<< Introduction

Part One: Selected Macroeconomic Indicators and Their Performance

In February 1997, Nawaz Sharif became Prime Minister of Pakistan. He made improving the economy his top priority, emphasizing liberalization and privatization of the economy. During his previous term in office (1990-93), Nawaz Sharif began the process by successfully privatizing eighty small- and medium-size factories. But many sectors of the economy were still state controlled in 1997, so economic revival was not an easy task for Sharif's government. Among the biggest challenges faced by the new government was the question of relations with the IMF, which were severely strained under Benazir Bhutto because of corruption and economic misgovernance by her government. Prime Minister Sharif was able to improve relations with the IMF, but they remained cordial only for a short period of time. The second biggest challenge for Sharif's government was to avoid default on its foreign obligations. When Benazir Bhutto's second government was dismissed in November 1996, foreign exchange reserves had sunk to below  $630 million, or just enough to finance a little over four week's imports. This was in contrast to debt repayment of just over $600 million due in December 1997. In order to cope with this precarious situation, Sharif made a direct plea to Pakistanis living abroad to make foreign exchange deposits to help tide the country over with its debt obligations. The third challenge for the Sharif government was to control the rising domestic debt, which reached 90 percent of the GDP in 1996-97. The fourth challenge was to control the accelerating trends in poverty, which were on the rise in the 1990s.

Towards the end of 1997, Pakistan again found itself in political crisis. [6] This political instability greatly affected the economy and had an especially great impact on foreign investment. Domestic businessmen put investment decisions on hold. In addition, several necessary, but sensitive, decisions were postponed. The government had done nothing to act on its commitment to reduce the number of federal government employees from 300,000 to 200,000 by the end of November. The government also promised international agencies that it would protect public sector power corporations—such as the Water and Power Development Authority (WAPDA), Karachi Electric Supply Corporation (KESC), and Sui Northern Gas Company—from imminent bankruptcy by raising utility rates from 20 to 50 percent. But Sharif balked at taking such decisions in the politically charged environment that prevailed in the country.

At the beginning of 1998, Nawaz Sharif's government claimed that the country's economic prospects were improving. But in reality, the economic scene remained cheerless, if not bleak, and negatively affected by the deteriorating law and order situation in the country. Several other factors also undermined confidence. The government, despite its electoral mandate, had shied away from taking tough, but necessary, fiscal decisions. In addition the government did little to achieve the macroeconomic targets set out in its loan program with the IMF.

In May 1998, Pakistan conducted nuclear tests, which resulted in economic sanctions from the international community. These sanctions greatly affected the already poor economy. However, the situation changed at the end of the year when the United Sates began to relax the sanctions and encouraged international financial institutions to provide help to Pakistan. In November, the United States lifted some of the economic sanctions on India (which also tested nuclear weapons in 1998) and Pakistan after securing their commitments to practice non-proliferation. However, according to the Economist Intelligence Unit (EIU):

The sanctions imposed on Pakistan by the USA are not significant in terms of potential American assistance to Pakistan; in fact, the US government has not given any economic loans or grants to Pakistan since the USA aid was cut off to Islamabad in 1990 following Pakistan's refusal to freeze its nuclear program. However, they have indirectly affected other resources of assistance: the IMF, World Bank and Asian Development Bank will not resume economic assistance until the US and other G8 countries have signaled that they will not block approval. [7]

It was again towards the end of 1998 that Pakistan faced another severe political crisis. Sharif enforced his Shariat Bill to impose Islamic law, which prompted widespread opposition from minorities, human rights groups, and even some Islamic groups, who complained that it would undermine rights guaranteed in the 1973 constitution while simply serving to distract from more important issues. [8] Civil strife increased in Karachi and the Mutthida Quami Movement (MQM) ended its coalition with the Pakistan Muslim League Nawaz (PML-N) party. Subsequently, Sharif dismissed the government in Sindh and imposed central government rule in the province. Furthermore, the army chief resigned amid rumors about an imminent military coup in the country, which was followed by an intensification of the political crisis in October 1999, when the military took over the reins of government. All these factors adversely affected the economy as political uncertainty led to the evaporation of foreign investors' confidence.

Reflecting on the results of Nawaz Sharif's second government, now an attempt will be made to analyze the performance of Pakistan's economy based on analysis of its macroeconomic indicators.

