Addressing the Trade Deficit

At the outset of this article, let me go through the events which culminated into the unprecedented trade deficit causing a currency crisis in Pakistan. The problem was indeed brewing since 1995. The period since 1995 is full of events that I believe have been affecting our trade performance either directly or indirectly. At least one of them keeps haunting our economy to date because timely actions were not taken. 
To begin with, WTO was established in 1995, unleashing the process of trade liberalization across the globe, of course in a phased manner. In 1997, the East Asian countries experienced the Asian Financial Crisis which also affected us indirectly. 

In 1998, the government froze the foreign currency accounts after nuclear tests and adopted a system of multiple exchange rates. U.S., Japan and other Western nations imposed economic sanctions on Pakistan (1998-2001). The government managed the economy by reducing imports, but of course, exports fell too (Figure 1).
Between 2001 and 2003, the trade deficit was quite meagre. But soon after both exports and imports started climbing up, however, on much different paths. In 2005, Multi-Fiber Arrangements (MFA) which had governed the world trade in textiles and clothing, and imposed voluntary export quotas on the amount countries could export to developed countries, started dismantling in a phased manner. 
Pakistan signed bilateral free trade agreements (BFTAs) with Sri Lanka (June 12, 2005), China (November 24, 2006) and Malaysia (November 8, 2007) as well as the South Asian Free Trade Area agreement, or SAFTA (January 6, 2004) with the SAARC countries. Pakistan didn’t properly manage to capitalize from these FTAs.
Complete dismantling of MFA in 2008 affected us the most because of our industrial production and exports which were heavily concentrated on textiles and clothing. Pakistan could not endure the fierce competition in the global markets once the guaranteed export market under MFA was revoked. 
The other well-known event was the Great Recession of 2007-2009, which did affect us but not to the tune of MFA. It affected us because our major export markets i.e., U.S. and the EU, faced the brunt of it. This global financial crisis stands as an important lesson for us about the ill effects of market concentrations. 
Despite Pakistan facing disastrous floods in 2010, it managed to maintain an upward thrust in its exports and imports. Since 2011, imports have outpaced growth of exports. It is worth noting that exports (of goods and services) as a percentage of GDP were at 16.7% in 1995 which came down to 8.7% in 2018, while imports (of goods and services) as a percentage of GDP were 21.5% in 1995 that declined to 19.4% in 2018. This is the time period when Pakistan experienced ‘deindustrialization’.
In 2018, trade deficit was $36.8 billion and net outflow of investment income was $5.6 billion. Fortunately, Pakistan received remittances of $24.1 billion. Consequently, overall current account deficit became $18.3 billion, an all-time high! You may ask, how did Pakistan finance this deficit? Pakistan managed to attract $12.4 billion of foreign investment (i.e., foreign direct investment, portfolio investment and others), and used $6.3 billion of its foreign exchange reserves. In 2017, Pakistan also used $4.03 billion of its reserves to finance its current account deficit. This generous use has fast depleted the foreign currency reserves causing emergence of a currency crisis situation.
Due to the currency crisis, Pakistan is facing difficulty in paying for its essential imports and servicing its foreign debt repayments. Because of the excessive demand for currency, a sharp fall in the value of Rupee has taken place. Between July 2018 and April 15, 2019 the Rupee/Dollar parity fell from 104.97 to 141.14, a decline in value of 33%. To prevent further depreciation, the Central Bank has raised interest rate to 10.75%, which has consequently raised the cost of production. The February and March data for exports show a continuous fall in exports rather than an increase that some were predicting. So, depreciation didn’t help exports in the immediate run. All I can predict is further depression in the economy and a gloomy situation for exports.
The current size of imports as compared to exports is much too high, 2.2 times. The question thus is whether we should be concerned about the trade deficit situation? Perhaps not too much. This is because the country chose the path of trade liberalization and this outcome was expected. Our policymakers need to be more concerned about the sluggishness of exports as the export earnings did not grow to closely match with import payments.
To understand why we should not be more concerned about rising imports, four points are in order: (i) increase in imports raises competition (if imports are not unfair), which is a healthy sign as it forces domestic industries to improve productivity and efficiency. Of course, in the process the protection to infant industry, who are on the early part of the learning curve, is eroded (I am only concerned for the infant industry if they are hurt), but unfortunately many of our industries have been in the state of infancy for too long, consequently, they are chronically sick. Policymakers need to decide about the future of these industries; (ii) rise in imports also means better availability of industrial inputs, which is good to increase the production of exportables; (iii) increase in consumption of imported goods, if it relieves domestic goods for exports, may not be too harmful of a substitution for trade balance; and (iv) increase in imports also means transfer of technology because imported machinery embodies technology. Unfortunately, there has been a disturbing trend in transfer of technology as the share of machinery in total imports fell from 36% in 2007 to 31% in 2018.
Now onwards, I shall concentrate on the export-side to specifically explain where things went wrong.
After the dismantling of MFA in 2008, while their foreign competitors reaped the benefits of the opportunity, Pakistan’s textile and clothing industries could not withstand global competition from open market access. For instance, between 2007 and 2017 Bangladesh realized an increase in clothing exports from $9.96 billion in 2007 to $29.38 billion in 2017, while in comparison Pakistan realized an increase from $608 million to $2.32 billion. The difference between the breadth of benefit gained being the reason that Pakistan didn’t prepare its industries to face fierce competition created by competitor countries. 
