The key to ensuring Pakistan's future macroeconomic stability lies in strengthening other institutions that can complement and support broad economic development. To quote Dr. Ishrat Husain, a leading economist and governor of the State Bank of Pakistan:

Pakistan's long term prospects will depend upon the interplay of evolution in political and social developments, economic policies to be pursued, the quality of governance and institutions, and most important investment in the human capital. It has become quite obvious from both Pakistan's own history and the experience of the developing countries that sustained economic growth and poverty reduction cannot take place merely on the strength of economic policies. Political stability, social cohesion, supporting institutions, and good governance are equally important ingredients coupled with both external environments for achieving economic success. [94]

Pakistan must strive to maintain its present level of macroeconomic stability. The most important thing needed is the will power of the ruling elite and the continuity of structural reforms undertaken by the military government. The country is now on the path to macroeconomic stability and is less vulnerable to external shocks than it was a decade ago. There has been improvement in all of the major macroeconomic indicators. The growth rate of the economy, which was under 4 percent during the 1990s, has shown considerable improvement.

Governance has improved in Pakistan as a result of the structural reforms undertaken by the military government, although some resistance to these reforms persists from those with vested interests. The accelerating debt situation has been contained within manageable limits. Furthermore, Pakistan has retired some of its debt in recent years. Although poverty still remains high in Pakistan, it is hoped that the present reforms will help to reduce the poverty level. Likewise, there has been improvement in Pakistan's trade balance in recent years, with the trade deficit declining by more than a billion dollars. Although the trade balance has not reached a surplus level, exports have grown. The level of foreign investment has grown in comparison to previous years because the government is taking measures to encourage foreign investors. However, the worsening internal security situation after the U.S.-led war in Afghanistan continues to make foreign investors wary about Pakistan, as threats and attacks on foreigners affect the investment environment. 

Before 1990, Pakistan was among those few developing countries with very bright prospects for economic growth. This optimism was dashed in the last decade. During this period the country became politically unstable, with frequent changes in the corridors of power. Civilian governments fell amid charges of corruption and economic mismanagement. Though elections were held in Pakistan in 2002, it has yet to achieve political stability. The coalition government of Mir Zafar Ullah Jamali is facing stiff resistance from the opposition benches on issues such as the Legal Framework Order (LFO) and other constitutional reforms. If Pakistan is to achieve macroeconomic stability, it must become politically stable by strengthening the institutions of democracy. There is no denying the fact that Pakistan achieved higher growth rates under military governments, but questions remain about whether it can sustain such growth rates in the long run without a more stable political system. A country can only achieve a sustainable, high growth rate if it is democratic, because democracy and free markets together provide the self-regulating mechanism that is essential for nurturing sustained economic growth.

In the present situation, Pakistan has two options to achieve macroeconomic stability. The first option is to depend upon external actors like the IMF and World Bank, along with other international financial institutions, to assist Pakistan in achieving macroeconomic stability. But historical evidence has shown that the IFIs have been unable to solve all of Pakistan's economic problems. There has been abundant criticism of IFI lending conditionalities in Pakistan. I do not deny the role of these institutions in the economic development of Pakistan, but argue for less dependence on these institutions.

The second option for Pakistan, which could be more realistic and rational, is for it to put its own house in order to achieve macroeconomic stability. Pakistan has the potential for economic stability, provided sound fiscal policies are pursued, economic governance is improved, political stability is achieved, internal differences among different segments of the society are mended, and the law and order situation is improved. The following steps are suggested to improve Pakistan's macroeconomic stability.

Strengthening Institutions

Recent empirical evidence suggests that sound economic policies cannot make any difference in the lives of the common citizens if the country does not have strong institutions to implement such policies. Pakistan inherited a strong civil service, judiciary, and police, which satisfied the demands of millions of people. But as its population expanded, the nature of governance became more complex and the capacity of these institutions did not keep pace with the emerging demands of the economy. These institutions were weakened by a succession of corrupt governments. [95] The police became politicized, the judiciary was corrupted from the lower level to the upper level, and the civil service also failed to provide adequate service to the population. Pakistan can improve its economic governance provided its institutions are strengthened.

To begin with, there is an urgent need to continue addressing the internal security situation. Police and the judiciary are the guardians of law and order. The military government has already introduced reforms in the security services through a new police ordinance. Yet the police are still over-burdened and corruption remains a problem. The success of recent reforms is largely dependent on moving toward full implementation of the new ordinance.