Poverty

The most common way to measure poverty is based on income or consumption levels. A person is considered poor if his or her consumption or income level falls below a minimum level necessary to meet basic needs. This minimum level is usually called the poverty line. The World Bank uses reference lines set at $1 and $2 per day in the 1999 Purchasing Power Parity (PPP) terms (where PPPs measure relative purchasing power by comparison to other countries). It was estimated that in 1999, 2.2 billion people worldwide had consumption levels below $1 a day—23 percent of the population of the developing world, with an additional 2.8 billion living on less than $2 a day. [9] In Pakistan, 31 percent of the population lives on less than $1 a day, while 85 percent lives on less than $2 a day. [10] Furthermore, Pakistan has a per capita income of $420 a year. Recently the World Bank began including many other factors besides income levels to measure poverty. These non-income indicators include health, education, and access to basic services. [11] In these terms, Pakistan has, for example, an adult literacy rate of 42 percent for males and 71 percent for females. [12] In the health sector, nearly one in ten children die before reaching the age of five. [13]

The government of Pakistan uses a different yardstick for measuring the poverty in the country and sets its own poverty line. Instead of applying the universal formula of one dollar a day of earnings per capita to count the absolute poor, it now considers a monthly income of PRs 748, enough to afford 2,350 calories a day, or almost PRs 1,000 less, as being poor. Those having less than that income are held as too poor now. What that means is that, instead of an income of PRs 1,710 a month on the basis of PRs 57 for a dollar for 30 days, one has to get PRs 25 per day or PRs 748 in a month not to be regarded as poor. [14]

The incidence of poverty increased in Pakistan during the 1990s. [15] A report from the Asian Development Bank, "Country Strategy and Program 2002-2006, Pakistan," outlines the economic reversal that occurred in the 1990s. Poverty increased from 26.6 percent in 1992 to 32.2 percent in 1999, with the total number of poor increasing by more than 12 million people. Poverty is most intense in rural areas, where about three-fourths of the poor live. The failure of economic growth to keep up with a burgeoning workforce (growing at an average rate of 2.4 percent a year) exacerbated these trends. Structural causes of economic failure, such as an expanding foreign debt and economic mismanagement, were joined by a failure to invest in growth in human development, in areas like education, health care, and other basic social services. Private investment faltered also, driven by political uncertainty. [16] According to some studies, caloric-based poverty in effect doubled from 17.4 percent in 1987-88 to 32.6 percent in 1998-99. [17] As a result, Pakistan became less competitive as economic globalization expanded in the 1990s.

The government of General Pervez Musharraf made poverty alleviation its top priority, a platform it supported by the allocation of more resources for poverty reduction. [18] The first pillar of this strategy is macroeconomic stabilization and resumption of economic growth. In the past, Pakistan has struggled to achieve macroeconomic stability. The country faced a debt payment crisis in 1998, investor confidence was at the lowest ebb, links with the international community were disrupted, and financial reserves were so low that the country was at the brink of default. By 1999, the public debt of Pakistan became unsustainable, with debt servicing pre-empting more than half of revenues, and external and domestic debt exceeding the country's GDP. The government of General Musharraf rectified this worsening economic situation in the next three years and, as a result, in 2002 inflation had fallen to less than 4 percent, the fiscal deficit was brought down to 5 percent, external debt indicators improved, public debt servicing declined, the exchange rate stabilized, and exports were growing at the rate of 16 percent. Foreign currency reserves reached $10 billion. This improvement in all the macroeconomic indicators enhanced the image of the country internationally.

The second pillar of Musharraf's poverty alleviation strategy is improved governance. Governance has improved due to reform of the public sector. The government especially emphasized accountability, transparency, and predictability in decision-making. The government introduced a political devolution plan whereby administrative, functional, and financial responsibilities for the delivery of social services are delegated to district governments. Discretionary powers of government officials have been reduced and placed under the administrative control of the elected representatives of the people.

Structural reforms constitute the third pillar of the poverty alleviation strategy. Broad based reforms in tax administration, trade liberalization, and the financial sector form the core. In tax administration, the Central Board of Revenue is being restructured, while the tax base has been widened. Trade liberalization has resulted in tariff rationalization, removal of various restrictions on exports and imports, and deregulation. Financial sector reforms have already resulted in a sound and healthy banking system, a buoyant stock market, a growing corporate debt market, and the strengthening of regulation and supervision.

