Growth and stagnation in Pakistan’s Economy

Pakistan has been through a decade of unprece dented social and political turmoil, economic stagnation and rising poverty. This stagnation is unique in Asia, which has emerged as the fastest growing region of the world. The decade of the nineties has been a "lost decade" for Pakistan. Even Bangladesh and Nepal have notched up growth rates above 5 percent per annum in the last decade..What are the factors that have prevented Pakistan from utilising the opportunities presented by the end of the Cold War and the gradual dismantling of barriers to trade and investment in Asia? Do these arise merely from the so-called "mismanagement" of the economy, as General Pervez Musharraf and his lawyers argued before the Supreme Court to justify the coup that brought him to power in 1999?.A study of Pakistan's political economy over the last three decades might point to some answers. The crisis faced by Pakistan's economy in the 1990s has its roots in the nature of dependent industrialisation that has long characterised Pakistan's economic strategy. The close links forged with Western powers, especially the United States, and the rewards of this special relationship, undermined the potential for a self-reliant and sustainable growth strategy..In the 1980s, when India was stuck with its 'Hindu rate of growth', the Pakistani economy consistently experienced high rates of growth. In the early 1990s, Pakistan's per capita income of USD 500, was about 25 percent higher than India's figure of USD 390. The average Pakistani was (and is) better fed and clothed than the average Indian. While 52 percent of India's population in 1992 survived on an income of less than a dollar a day, only 11 percent of Pakistanis were below this poverty line. Pakistan has roughly two million migrant workers, whereas with its much larger population, Indian has the same number of migrant workers in West Asia. What, then, is the cause of the downward spiral that has forced Pakistan to crawl before the IMF, not once, but thrice during the last decade?.At first glance, the structure of the Pakistani economy looks disarmingly like that of the Indian economy. The structure of output in the two antagonistic neighbours is amazingly similar. In both countries, the industrial sector constitutes 27 percent of GDP. Pakistan's service sector is only marginally larger than India's. The agricultural sector's share in output has fallen below 30 percent in both Pakistan and India. Yet these similarities hide fundamental differences, both in the underlying structures of the two economies, as well as in their relationship to the world economy. While the Indian economy has grown largely on domestic savings and investment, Pakistan has long financed its investment from foreign loans and remittances..Many observers have noted that Pakistan's politics and economy have been shaped by two legacies — that of Zulfikar Ali Bhutto and of Gen Zia-ul Haq. Bhutto's was the populism of an elected leader who aspired to develop a strong and resurgent Pakistan. His emphasis was on large-scale manufacturing and industrialisation, and later on a programme to develop the atomic bomb. This was to neutralise Indian hegemony on the Subcontinent and avenge the military defeat of 1971. Bhutto's emphasis on 'socialism' and a strong public sector was to shape the political economy of Pakistan in hitherto uncharted ways..In contrast, Gen Zia-ul Haq relied on Islam and private enterprise to consolidate his power. This was to take Pakistan along a path that would shape its politics and economics for the next two decades, and perhaps, lay the basis of the social and economic crisis that plagues the country even today. Both legacies ignored the tensions in the social and economic spheres. As a result, they missed the opportunity to establish the foundations of an independent, sustainable growth and modernisation strategy oriented to modernising society and economy..Growth was at its highest during the Zia era (1977- 1988), and a considerable part of the present analysis looks at the factors behind this phenomenal record. The post-Zia period is analysed to understand the balance of payments and fiscal crisis that mires the economy today. The economic crisis deepened after the nuclear explosion in 1998 and the International Monetary Fund's bitter prescriptions have done little to restore macro-economic stability. It was this continuing crisis that was used by Gen Musharraf in 1999 as justification for military intervention and the coup against Nawaz Sharif's government. Currently, Pakistan looks to mitigate the effects of the escalating crisis by joining the American camp in the war against the Taliban..For an in-depth understanding of the political economy of Pakistan, it is important to chart the journey from Bhutto's economic policies, through the Zia regime in which the country saw a growing dependence on foreign savings, to the crisis of the 1990s and the pressure from IMF that forced the so-called democratic regimes to impose an unprecedented burden on the people of Pakistan in an era of declining foreign aid and remittances. The accentuation of the crisis after the nuclear explosion in 1998 must also be examined. Finally, the policies adopted by Gen Musharraf and his finance minister, Shaukat Aziz, unhindered as they