In the judicial system, there is a need to introduce reforms to address the adequacy of staffing, the guarantees needed to preserve the independence of the judiciary, and the availability of remedies for the public, including the need for an efficient and well structured subordinate judiciary as well as examining possible alternative dispute resolution mechanisms. [96] There should be a defined time period for the resolution of civil and criminal cases in the courts in order to achieve the credible enforcement of justice in the country.

Second, there is a need to strengthen local government institutions introduced under the controversial political devolution plan. This plan, although a new one, is really very effective and provides a mechanism that fulfills the governance needs of the public at the grass-roots level. To implement devolution, the government has introduced training courses for successful local government candidates, but a need remains to improve and institutionalize this system. The plan for devolution of power is still facing resistance from vested interests who lost power in the process. If the government continues to implement the devolution policy, it is hoped that these problems will be solved soon.

Third, institutions of accountability (like the Auditor General's Office) must be strengthened, as they are the constitutional watchdog of government revenues and expenditures. Presently, these audits are far from satisfactory, with widespread corruption prevailing. The Auditor General's Office is ill equipped to carry out its work. The AGO's staff lacks adequate infrastructure, making them dependent upon the audited organization and compromising their integrity and honesty. There is a need to strengthen this office in order to implement effective financial governance in the country.

Fourth, there is need to bring about reform throughout Pakistan's largely underpaid civil service. Salaries are often not enough to meet basic needs and the pay of government employees has failed to match increases in inflation. These low salaries represent a significant temptation to corruption. The salary structure of government employees must be increased in order to curb the crisis of corruption.

Finally, there is a need to improve the institutions of inter-provincial harmony to help in eradicating inter-provincial competition and jealousy. The Council of Common Interest, National Economic Council, and National Finance Commission are three institutions that are concerned with the distribution of the resources among the provinces. If these institutions were strengthened, policies that favor one province over another would not be adopted, which has been quite common in the past.

The military government of General Musharraf introduced major institutional reforms in the governance sector. Merit-based recruitment, performance-linked promotions, adequate compensation, and continuous upgrading of skills and knowledge are some of the essential ingredients of these reforms. The new government of Zafarullah Khan Jamali needs to continue these reforms in order to strengthen these institutions. There is no denying the fact that these reforms face stiff resistance from vested interests, but unless these reforms are maintained and strengthened, these institutions will again become the graveyards of democracy.

Achieving Good Governance

The experience of Pakistan and other developing countries in the 1990s suggests the importance of good governance. Components of effective governance, such as the rule of law, transparency, accountability, and predictability, should all be strengthened. Authoritarian military governments have a relatively better record of governance in Pakistan, but these gains have proven short-lived. Only democratic civilian governments with clear rules of transition and strong, functioning institutions can provide the platform for good governance. It must be demonstrated during the next five years that democracy and good governance are not mutually incompatible, that democratically elected governments can also serve collective interests, in contrast to purely personal interests, and that the quality of governance can be improved. The interplay of voice and accountability, civil liberties and free media—which form the core of democracy—reinforce the quality of governance.

Recent initiatives, including devolution of power to local governments, a national anti-corruption strategy, establishment of a national accountability bureau, and the encouragement of public-private community partnerships are welcome steps in the improvement of governance. The devolution of power plan, which came into force in 2001, is facing problems from the bureaucracy and from politicians representing vested interests. However, devolution remains a good plan with the potential to fulfill public demands for political participation at the local level. The success of these steps depends upon the quality of enforcement of these reforms in the future.

Expanding Human Development Initiatives

Human development and economic development are highly interlinked. [97] Pakistan has a poor record in the area of human development, which in turn has impacted its economic development efforts. Pakistan's Human Development Index on a global scale has been slipping year after year. In 2001 it stood at 144 among 173 nations, far behind many African countries. [98] In fact, this under-development of human capital is the most daunting challenge faced by Pakistan. High population growth—one of the fastest in the world—has given rise to a growing dependent population and increased unemployment among youth. One-half of the population is illiterate, making it more difficult to impart new skills to the ever-burgeoning labor force. Expenditures on education are insufficient, with only 2 to 3 percent of the budget allocated for these needs. Thirty-three percent of the population lives below the poverty line. The government must reorient its expenditures to place an increased priority on education.