The fourth pillar of the strategy is poverty-targeted interventions. Prominent among these are education sector reforms, healthcare for all, population planning, Zakat, the Khushali program for employment generation through public works, a food support program, and the Khushali bank. [19] The Zakat system has been revamped to provide financial grants to the beneficiaries to start small enterprise or other income generating activities. The food support program subsidizes wheat flour for those below a certain threshold of monthly income. Khushali program funds are allocated to local governments to create and improve the physical infrastructure, while creating employment. The Khushali bank is a micro-finance institution, which provides small loans to the poor under supervised group guarantee schemes. [20]

Governance

Good governance is an important element of economic stability and growth. It provides a system in which people have access to justice and the writ of the law is enforced. Along with other factors, poor governance breeds corruption and hinders economic development. It would be pertinent to mention at this juncture one definition of good governance. According to the World Bank, governance is "the exercise of authority, control, management, power of government." [21]

The World Bank emphasizes that good governance is central to creating and sustaining an environment that fosters strong and equitable development, and is an essential component of sound economic policies. Government plays a critical role in the provision of public goods and services. It establishes the rules that make markets work efficiently and, more problematically, it corrects for market failures. In order to play this role, governments need revenues to produce public goods and services. This in turn requires the system of accountability, adequate and reliable information, and efficiency in resource management and the delivery of public services. [22]

Pakistan failed in all of the areas associated with good governance since 1947, in general, and in the 1990s, in particular. The civilian governments played havoc with the governance indicators. Weak governance has been an important source of macroeconomic difficulties, particularly in the 1990s. It contributed to slowing Pakistan's economic growth; reduced the effectiveness of public expenditures; weakened the overall macroeconomic management; undermined investor's confidence; encouraged tax evasion, loan defaults, and non-payment of utility bills; and fostered corruption. Furthermore, key governance problems included poor fiscal performance, mismanagement of domestic and external debt; social exclusion of the poor, women, and minorities from access to basic services; poor public sector performance; inefficient and ineffective intergovernmental relations between the federal government and the provinces; marginalization of local governments; and a loss of trust by the common citizenry in public institutions, especially in the administration of justice and police.

Corruption and poor governance have deeply affected the economy of Pakistan. Past civilian governments were corrupt and made money through illegal means, thereby increasing instability in the country. In 1997, under the caretaker government of Meraj Khalid, a team was formed to provide estimates of economic loss to Pakistan during the regime of Benazir Bhutto (1993-96). The team headed by Shahid Javed Burki and assisted by Hafiz Pasha "estimated the cost to the country of political corruption and inefficiency at 20 to 25 percent of its 1996-97 GDP. Translated into monetary terms, this was equivalent to some $15 billion." [23] This cost was estimated on the basis of the losses incurred by the most important sectors of the economy, such as banking and public sector corporations like WAPDA and KESC.

When General Pervez Musharraf took over in October 1999, there was a dire need to take measures to improve governance and introduce structural reform in the basic governance infrastructure. These governance reforms were also long desired by the international financial institutions. In order to improve governance in the country, General Musharraf implemented a wide range of structural reforms, including:

• Restructuring and right-sizing of the civil services
• Rationalization of pay and pensions finalized
• Increased autonomy granted to Federal Public Service Commission (FPSC)
• Strong focus on training and improved procedures for performance assessment
• Devolution of political power to the grassroots level
• Judicial reforms
• Police reforms
• National anti-corruption strategy
• Freedom of information act promulgated
• Pakistan Public Procurement Authority established [24]

As a result of reforms in governance, Transparency International (a German-based organization) in its recent report on government corruption clearly stated, "corruption at the top levels of government has very significantly declined." [25] The World Bank also supports reforms initiated by the Government to improve its effectiveness at federal, provincial, and district levels. The ongoing Project to Improve Financial Reporting and Auditing (PIFRA) has enabled the government to develop a new accounting model, which consists of revised forms, principles, and methods of accounting and financial reporting to establish an integrated financial management system in Pakistan. The PIFRA project also provides for the introduction of a double entry computerized General Ledger System for all government financial transactions in a phased manner. The basic purpose of this system is to make government bookkeeping more effective and efficient, reducing opportunities for corruption. It will make the financial business of the government more transparent and timely.

Governance reforms have been opposed by a powerful status quo of vested interests and severe fiscal constraints that put additional restraints on the reform agenda. However, the government's record of implementing reform commitments made in 1999—in particular providing a legal basis for devolution and police reforms, ensuring the complete separation of judicial and executive powers, and completing the local government elections on schedule—suggests readiness to confront issues that have plagued the country since independence.