are by the pressures faced by a democratic regime, must come under scrutiny..Bhutto's 'socialism' and economic restructuring.1971 was a traumatic year for Pakistan. The Bhutto regime had to grapple with the break-up of the country and the independence of Bangladesh. The departure of the eastern wing robbed the western wing of a large internal market. Since trade between the two wings constituted about 50 percent of the western wing's total exports and 20 percent of imports, truncated Pakistan faced an urgent need to find new markets for these products. The economy also faced large external shocks due the fourfold increase in petroleum prices by Oil Producing and Exporting Countries (OPEC). Pakistan succeeded in overcoming the twin shocks. Bhutto also tried to accelerate the pace of investment and modernisation and to enlarge the heavy industrial base of the economy. Yet the Bhutto years (1971-77) were characterised by moderate or low growth, and the emergence of the persistent imbalances that continue into the present..Upon assuming power, Bhutto devalued the rupee and raised the profitability of exports at a time when world markets were experiencing a commodity boom. Exports increased by 40 percent between 1972 and 1974 as Pakistan found new markets for its commodity exports, primarily rice, cotton and sugar. Though the export boom helped to compensate for the loss of the eastern wing's market, it was not sufficient to meet the increasing import bill. The newly launched modernisation drive and the establishment of basic industries, such as steel, increased the demand for imports. While exports doubled from USD 591 million in 1971 to 1141 million in 1977, imports increased fourfold from USD 638 million in 1971 to an astounding 2325 by 1977. This was the genesis of the perennial balance of payments crisis that has confronted Pakistan since..To bridge the growing deficit in trade and balance of payments, the Bhutto regime was forced to turn to foreign sources. The increasing dependence on external commercial loans led to a sharp increase in Pakistan's debt burden. This dependence on external debt also points to the Bhutto government's failure to mobilise domestic resources for investment. Domestic savings could finance only 60 percent of the investment in the economy. Borrowing from international sources to finance the savings-investment gap became imperative..Yet, Bhutto will be remembered, not so much for the external debt shock, but for the dramatic shift in the economic policies and the campaign to undermine the stranglehold of large business families and feudal landlords. His mass appeal revolved around his articulation of the strong sentiment for economic and social reforms that swept through Pakistan in the late 1960s, when the Ayub Khan regime was crumbling. Bhutto described General Ayub's economic strategy as "a monstrous economic system of loot and plunder which the regime lauded as free enterprise"..Support for Bhutto's reforms came from a wide constituency — the urban middle class, the landless peasantry, workers and, curiously, even landlords. Conservative landlords shared with radical groups a resentment of the nascent bourgeoisie of emerging large industrialists. The landlords were particularly antagonistic to the traders who had migrated from India and, by the end of the Ayub era, had emerged as the new industrial elite. Sindhi landlords were important members of Bhutto's Pakistan People's Party (PPP) and supported the nationalisation measures that were aimed at the industrialists. However, they were hostile to Bhutto's land reforms and played an important role in undermining the programme for confiscation of surplus land and its redistribution..In 1972, the PPP had pushed through land-ceiling legislation to reduce the size of land holdings and to redistribute confiscated surplus land. "We are as much against the ignorant and tyrannical landlord as we are against the robber barons of industry", Bhutto declared. This legislation restricted ceiling on ownership to 150 acres of irrigated land or 300 acres of unirrigated land. Surplus land was to revert to government without any compensation to the landlords and distributed free to the landless. However, there were numerous exemptions. Landowners were allowed to retain an additional 50 acres above the ceiling if they invested in tractors and tube wells. Generous tax exemptions were granted for the purchase of agricultural machinery and land development. These were all incentives for modernising agriculture..The results were dismal. Given the fact that the ceiling was on individual rather than family ownership, large landowning magnates had little difficulty in retaining control over land through division within family members. The implementation of the reforms was also arbitrary. Landlords hostile to the regime were targeted, while those loyal to PPP were left alone. As a consequence, more and more landlords flocked to the party. The total land seized for redistribution was less than 1 percent in Punjab and 3 percent in Sindh..The only province where land reforms were effective was the North West Frontier Province (NWFP), where it was used to undermine the social base of Bhutto's political opponents, the National Awami Party (NAP). Balochistan NAP leaders were also targeted. In all, 12 percent of the land in NWFP