The government implemented a comprehensive package of education reforms, a comprehensive poverty alleviation strategy, a medium-term health strategy, fiscal restructuring, and devolution of administrative and financial powers to the local government, forging a public-private partnership for the delivery of social services. There is still much room for improvement in these sectors. In the education sector, technical education should be a top priority. In the health sector, efforts should be made to introduce health facilities in remote areas. In the poverty sector, the major emphasis should be on generating employment, increasing the economic growth rate, and, most importantly, controlling the population growth rate.  Presently, Pakistan's population growth rate is 2.5 percent, which is very high among the developing countries. It is estimated that, if present trends in population growth continue, Pakistan's population will double in twenty-five years. This is a very dangerous trend because the economy is not growing at the same rate as the population. Devolution of power to local governments is a welcome step in this direction. Its aim is empowerment of people at the grassroots level to make choices about essential services such as education, health, water supply, farm-to-market roads, land leveling, and watercourse improvement. The military government introduced these reforms, but effective change will depend upon continuation and expansion of implementation of these reforms.

Increasing Foreign Direct Investment

Pakistan must increase Foreign Direct Investment, if it intends to enhance the growth of its economy. The experience of the developing countries is that FDI is directly related to economic growth. Two recent examples from the developing world are China and India. Shahid Javed Burki, a leading expert on the economy of Pakistan, argues that FDI flows from private sources have driven economic development in the last two decades. [99] In recent years, developing countries such as China and India have attracted large amounts of FDI. Typically, these countries attracted the attention of foreign investors because of their large market size. In addition to market size, the following factors have proven to be critical for attracting foreign investment:

• World-class physical infrastructure
• A secure law and order situation
• Skilled and productive labor
• Innovative capacities
• Agglomeration of efficient suppliers, competitors
• A well-developed institutional infrastructure [100]

Many factors make Pakistan an attractive place for foreign investments. First, the Pakistani economy has developed resilience and response capacity to meet exogenous shocks and mitigate event risks. Pakistan's vulnerability indicators have made a positive turnaround. During recent years, its economy could have potentially experienced downturns in response to four major regional or global events—the May 8, 2001 bombing of French technicians in Karachi; September 11 and the subsequent Afghanistan war; the attack on India's Parliament on December 13, 2001 leading to mobilization of Indian troops; and the 2003 war in Iraq. The economy faced all of these shocks calmly and without any sign of volatility. Thus, foreign investors can be assured that they can carry out business in a stable and certain environment.

A second enticement for FDI is the fact that Pakistan has a population of 149 million, which provides a large market for consumer goods. One-third of Pakistan's population lives below the poverty line, but there is a growing middle class with adequate purchasing power, "comparable in average per capita income with the countries in Southern Europe." [101] Moreover, Pakistan can provide foreign investors with low-cost labor, reducing the cost of production. Furthermore, Pakistan's proximity to Central and South East Asia provides a strategically located base for foreign investors to introduce, produce, and distribute their goods to these regions.

Pakistan also has a world-class physical infrastructure, which is necessary for investment. It inherited strong institutions from the British, meeting the demands of millions of people. It provides adequate communication infrastructure for foreign investors.

Finally, there is also a strategic consideration for increasing FDI in Pakistan, with implications for global security. The reconstruction of Afghanistan can be more easily facilitated if foreign investment grows in Pakistan. There is no denying the fact that Pakistan's domestic situation, in recent years, was unsatisfactory. The country has faced crises such as political instability, a deteriorating security situation, institutional decay, and sectarian violence, which have inhibited foreign investment in Pakistan. In part, this situation has been exacerbated by the war on terror in Afghanistan and its impact on Pakistan. But now, with the dust settling in Afghanistan, the situation is also improving in Pakistan. Law and order has improved and the country is moving out of political crisis. Pakistan's democratic process is restored and a civilian government is at the helm.

In the present circumstances, the government should take the following measures to accelerate the level of FDI. First, Pakistan has a large pool of unskilled labor, which is a burden on the economy. Neglect of attention to technical education in the educational system contributes to this problem. The government must place increased emphasis on technical education at the secondary school and college level. The advantages of increased technical education in stimulating economic growth are demonstrated by the Indian experience. India invested in technical education in the 1970s and is now enjoying the fruit of that investment.

Second, the government must make efforts to improve Pakistan's image in the international community. It has suffered in recent years because of the rise of anti-Western fundamentalism in the country. In particular, the international media have played a role in shaping this concern. More attention needs to be drawn to the positives of Pakistan.