Debt Burden

The debt burden has long been a very serious problem for Pakistan, but was especially so in the 1990s. [26] The civilian governments not only amassed large amounts of foreign debt, but also used this debt for meeting the current expenditures of government. In 1998, Pakistan was hovering on the brink of default. Its foreign exchange reserves, which were $1.3 billion on the eve of the May nuclear tests, fell to $400 million by mid November 1998. A confidential report prepared by State Bank of Pakistan outlined the precariousness of the debt profile. According to the report, "in 1998-99 (fiscal year ending June 30^th), Pakistan's external debt repayments total $7.9 billion, including $5.6 billion in debt amortization and $2.2 billion in interest payments; of this amount, $1.6 billion was payable to non-Muslim countries, $1.1 billion to IMF and World Bank and the rest was paying for short term borrowing." [27] The report also noted the precarious position of reserves at $930 million at the end of June, meaning the country would have to default on international debt, if the allied Muslim countries were unable to inject cash resources to keep Pakistan afloat until the sanctions were lifted.

Pakistan's debt situation reached an unsustainable level by 1999 because of the persistence of the current account and fiscal deficits during the 1990s. These twin deficits resulted in explosive accumulation of both domestic and external debt. [28]

Domestic debt was growing at an annual average rate of 16 percent during the period 1990-99, reaching almost 52 percent of GDP by 1999-2000, up from 44.1 percent in 1990-91. In other words, the domestic debt grew by fourfold—rising from PRs 488 billion to PRs 1,642 billion in one decade. Pakistan's total debt and external liabilities grew by an average rate of 6.4 percent per annum during 1990-99. It stood at $23 billion in 1990-91 and reached almost $38 billion by 1998-99. This sharp increase in the total debt resulted in the increase of debt servicing liabilities in the 1990s. In 1990-91, almost 40 percent of revenues were consumed by debt servicing, while in 1998-99 debt servicing was consuming 63.5 percent of the national budget, leaving 36.5 percent to be spent on defense, civil administration, and development works. [29]

The main reasons for this accumulated debt can be described as follows:

• The rising trends in the non-development expenditures (debt servicing and defense) have been the cause of rising debt. The major chunk of the budget is consumed by these elements.
• The persistence of the low growth rate of the economy also compelled the successive governments to resort to external debt. Throughout the decade of 1990s, Pakistan's growth rate remained under 5 percent.
• Economic mismanagement and corruption by the civilian governments resulted in the loss of public exchequer. In order to fulfill their agendas, the civilian governments resorted to external debt.
• Corruption by successive governments in Pakistan also compelled the country to opt for foreign borrowing to meet the current expenditures of the government.

Table 1.1: Trends in External Debt and Foreign Exchange Liabilities (US$ billion)

Source: Ashfaque Hasan Khan, "Economic Performance during 1999-2002," Ministry of Finance, Government of Pakistan, http://www.finance.gov.pk/summary/99_2002.pdf, 7.

Table 1.2: Debt Servicing

Source: Ashfaque Hasan Khan, "Economic Performance during 1999-2002," Ministry of Finance, Government of Pakistan, http://www.finance.gov.pk/summary/99_2002.pdf, 9.

As shown by Tables 1.1 and 1.2, the rising trend in both domestic and external debt resulted in a serious problem for Pakistan in a number of ways.

First, it crowds out public finances by pre-empting 56 percent of budgetary revenues, necessitating cut backs on essential public expenditures for promoting growth and poverty reduction. Second, it forces the economic managers to continue borrowing for meeting even the non-development and recurrent expenditures to run the state. Third, the annual external debt service payments falling due every year amount to $6-7 billion, which consume more than two-thirds of export earnings. This burden is totally disproportionate to the capacity of any developing country in the world, since Pakistan will pay most of its earnings to its creditors and will have very little left for imports of goods and services. [30]

For the reasons mentioned above, the government of Pakistan must find a solution to its debt problem.

When General Musharraf came to power in October 1999, external debt and foreign exchange liabilities stood at  $38 billion. It should be pointed out that the Musharraf government has done well on the debt management side. It has not only slowed down the pace of acquiring new or additional debt, but also brought down the level of debt servicing, thereby increasing foreign exchange reserves. The military government formulated a debt management strategy, which had the following features:

• Seeking debt relief from lenders and using the savings solely for poverty reduction programs
• Reserving privatization proceeds exclusively for retirement of public debt
• Reducing the cost of borrowing through lowering of the interest rates on government schemes
• Gradually eliminating all borrowings for non-development expenditures
• Privatizing public sector corporations in the oil and gas sector to achieve greater efficiency, provide for investment resources, and generate funds for debt retirement
• Constituting a high level debt management committee, under the chairmanship of an expert, with the governor of the State Bank and other senior government officials as members, to suggest measures for establishment of an efficient debt management system and for reducing the debt servicing burden
• Increasing the flow of remittances through official channels
• Relying on non-debt creating inflows (e.g., grants and foreign direct investment) [31]