was redistributed and approximately 33 percent of the landless households received some land, leading to a sharp increase in support for the PPP and a corresponding decline in the NAP'S popularity. Otherwise, by and large the only legacy that Bhutto's land reforms left behind was one of deceit and vendetta..The nationalisation of private banks, insurance and large industry faced fewer obstacles. In the first phase, Bhutto targeted basic industries and nationalised 31 industrial units producing capital and intermediate goods which providing about 20 percent of value added in large-scale manufacturing. Most of private units producing consumer goods were left untouched..The newly nationalised banks redirected credit to landlords, rich peasants and small-scale industrialists. Many of these small industrialists were the more affluent peasants, landlords and small traders. This easy flow of credit to medium and small industrialists restored the private sector's confidence in the regime to some extent. Bhutto's PPP argued that its nationalisation was aimed at curbing large monopolies, and was not directed against the private enterprise per se. The government was emphatic that there would be no further nationalisation and that the aim was to foster a mixed economy, with a healthy combination of both the public and private sectors. In addition, former owners of the nationalised units were generously compensated..However, by late 1973 the atmosphere of cooperation had been vitiated by further nationalisations. Many small and medium units were also taken over by the state. Some observers, such as Omar Noman, argue that this was not the result of a well-defined and systematic strategy of greater state control over the economy, but an ad-hoc response to short-term crises. In 1973, as the price of edible oil trebled due to floods and hoarding, the government nationalised the edible oil industry. In 1976, it nationalised the flourmills, cotton ginning and rice husking, thus antagonising the small and rural petit bourgeoisie. Private sector confidence reached a new low and undermined Bhutto's strategy of a corporatist state intervention..As private investment declined, the government's growth strategy was forced to depend more and more on public investment, which rose sharply from PNR 58 million in 1971 to 1085 million by 1977. Meanwhile private investment declined from PNR 700 million in 1971 to 183 million by 1975. Two-thirds of the industrial investment was now concentrated in the public sector, a significant proportion of which was in the capital goods sector. Thus, the newly set up Pakistan Steel Mill Corporation and a nuclear reprocessing facility became symbols of the regime's strategy to diversify the industrial base..The public sector enterprises soon began to run large deficits. They were not allowed to raise prices and were forced to absorb large numbers of workers. The location of these new public enterprises was decided on political considerations. Some of these enterprises were established in the constituencies of PPP leaders. Growing deficit combined with the failure to raise revenue led to increasing gaps in state finances and the destabilisation of the macro-economic balance. By 1974-75, the budget deficit was as high as 10 percent of the GDP..The external shocks to the economy and nationalisation led to a sharp decline in growth rates. Despite increasing public investment, the growth rates in agriculture and industry fell to a new low (Table 1). The only redeeming feature was the surge in the tertiary sector, thanks to the expansion in construction, public administration and defence..The rising trade and budget deficits, along with the rising debt service burden aggravated the balance of payments situation. Pakistan had to negotiate two debt-rescheduling arrangements with the Aid Consortium and the World Bank during the 1972-74 period. The World Bank was critical of the government's macroeconomic policies and stipulated a set of reforms and domestic resource mobilisation targets as a precondition for resuming aid. There was a deadlock as the government refused to accept the advice to curtail its expenditure. Only after a compromise was reached was foreign aid resumed, and during the next few years OPEC emerged as an important and growing source of external assistance. Total foreign assistance reached a new high and by 1975 it had touched USD 1.2 billion..By 1977, the Bhutto regime had alienated itself from all the three economically dominant classes — the bureaucracy, the rising bourgeoisie and the landlords. The latter were particularly aggrieved by the nationalisation of agro-processing industries such as cotton ginning, rice husking and flourmills in which they had invested. The PPP's base among the subordinate classes was also alienated after the purge of left wing elements and the party's gradual shift to the right under the World Bank programme. A confrontation with the opposition, encouraged by the armed forces, led to a military takeover in 1977..The Bhutto government's economic strategy exposed fundamental weaknesses in the Pakistan economy. The low savings rate and the state's inability to mobilise resources for investment have persisted to this day. The narrow export basket and the failure of the import substitution strategy had made the trade gap unsustainable, while