

The feudal elites are central to the patron-client character of Pakistani politics. Their politics are driven by managing and strengthening family interests. Political parties and leaders depend on patron-client networks to win votes. In these circumstances those who enter politics or the civil service are expected to use their position to advance their kin, clients and patrons.

The other major player is the military, she writes. "There have been four military governments, three of which came to power through coups. Direct military or military-dominated civilian governments have been in power for a total of 37 years, more than half of the time since independence. Pakistan's leaders have utilized its strategic position to bolster and legitimize their regimes while extending their influence into the economic sphere."

External allies have helped Pakistan's military maintain power and consolidate its position. Through the Cold War, the Soviet invasion of Afghanistan in 1979 to the current day War on Terrorism, Pakistan has proved a staunch ally of the West. The US and its allies have rewarded the military by not only showering aid on it but by giving legitimacy and international recognition to successive military regimes.

Relationships with the US of recent have soured following the US-led assassination of Osama Bin Laden last year at a compound suspiciously close to Pakistan's ISI headquarters.

"Nonetheless overseas financial aid remains substantial. No one wants an unstable Pakistan. It is too important from a geopolitical point of view. As a result, prospects of a fiscal crisis or a popular uprising forcing change are low. Financial aid will always be forthcoming."

Meanwhile the military's direct and indirect economic interests have grown with time, particularly during the tenure of President Pervez Musharraf. They now span banking, insurance, cement, fertilizer, electricity and sugar. Pakistan's military regimes have supported the rise of a number of military-industrial elites in politics.

"Having said that it should be highlighted that the country's growth performance under military regimes has on average been better than under the watch of civilian governments and they have done more to deregulate, privatize and liberalize the economy. However, they have fallen short in moving the country onto a sustainable growth path."

The military-elite complex

The relationship between the armed forces and the feudal elite itself is complex. Even when not in power the military has been an important behind the scenes influence. Again while the elites and the military are rivals on the surface, in reality they overlap and have worked together to entrench the system of vested interests, to the detriment of Pakistan's electorate. The armed forces have historically been dominated by Punjabis and have represented the landed and industrial elite. In an effort to legitimize and perpetuate their rule all military leaders have sought to co-opt powerful political families.

With few exceptions all the major political dynasties have been a part of successive military regimes to protect their own long term political interests and to receive state patronage. Some of the most powerful political families were propped up by military regimes.

The result of this vested-interest infested political system is that Pakistan's legal framework, the very foundation for protecting economic incentives, has never been stable. The constitution has been abrogated and fundamental legislation has been molded by successive leaders to suit their needs.

The outcome is that parliament has been systematically weakened. The political independence of civil servants at all levels has been increasingly shackled.

President Musharraf is estimated to have appointed some 1200 acting and retired military officers to senior government positions during his time.

The cost to the economy, the people and business has been high. Pakistan ranks 134 of 182 countries on the corruptions perception index. On the UN's Human Development Index Pakistan ranks 145th out of 187 countries.

While Pakistan's stock market has outperformed and there are still good companies to invest in, the economy has been on a downward trajectory for some time. History shows good demographics and a high investment rate (which Pakistan does not have) are not enough to deliver high growth. What drives growth are economic incentives that encourage investment, specialization and innovation. Pakistan's failure to realize its growth potential can be traced back to the nature of its political and social system which has impeded the emergence of strong institutions that create and protect the economic incentives for growth." The savings investment rate, at 13 percent of GDP, is extremely low compared with its Asian peers, which has been a major constraint to expansion of manufacturing. Financial sector assets are 40 percent of GDP, compared with 80 percent on average for Asian emerging markets. Banks make up 90 percent of the sector. Worse, the majority of loans are being channeled to the government, whose financing needs are unlikely to wane any time soon.

"The government has made a stab at reforms following the IMF bailout in 2008. Tax administration has improved," she writes. "Some tax exemptions have been removed. In 2008, domestic petroleum product prices were increased by 70 percent and electricity tariffs by 90 percent. Political instability and Pakistan's entrenched client-patron system continue to undermine genuine attempts at fiscal discipline and economic reform.

As a result government tax revenues today account for less than 10 percent of GDP. About 1 percent of the population pays income taxes while agriculture as a sector, the source of wealth and power of the feudal elite, pays no taxes. Meanwhile interest payment take up a third of total government spending while subsidies account for almost 4 percent of GDP.

Consumer price inflation has been moderating this year as the economy has slowed and global commodity prices have weakened but average price inflation remains high. Central bank financing of the fiscal deficit has been an important driver of both consumer price inflation and inflation expectations, both continuously hovering around 15 percent. In addition to its obvious impact on poverty, high inflation also, needless to say, hurts growth and the poor disproportionately. Poverty incidence stands at 50 percent.

"Despite its huge potential," Whelan concludes, "Pakistan has failed to specialize and develop both its manufacturing and export facing industries. Its main industries are textiles and apparel, food processing, pharmaceuticals, construction materials, paper products and fertilizers. Its exports are low value-added and labor intensive. Cotton, related together with garments, shoes and carpets make up close to 50 percent of total exports.

"The risks to growth are skewed to the downside," she writes. "Having said that, Pakistan's equity market has been a regional outperformer, suggesting that even amid our dire economic prognosis there are companies of value to be found. We would say though, strongly so, that investors need to tread carefully. Sometimes there is a disconnect between economic fundamentals and investment returns but one cannot escape the former forever."