 As a result of this debt management strategy, domestic debt declined from 51.7 percent of the GDP in 1999-2000 to 47.0 percent in 2001-02, a reduction of 4.7 percentage points of the GDP. The external debt and foreign exchange liabilities now stand at $36.5 billion, down from approximately $38 billion in 1998-99—a reduction of $1.5 billion or from 62.3 percent of the GDP to 58.8 percent. Debt servicing as a percentage of total revenue, which stood at 63.5 percent in 1998-99, declined to 49.7 percent in 2001. [32]

Gross Domestic Product (GDP)  Growth Rate

Although it lagged behind East Asian countries (the so-called "tigers") and China during the last two decades, Pakistan's growth rate remained high in comparison with the other countries of South Asia until the 1980s. Pakistan's growth rate also exceeded many African and Latin American countries. [33] However, Pakistan's GDP growth rate became sluggish during the 1990s. [34] As against an average growth rate of 6.1 percent in the 1980s, it slowed down to 5.1 percent and then to 4 percent during the first and second half of the 1990s, respectively. On the other hand, the population growth rate remained high, leading to a decline in the per capita income of the country.

In part, the variability in the GDP growth rate is because Pakistan's economy still has a large agriculture component. Although this sector only contributes about 25 percent of the GDP, it employs half of the workforce. Pakistan's major exports (textiles, finished fabric goods, and yarn) are dependent on the outcome of the cotton crop. Weather variability, pests, disease, and other natural calamities contribute to volatility in agriculture production levels. Wide variations in policies for government support to agriculture, compounded by economic difficulties that restrict availability of key inputs like seeds and pesticides, exacerbate nature's obstacles to crop production. With agriculture such a significant part of the economy, agricultural production is highly correlated to Pakistan's overall economic performance. [35] When the agricultural sector has performed well, the GDP has been high. Agriculture is extremely important not only for its contribution to the GDP, but also because of its importance for the manufacturing sector.

In addition to agricultural factors, other principle causes of the slow-down in the growth rate were the continued low rates of savings and investments; governance problems hindering the effective use of public resources; structural problems in large-scale manufacturing; and considerable financial and political instability. Macroeconomic policies failed to halt the growing imbalances in the budget and external accounts, and policymakers did not realize the economic dangers of growing financial vulnerability. [36] Recent growth rate trends in the GDP are given on the next page in tabular form.

Table 1.3: GDP Growth Rate Trends

Source: Various issues of Economic Survey of Pakistan (Islamabad: Ministry of Finance, Government of Pakistan).

Foreign Investment

In recent years, developing countries—such as China, India, Hong Kong, Malaysia, Indonesia, and Thailand—have attracted a lot of foreign direct investment (FDI). The inflow of FDI to Pakistan has, however, remained far from encouraging despite numerous incentives offered to foreign investors, particularly after the initiation in 1992 of the liberalization program. In the early 1990s, the country began to attract a respectable amount of foreign capital, a significant amount of it for the development of the power sector. Taking note of the large size of the Pakistani population, transnational corporations came in to develop markets for beverages and fast food. Today, the most important areas of FDI in Pakistan are energy, chemicals, foods and beverages, machinery, construction, textiles, and the power sector. Attractive incentives apart, Pakistan's population of about 149 million offers vast potential for the marketing of both consumer and durable goods. At the same time Pakistan's geographic contiguity with Central Asian republics also has the potential to serve as a gateway to foreign investors for extending their marketing activities into the countries of that region.

Despite all of these factors, FDI in Pakistan has been on the decline. These declining trends in FDI have resulted from public policy and the changing geo-strategic environment of Pakistan. According to the Economist Intelligence Unit's 2001 report on Pakistan:

Among the major reasons for the poor position with regard to foreign investment is the generally negative perception of Pakistan in international business circles. Images of gun-toting, anti-western Islamic fundamentalists, sectarian warfare and rumors of war with India are common enough. Nor does it help to know that there is an unaccountable military regime in office, while the judiciary appears incapable of delivering independent judgments in the event of clash of interests between the foreign or the domestic investors on the one hand and the government on the other. Finally, the significant exodus of indigenous capital and entrepreneurs to Canada, the US, and elsewhere in the last few weeks is hardly encouraging for potential foreign investors. [37]