Critics of the MFA used to argue that it was a binding constraint on export growth as it not only retarded growth but also encouraged industries to produce low quality products as quota allocation was mostly based on quantity and not the value. It was then felt that with the availability of freer market access after MFA dismantling, industries with government support would capture a bigger market share but this did not happen. 
The new entrants in global textiles and clothing markets, especially Bangladesh and Vietnam, entered with a new mindset, better technology and business management practices, often through the courtesy of foreign investment. Hence, they were successful. Vietnam, after introducing market economy reforms, signed a bilateral trade agreement with the U.S. in 2001 which lifted substantial non-tariff barriers and lowered tariff from 40% to 3% on a number of goods. As a result, trade between Vietnam and U.S. that was $451 million in 1995 rose to $54 billion in 2017. Our competitors, in general, were able to get better market access due to better economic diplomacy.
Pakistan did not pay much attention to generating exportable surplus due to high domestic consumption, low productivity, underutilization of installed industrial capacity owing to energy crisis, and low investment in the manufacturing industries. Most of the investment resulted from Balancing, Modernization and Replacement (BMR) facility available to industries, which merely replaced old machinery with new machinery. Investment for new industrial capacity was negligible. Due to inadequate investment, exporters could not take positions and make appropriate moves to meet the fast changing consumer demands in export destinations. Investment in textiles remained quite low, mainly because profit margins became unattractive due to fierce competition coming from foreign competitors. Besides, domestic margins are higher than foreign margins in certain sectors, like real estate.
Global industrial production patterns have drastically changed. The traditional vertically organized industrial patterns (raw materials  intermediate goods  manufacturing  marketing sales  after-sales services) are being replaced by network arrangements among firms (which is an efficient response to market transaction costs). Network arrangements have increased the importance of local supplier firms, industrial clusters and international distribution networks in determining export performance. But Pakistan did not encourage its industries to adopt this shift and preferred to live with its traditional industrial pattern. As a result, domestic firms failed to connect with the global value and global supply chains through outsourcing activities.
Pakistan signed BFTAs in the presence of overvalued exchange rate, and as a result, duty-free imports were made extra cheap, whereas exports were made more expensive to the trading partners. Decision-makers didn’t take timely decisions to remove exchange rate misalignment. That being so, our trading partners benefited most from BFTAs and we didn’t.
Trade facilitation system is weak as compared to competitor countries, which made exporters uncompetitive by raising cost of transaction. 
Technical skills availability is also a major problem. Evidently, Chinese workers are working in textile processing units imported from China, while Sri Lankan workers are working in the apparel industry.
Due to low productivity, Pakistan could not generate sufficient exportable surplus. While efforts should have been made to raise productivity levels and the quality through technological progress, it didn’t do so.
Suggestions for Policymaking
•   Pakistan’s total external debt and liabilities were $99.11 billion by the end of December 2018, which must have crossed the psychological barrier of $100+ billion by now. Policymakers need to take serious decisions to increase foreign earnings, especially after availing the new IMF loan facility. If we are unable to service this massive debt, then it will have very serious consequences for the economy and security! To overcome the currency crisis, perhaps the only viable option available is export growth, which should be on the top of economic policy agenda.
•   Pakistan needs good economic diplomacy. This is because even if domestic industries become highly efficient, productive and start generating exportable surplus, exports growth would be impossible without a good economic diplomacy creating market access. We need to learn from the experience of South Korea and Vietnam, who were successful in their export drive by obtaining market access in advanced countries. The government needs to put in more resources for economic diplomacy. 
•   Carefully plan and negotiate FTAs for competitive products with high export potential. Keep in front the preference received by the competitor countries in their FTAs with China and others. And ensure that FTAs would ‘create’ exports, not just ‘divert’ exports from existing trading partners.
•    Exporters need to be fully facilitated in connecting with the global supply and value chains through outsourcing activities. This would happen when free movement of goods, services and factors of production is allowed.
•   By jumping the tariff-wall, FDI has largely flowed into import-substitution industries who sell almost all of their output in domestic market. As a result, they do not earn foreign exchange for outbound income to their home countries; this has also become one of the major reasons for present currency crisis. Therefore, encourage new FDI increasingly in export-oriented industries, especially through CPEC-SEZs. 
•  Inevitably, the new drivers of Pakistan’s export growth are agro-based, medium-tech and cultural goods producing industries. The share of its cultural goods in total exports is 9% while the total world export market for cultural goods is about $500 billion. Such export potentials for agro-based and medium-tech are waiting to be tapped. Promotion of such heterogeneous export-oriented industries requires different policy packages, not just one. 
•    Given the paucity of financial resources, in the short to medium-terms, instead of encouraging non-exporters to enter export markets, Pakistan needs to focus on firms that already export as they already have an existing global market presence, knowledge of exporting, and develop the relevant export infrastructure. 
•    Modernize and enhance workers’ proficiency if we want to produce high quality products that have high demand in advanced countries to increase export earnings. Continuously align the exchange rate to give fair treatment to both exports and imports. Similarly, it is important to ensure a world-class system of trade facilitation to reduce trade cost and time uncertainty.

The writer is a Professor of Economics at the School of Social Sciences and Humanities at NUST, Islamabad. 
E-mail: [email protected]

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