Believe it or not, seven/eight years of continued economic mismanagement and bad economic policies have thrown Pakistan’s economy in deflation. Deflation, as opposed to inflation, is defined as the persistent decline in general price level. Deflation occurs when the inflation rate continuously declines and falls below zero percent (a negative inflation rate).
Pakistan has seen its inflation rate, as measured by the changes in Consumer Price Index (CPI) a decline from 9.2 percent in April 2014 to 3.9 percent in January 2015. Most importantly, inflation rate as measured by the changes in Wholesale Price Index (WPI), witnessed a sharper decline since June 2014. The WPI based inflation was 7.7 percent in June 2014, declined to zero percent in November, turned negative by 0.9 percent in December and further to negative 2.4 percent in January 2015.Excluding energy, WPI based inflation decelerated from 7.2 percent to 1.5 percent during the same period. Most importantly, non-food and non-energy inflation decelerated even sharper, declining from 7.3 percent to negative 2.8 percent during the same period. Inflation data, beyond any doubt, confirms that Pakistan has landed in deflation.
The WPI based inflation is more akin to producer price index. If businesses see the prices of their products falling sharply, it is an indication of deteriorating economic conditions of the country. A rapidly declining consumer price builds expectations of a further decline in prices, therefore consumers delay their purchases and reduce consumption. Businesses, on the other hand, see their profits declining because of the decline in prices of their products. It discourages businesses to expand their operations, it idles the productive capacity leading to a fall in private investment.
In a deflationary phase, as we are already into it, people lose jobs as private sector fails to expand its operations because there are reduced expectations on future profits when future prices are lower. The loss or fear of loss of jobs forces people to reduce consumption. Thus private sector reduces investment and consumers reduce consumption, leading to a sharper decline in domestic demand and reduction in economic activity.
Misplaced fiscal and monetary policy also contributes to taking the economy in a deflationary phase. Pursuance of tight fiscal and tight monetary policy under the ill-conceived IMF Program has indeed contributed significantly in taking the economy into deflation. Austerity measures (sharp reduction in budget deficit) indeed contributed to deflation. Decreased government, businesses and consumer spending on the one hand and tight monetary policy (reduction in money supply) on the other have caused deflation in Pakistan. Once deflation has shown its ugly head, it can be very difficult to break the cycle of deflation. Japan and Europe are the classic examples of recent times.
Deflation is a rare phenomenon that does not occur in the course of a normal economic cycle. Investors therefore recognise it as a sign that something has severely gone wrong with the state of the economy. In a deflationary phase, economic activity slows considerably, domestic demand collapses, unemployment and poverty rise, and most importantly, it breeds social unrest in the country.
Let me provide empirical support to my above argument. Deflation is caused by slower monetary expansion in the midst of a collapse in domestic demand. This is the explanation given by Ben Bernanke, the former Chairman of Federal Reserve System, while studying the Great Depression of the 1930s. Is there any sign of slowing economic activity and collapse of domestic demand in Pakistan?
The most important sign of slowing economic activity is the decline in imports of crude and petroleum products during the first half (July – December) of the current fiscal year. The readers would recall that one of the factors that caused sharp decline in the international price of oil was the slowing down in economic activity in countries like China, India; Europe etc. Slower growth in these economies has reduced the demand for fuel. Likewise in the case of Pakistan, further slowdown in economic activity has resulted in the decline of imports of crude and petroleum products in quantity terms by 3.3 percent and 2.1 percent, respectively.
Secondly, the large-scale manufacturing (LSM) is stagnating for quite some time; the reasons for this stagnation are well known. In the absence of idiosyncratic manipulation of statistics, the LSM continues to grow in the range of 1.0 – 2.5 percent per annum over the last two years.
Thirdly, the subdued domestic demand is well reflected through the collection of sales tax at domestic level. Domestic demand serves as tax base for sales tax at domestic stage which has simply collapsed during July-December 2014. Despite increase in its rates, sales tax at domestic level grew by only 1.7 percent – far less than the prevailing inflation rate.
Fourthly, collapse in domestic demand and continuous decline in wholesale as well as consumer prices have discouraged private sector to expand their businesses. This fact is well-reflected through their borrowing patterns from commercial banks. Credit to private sector is down to Rs 164 billion during July-January 2014-15 as against Rs 300 billion in the same period last year. Investment, particularly private investment, is on the decline since 2007-08 and given the current state of the economy, we may see a further sharp decline this year as well.
Finally, exports and most importantly, manufacturing exports are on the decline. Exports registered a negative growth of 4.3 percent, and textile and other manufacturers declined by 0.4 percent and 15.0 percent, respectively during the first half (July-December) of the current fiscal year. The stagnation in LSM is consistent with the decline in exports, overall economic activities, imports of energy and credit to provide sector.
The above analysis clearly shows that Pakistan’s economy has landed in deflationary phase. The collapse of domestic demand supported by ill-conceived IMF dictated fiscal and monetary policy played key roles in taking the economy into deflation. To take the economy out of deflation requires a change in fiscal and monetary policy. Fiscal/monetary stimulus is pre-requisite to combat deflation. Monetary stimulus (reduction in interest rate) has not worked in Japan and Europe thus far.
In a country like Pakistan we need fiscal stimulus through raising development expenditure, particularly in energy and social sector to pump prime the economy. IMF dictated budget deficit target will prolong the deflationary phase with all its adverse consequences for the economy.
Pakistan has entered into a difficult and challenging phase in its economic history. Once in deflation, it requires deft handling of the economy. If no corrective measures are taken soon, it will be very difficult to come out from deflationary spiral. I would urge the government and its spin master to avoid presenting a rosy picture of the economy. The data presented by the government themselves speak volumes about the deteriorating conditions of the economy.
The economy belongs to the 190 million people of this country. We should not play with the fate of the people by giving them a false sense of prosperity. The sooner we accept the better it is for the country and its people.