Furthermore, the war in Afghanistan and Pakistan's status as a frontline state against terrorism create fears of instability among foreign investors. Other important factors for the declining trends in Pakistan's FDI include: the East Asian financial crisis of 1997; economic sanctions and the freezing of foreign currency accounts after the May 1998 nuclear tests; crises with the independent power producers (IPPs), [38] particularly the way these issues were handled by the Sharif government; the low level of foreign exchange reserves and threat of default on external payment obligations; and disarrayed and unstable relations with international financial institutions. [39]

On November 24, 1997, the Sharif government launched a new investment policy. It was aimed at improving the business environment and opening up new sectors to foreign investment. Until then, only the manufacturing sector, which accounts for 20 percent of the GDP, was open for foreign investment. However, the new policy opened up for foreign investment in other sectors like infrastructure, housing and real estate, agriculture, health and education, and wholesale and retail trading. [40] Furthermore, the government extended tax and tariff concessions to foreign investors in these areas. In addition, foreign investors were granted immunity from disclosing the sources of their capital and all the local and foreign investors were granted exemptions from customs duties and sales tax on imports of machinery not manufactured in Pakistan. The new policy divided the industry into four categories—value-added or export industry, high technology, priority, and agriculture-based. [41] The government hoped to attract at least $5 billion in private foreign investment in the following three years as a result of this policy. However, political instability and perceptions of rising violence remained as deterrents to investors, as do lackluster macroeconomic conditions. Moreover, the investment policy violated the terms of the agreement signed with the IMF, under which no tax holidays or exemptions were to be granted.

The total foreign investment during the 1996-97 fiscal year was $950 million, a 27.3 percent decrease from the previous year's level. Of this, FDI accounted for only $682 million, compared with $1.1 billion in the previous year. [42] Despite the efforts of the Sharif government, foreign investors did not respond to the government incentive program designed to appeal to them. The then US ambassador to Islamabad, Thomas Simon, highlighted impediments to capital flow, citing "frequent reviews of power generation policies of the government, frequent changes in the policy planning, a bad law and order situation, and uncertainties at the macro-economic level." [43]

The most important event regarding foreign investment during the Sharif regime was the prime minister's attack on the independent power producers (IPPs). The government's main charge was that IPPs were offered high power supply rates and profit margins because Benazir Bhutto and her husband Asif Ali Zardari took commission and kickbacks from the companies involved. As a result, Sharif claimed that Water and Power Development Authority (WAPDA)—which is obligated to buy power from IPPs—is facing bankruptcy because it cannot afford to buy private power at the prohibitive rates negotiated with them.

A second event that had a major impact on foreign investment in Pakistan was the nuclear tests of May 1998. Following the tests, the Sharif government announced the freezing of all domestic and foreign exchange accounts. These accounts were worth around $11 billion, of which $7 billion belonged to resident Pakistanis, $2.5 billion to non-resident Pakistanis, and $1.5 billion were institutional swap funds with private sector banks. [44] Sharif argued that with external reserves of only $1.3 billion, he could ill-afford a potential run on foreign currency deposits following a loss of confidence caused by the sanctions. However, this decision of the government backfired and had two repercussions. First, the decision pushed the rupee/dollar exchange rate from PRs 46:$1 to PRs 49:$1. Second, foreign exchange remittances by expatriate Pakistanis plunged from an average of about $4 million a day to under $1 million a day, leading to a rapid decline in reserves.

Furthermore, foreign investment was also affected by the "Kargil crisis" between India and Pakistan in 1999. The crisis created an environment of instability in the South Asian region due to the imminent threat of war between India and Pakistan. Foreign investors were particularly concerned with the situation, putting their investment decisions on hold. This is evident from the fact that during fiscal year 1998-99, foreign direct investment in Pakistan totaled just $296 million, compared with $436 million in the previous fiscal year. Thus, the major factors for decline in foreign investment in Pakistan during fiscal 1998-99 were the IPPs dispute, the nuclear tests, and the Kargil crisis. Furthermore, the imposition of certain foreign exchange controls and delays in processing foreign exchange demands also caused problems for foreign companies invested in Pakistan. 