Third, Pakistan must strengthen its judicial system, which will have two advantages. On the one hand, it will continue to strengthen domestic security in the country. On the other hand, a legal system that deals even-handedly with commercial interests will contribute to enforcing the sanctity of contract. By taking the above-mentioned steps, Pakistan can improve its attractiveness to foreign direct investment.

Enhancing and Sustaining a Growing GDP

There have been two problems with the GDP growth rate in Pakistan. First, Pakistan has not been able to sustain growth over the long term. Sometimes Pakistan grows at a rate of around 7 percent and sometimes it retreats to a 3 percent growth rate. Second, the growth rate of the economy in Pakistan has not been linked to improvement in human development factors. Basic indicators like education, health, poverty, safe drinking water, etc., have been neglected in Pakistan. The "trickle down theories" and market forces of the 1970s and 1980s have failed to provide relief for the general public. A need exists to link the growth rate of the economy to improvement in human development. The basic argument is that a higher growth rate is of limited utility if it does not benefit the population as a whole, including the poor.

How can Pakistan improve and sustain its growth rate? The answer lies in the following proposals:

• Production in agriculture must be enhanced because of its large share of the GDP. Agricultural production can be improved by taking two kinds of measures. First, the government must provide facilities to small and medium landowners to cultivate their lands. These facilities may include the provision of seeds, fertilizers, machinery, and water. Second, the government must play an important role in determining the prices of the goods produced in the agriculture sector. It is really discouraging to farmers when they are not getting adequate prices for their products, exacerbating rural flight to urban areas.
• In the industrial sector, the government must place emphasis on the development of small and medium industries. The government can facilitate this by providing targeted loans to this sector. Pakistan can substantially increase export earnings from light industry in the areas of carpet and textiles, sports equipment, dairy products, etc. The sick heavy industrial units promoted in the past should be rationalized, because they have become a burden on the economy. India is a classic case study of effective transition in this regard.
• Continuity in economic policy is an essential component for sustained growth. Pakistan's track record has been such that one government has completely changed the policies of its predecessor. Some examples of such fickle policies are those dealing with privatization, construction of the Lahore-Islamabad motorway, and various agreements with power companies.
• There is a need to create inter-provincial harmony in Pakistan. In the past there has been a perception of deprivation and exploitation of the smaller provinces by the larger ones. Inter-provincial tensions have revolved around issues of resource distribution, investment and employment, water issues, etc. These factors hinder the growth rate of the economy. Pakistan needs to create inter-provincial harmony to achieve better growth.

Given the present growth rate of the economy, i.e., around 5 percent, there are bright prospects for Pakistan in the future. The central challenge is to sustain the present growth rate, instead of succumbing to the fluctuations of the past. Continuity in economic policy, improvements in the agricultural and industrial sectors, and sustaining reform in the governance environment will determine the growth rate of the country in the future. A report published by the World Bank, "Global Economic Prospects 2004," projected average growth rates in South Asia. The report forecasts that growth rates in the region will continue to accelerate to an average of 5.4 percent in 2003, assuming positive trends in agricultural production, recovery in external demand, and improvements in political and regional stability continue. [102] These conditions for higher growth rates in the region are equally applicable to Pakistan.

Achieving a Favorable Trade Balance

Pakistan's trade balance has been in deficit most of the time since the country's independence. Despite much effort by successive governments to liberalize trade, Pakistan's trade regime still has many barriers that are preventing it from being successful. Pakistan has faced various problems in trying to integrate its economy with world markets. The opponents of economic integration with world markets argue that it will lead to de-industrialization of Pakistan. Pakistan will not be able to compete with the giant economies of China and India because they possess economies of scale and are endowed with superior technological and human resource bases. [103] The basic problem for Pakistan is that its exports are mostly raw materials, which are subject to severe price fluctuations in international market prices. The main exports of Pakistan, cotton and rice, are less competitive in international markets. Given these inhibitors, the following steps should be taken by the government to enhance the competitiveness of the country's exports:

• Pakistan's main exports are dependent upon the agriculture sector and there is a strong correlation between growth in agriculture production and exports. In order to increase export earnings, there is a need to improve the agriculture sector.
• Pakistan must take measures to diversify its export base by moving to develop the production of value-added manufactured goods. As the steel and auto industries increase their efficiency, complementary downstream and upstream industries should be established. Within the textile sector, production of clothing and other value-added products should be expanded. One pound of cotton converted into finished fabric earns $1.61 on the world market, while the same amount of cotton converted into finished garments raises the income on the same pound of cloth to $4.17. Increased worldwide demand for blended fabric calls for investment in this sector. [104]
• Pakistan needs to increase labor productivity through education, on-the-job training, continuing education for the workforce, and dissemination of new knowledge and techniques. This will translate into increased productivity and lower unit labor costs. [105]
• Measures must be taken to attract foreign investment for export-oriented joint ventures in Pakistan and establish joint ventures with countries such as China. Foreign partners have played a role in production relocation in the clothing sector through outsourcing. Brand name merchandisers and large retailers of standardized products should be targeted. Foreign joint ventures can provide marketing, design, logistics, and financing, while production can be handled by domestic firms. This will require greater transparency and disclosure by Pakistani firms aspiring to joint venture relationships. [106]
• Pakistan should try to export finished, or at least semi-finished, products. Recently, there has been improvement on this front. In 2002, the textile sector earned nearly $8 billion out of total export receipts of $11 billion. [107]
• Further measures must be taken to liberalize the trade regime and minimize tariffs. This will generate competition and reduce monopolies in the domestic market, as well as improve the quality of production. The classic example in this regard is South Korea. More recent examples are China and India.
• Export tariffs must be reduced, which will help in boosting Pakistan's exports. The military government did well in this regard, with tariffs being reduced from 35 percent to 25 percent.

Managing the Debt

Presently, Pakistan's external debt and foreign exchange liabilities are approximately $32 billion, which is very high relative to its GDP. Debt service consumes a major portion of the country's economic resources, thus limiting resources for the social sector and human development. The present debt management strategy of the government has helped the country to reduce its debt. As a result of this strategy, Pakistan's foreign debt has decreased from $38 billion in 1999 to $32 billion in 2002-2003. Still, the amount of debt is very high and remains a great burden on the resources of the country. The external debt can be managed by taking the following policy measures:

• Controlling the non-development expenditures of the government, which are currently consuming around 70 percent of public revenue
• Controlling fiscal deficits, which are still very high. In the past, Pakistan kept on borrowing internally and from international financial institutions to bridge this gap. The government needs to introduce fiscal discipline in order to reduce the deficit. This does not translate into squeezing government expenditures, but rather a reallocation towards human development and social sector expenditures, along with more effective tax collection.
• Accelerating and sustaining the GDP growth rate
• Improving tax collection in the country, which has been historically inefficient. The Central Board of Revenue is always falling short of its revenue targets. On the other hand, there exists a strong mistrust between the tax administration and taxpayers, which exacerbates tax evasion. Many people do not pay taxes because of the uncertainties about the use of that revenue. Thus, the need exists to improve this environment, building an atmosphere of trust and confidence between tax collectors and taxpayers.
• Introducing an effective judicial system that strengthens accountability. This will help in reducing economic corruption and mismanagement.
• Continuing austerity measures and containing current expenditures on the part of the government.
• Providing more incentive to Pakistani citizens abroad and foreign residents of Pakistan to transfer their currency into the country. Foreign remittances will help in building up the foreign exchange reserves, thereby reducing the demand on the public debt.

If the declining trend in debt is maintained, then it is projected that in the next ten years Pakistan will make significant progress in reducing its external debt. To achieve that, the present strategy of debt management has to be continued. Government expenditures must be controlled and revenues must be increased.

The role of international financial institutions is crucial to the economy of Pakistan. The IFI's have assisted Pakistan in undertaking structural reforms in major areas of the economy. Governance reforms, financial sector reforms, social sector reforms, tax reforms, and police reforms have all been sponsored by the IFIs. Presently, the IMF is providing Pakistan with help for poverty alleviation under its Poverty Reduction and Growth Facility (PRGF) project, which will be completed by the end of 2004. The government of Pakistan has announced its decision not to seek further financing from the IMF thereafter. [108] Pakistan will thus join the 70 percent of IMF member countries with whom the IMF presently has no lending relationship. Given present trends in macroeconomic indicators of the economy, it is hoped that Pakistan will emerge from the burden of international financial pressure. To retain this expected financial independence, Pakistan will have to sustain its economic growth and macroeconomic stability in future.