Faced with these crises, the government of General Musharraf successfully tackled the issue of improving the atmosphere for foreign investment in the country. It resolved issues with the IPPs, negotiated a softening of economic sanctions with the United States, and improved Pakistan's credibility with the IFIs. On December 15, 1999, Shaukat Aziz, Pakistan's finance minister, announced specific measures to restore business confidence. The salient features were:

• All existing tax exemptions were to be withdrawn in the June 2000 budget.
• The tax was to be simplified in the June budget by stressing transparent and voluntary self-assessment schemes.
• A retail General Sales Tax (GST) and agriculture income tax were to be imposed in the June budget.
• Foreign exchange remittances of profit, dividends, and royalties were once again to be allowed without prior permission of the State Bank of Pakistan.
• Central excise duty was withdrawn on credit card and other business transactions.
• Only foreigners were to be allowed to open foreign exchange deposit accounts in local banks in an effort to assist the dollarization of the economy.
• Foreign exchange bearer certificates were discontinued and income tax immunities available to government bondholders were withdrawn in order to stop money laundering.
• Tax rates on government securities and bonds were cut.
• Pakistan's Euro-bond debt was successfully rescheduled. [45]

In early 2001, the government successfully resolved its dispute with Hub Power Company (HUBCO). This was a welcome step, and since then the flow of foreign investment into the country has increased. This improvement was particularly encouraging given that it is an accepted fact that raising foreign investment from a low and declining path to a higher and sustainable path is a daunting task. The flow of foreign investment does not increase overnight. Foreign investment stood at $475 million in 2001-02, higher then the $403 million figure of 1998-99. Details of Pakistan's foreign investment performance are presented graphically in Table 1.4 below.

Table 1.4: Foreign Investment

Source: Ashfaque Hasan Khan, "Economic Performance during 1999-2002," Ministry of Finance, Government of Pakistan, http://www.finance.gov.pk/summary/99_2002.pdf, 24.

Ten main factors—which might be called the ten checkpoints or "Ten Commandments"—govern a country's ability to attract foreign investment. In the case of Pakistan during the 1990s, all these factors were lacking or were weak in some way. These factors are:

1)     Political stability

2)     The law and order situation

3)     Economic strength

4)     Government economic policies

5)     Government bureaucracy

6)     A positive local business climate

7)     Physical infrastructure

8)     Quality of labor force

9)     Quality of life

10)   Welcoming attitude [46]

Substantial improvement in the above-mentioned factors occurred during the government of General Musharraf. The military government pursued sound economic policies, which restored macroeconomic stability in the country. This led to improvement in the country's credibility among international donors and restored foreign investor confidence. Consequently, foreign investment increased in Pakistan. But, in order to compete with the other developing countries in the areas of foreign investment, Pakistan must continue improvement in each of these areas.

Foreign Trade

There exist strong relationships between export growth and overall economic growth, in general, and manufactured export growth and overall economic growth, in particular. Those countries that have been most successful in expanding their manufactured exports have not only achieved higher economic growth, but also succeeded in alleviating poverty. This has indeed been the case in East Asia. Pakistan's exports fluctuated widely during the last fifty years. Exports received little or no attention during the 1950s, registering an average decline of 5.7 percent per annum. Exports recovered in the 1960s and grew at an average rate of 10.7 percent per annum. The 1970s witnessed acceleration in export growth, to an average rate of 22.3 percent. [47] The 1980s and the 1990s then saw a decline in export rates in comparison with the 1970s.

When viewed against the experiences of many successful developing countries, Pakistan's export performance during the 1990s has been lackluster. [48] The main reason for this is that, unlike many East Asian countries, Pakistan has not adopted an effective trade liberalization regime. Another reason for the fluctuating export rate has been the variation in agricultural production, which is largely dependent upon weather conditions. The decline in agricultural production not only affected exports, but also had a great bearing upon the manufacturing sector. Furthermore, changing geo-strategic conditions after the September 11 terrorist attacks greatly affected exports. For example, the war on terrorism in Afghanistan made Pakistani exports vulnerable, and the continuous tension and threat of war with India has similar effects. For these reasons, Pakistan's trade deficit has remained and continues to be among the most important areas of concern for successive governments.

When Sharif became prime minister in 1997, he introduced tariff reforms. These reforms were aimed at the liberalization of the economy. Furthermore, these reforms provided for tariff cuts on imports, reducing the top rates for customs duties from 65 percent to 45 percent. Automobiles were the only exception where the previous rates remained in force. Duties on imported machinery for industry were also fixed at standard 10 percent. These tariff reforms were aimed at achieving three objectives:

1)     To discourage smuggling, estimated to cost the Pakistani economy at least PRs 100 billion (~$2.5 billion) annually

2)     To force industry to become more competitive

3)     To meet part of the requirements put forward by the IMF for gaining new loans [49]

On July 17, 1997, the then commerce minister, Ishaq Dar, unveiled an ambitious new trade policy to increase exports from $8.26 billion in 1996-97 to $9.58 billion in 1997-98, and to reduce the merchandise trade gap from $3.4 billion in 1996-97 to $2.3 billion in 1997-98. [50] The new trade policy also reduced the interest rate for exporters, whereby 50 percent of the admissible duty drawbacks to exporters will be paid within three days of presentation of the documents; and import duties on a host of raw materials for export of finished goods were reduced or eliminated altogether. The import of a few items like chilies and pharmaceuticals were allowed from India. Furthermore, the new trade policy removed the restrictions on importation of gold and silver. Sales tax exemptions were granted to imported raw materials and components to be used by the export suppliers against international tenders.

According to Ishaq Dar, as a result of this trade policy, exports rose by 5 percent in dollar terms in the first seven months of fiscal year 1997-98, while imports contracted by 8 percent. Consequently, the merchandise trade gap narrowed by about $780 million in the first seven months of 1997-98. [51] However, the narrowing trade gap was not all good news. Falling machinery imports suggest that industrial growth remained lackluster, while the contraction in the petroleum bill reflected a softening in international oil market prices.

On June 15, 1998, the government introduced its trade policy for fiscal year 1998-99. The main purpose of the policy was to reduce the trade deficit by increasing exports and reducing imports. In the new policy, the export target was set at $10 billion, up by 17.6 percent compared with an estimated $8.5 billion in the last financial year. The imports for 1998-99 were projected to remain at approximately the same level as the prior year, i.e. $10.05 billion, thereby eliminating the merchandise trade deficit in 1998-99. The government claimed that it would achieve its export goals by "improving and modernizing export incentives" and "strengthening institutional export mechanisms" for its export regime. Among the export incentives offered were:

• Exporter refund claims were to be settled within thirty days.
• Export refinance funds for at least PRs 25 billion ($570 million) were made available by the State Bank of Pakistan (SBP) at 8 percent interest instead of the existing 11 percent interest rate.
• Companies classed as export processing units (those exporting 70 percent of their production) were allowed to import inputs without payment of customs duties.
• A ban on exports of fifteen particular items was lifted. [52]
• The private sector was allowed to export coke, rock salt, and caustic soda which were previously exportable by the public sector only.
• Restrictions on export quotas were lifted on maize, grains, soda ash, breeding camels, native birds, and cement. [53]

The trade policy also introduced certain measures for rationalizing the import regime. The main features of these measures have been given below:

• Import duties on gold were to be reduced by 40 percent.
• Import of scrap plastic was banned.
• Import of diagnostic/testing/analytical equipment was allowed to non-resident Pakistanis paying in foreign exchange.
• Import of second-hand machinery, except computers, was banned.
• Maximum import duties on many items were reduced from 45 percent to 35 percent. [54]

According to the Federal Bureau of Statistics (FBS), exports fell by 10.5 percent in the fiscal year 1998 to $7.72 billion from $8.63 billion in 1997. Meanwhile, imports contracted by 8.2 percent, from $10.12 billion to $9.29 billion, causing the trade deficit to widen slightly by $79 million to $1.57 billion. [55]

According to the IMF's "International Financial Statistics" report, merchandise exports rose by 6 percent in the first half of 1999, from PRs 190 billion to PRs 202 billion. Imports, however, rose by nearly 23 percent from PRs 206 billion to PRs 252 billion. In dollar terms, exports fell by 0.7 percent, year to year, while imports rose by almost 15 percent. [56] Petroleum products and machinery dominated imports, while the main exports remained cotton fabric and rice.

In 2001, the military government of General Musharraf took two important measures in the area of foreign trade. These measures were to explore different markets and diversify trade and, secondly, to reduce imports. In the area of trade diversification, Pakistan improved its trade ties with different countries. Some results, even if small, were evident: Pakistan's exports to China went up by 75 percent; to the United Arab Emirates (UAE) and Saudi Arabia by 25 percent each; to Bangladesh by 20 percent; to Indonesia by 161 percent; and to Korea and Australia by 9 percent each. [57] Other than the UAE and Saudi Arabia, all other countries are referred to as non-traditional markets in the context of Pakistan's previous export patterns. Furthermore, efforts were made to improve trade relations with Kenya, Nigeria, and Syria. In addition, the military government provided the following incentives to exporters:

• Exporters who posted at least a ten percent growth over the prior year's exports were allowed to retain 50 percent of the additional exports in their local foreign currency account. They could use this amount for the purchase of machinery, equipment, raw materials, and payment of commissions and promotional expenses.
• Export development charges were waived on additional exports.
• Exporters who demonstrated better performance were given monetary rewards. An "incentive scheme" that sought to reward three categories of exporters (large, medium, and small) for increases in overall exports, entering new markets, value addition, etc., was devised. An amount of PRs 2 billion was allocated for this project.