the anti-private sector bias of the regime drew hostility from international donors. Increasing aid from the OPEC partly mitigated the effects of the crises. But this reliance on foreign aid was to pose new problems in the coming decades..The failure of Bhutto's economic and political programme served to undermine the radical and left groups that had fought hard to establish a modern and more equitable economic and social sector in Pakistan. The collapse of this alliance of radical urban intelligentsia, workers, rural tenants and landless led to the consolidation of more conservative social groups under Gen Zia-ul Haq..Zia's militarisation and dependent growth.Zia-ul Haq ousted Zulfikar Ali Bhutto and imposed martial law in July 1977. The military intervention came amidst strong public protest against Bhutto, which had started in the wake of alleged irregularities in the election held in March 1977. Zia took over with the declared purpose of resolving the impasse between Bhutto's People's Party and the combined opposition, and promised to hold free and fair elections within 90 days. Bhutto's continuing popularity, and the fear of a vendetta against the top military leadership in the event that he returned to power in free elections, prompted Zia and his colleagues to postpone elections. In March 1978, the Lahore High Court judgement found Bhutto guilty of complicity in the murder of a political opponent. Zia used this as the excuse to imprison Bhutto. The endorsement of the high court ruling by the Pakistan Supreme Court helped Zia order Bhutto's execution in April, 1979. This set the stage for a decade-long military rule, which ended only with Zia's sudden death in a mysterious air-crash in August 1988..After Bhutto's elimination, Zia's legitimacy was at a low ebb and he was under pressure from Western governments to restore democracy. However, the Soviet invasion of Afghanistan, in December 1979, gave a new lease of life to the Zia regime as it blunted internal and external pressure for the restitution of civilian government. Zia finally ordered elections on a non-party basis in March 1985, after amending the constitution so that it substantially increased the powers of the president. Following the elections, Zia picked Muhammad Khan Junejo as the prime minister. But with Junejo asserting his authority a conflict ensued and Zia dismissed the government in 1988..In contrast to the economic stagnation of the Bhutto era, Pakistan experienced unprecedented growth rates, often exceeding 6 percent per annum during the 12 years of military regime. At a superficial plane, the fiscal and balance of payments crises also seemed to be well managed. To understand this period of high growth followed by a decade-long decline and recurrent crises, it is necessary to look at the policies of Zia-ul Haq, who over a decade fundamentally changed Pakistan's economy and society. The Islamisation of society and the rise of fundamentalist social groups is well known and partly explains the political and social crisis that has bedevilled Pakistan in the 1990s. What is less appreciated is how drastically the dictator-general changed the structure of the economy. He moved away from the 'socialist' policies of Bhutto and used foreign aid and remittances to make Pakistan heavily dependent on continuous receipts of savings from abroad..The high growth in the 1980s, along with rising consumption, provided the support and legitimacy that had eluded Pakistan's rulers for some time. While the Indian economy in 1980s grew at 5.5 percent per annum, the Pakistani economy grew annually by about 7 percent. Its agriculture expanded at twice the rate in India thanks to the completion of two large dams and associated irrigation projects..Some of Zia's policies were thought-out initiatives, while others were the result of fortituous circumstances. Others were accidents of history. First, Zia used his efforts to Islamise society to broaden his political support. Second, the Soviet occupation of Afghanistan and Zia's highly successful efforts to mobilise and coordinate large external assistance for the mujahideen from sources such as the United States and Saudi Arabia, increased his political standing and control after 1980. Third, he extended the role of the army in governance through extensive use of military intelligence, appointment of senior officers to key positions in public administration, and dispensation of patronage to the armed forces, thus creating a strong vested interest in the army for the continuation of his regime. But all these would have been insufficient to hold power for more than a decade, especially since the Pakistani army had not only just been sullied by the atrocities committed in East Pakistan but had also been held responsible for the splintering of the nation. What helped Zia most was a period of high and sustained rate of economic growth and a dramatic fall in absolute poverty. The economy expanded by nearly 6.6 percent per annum while inflation was moderate. This growth was broadly shared amongst different segments of the population with increases in real wages in urban and rural areas, which resulted in a decline in poverty levels..The Pakistani economy during the 1980s, benefited from a number of special factors, both domestic and external. The completion of the long-gestation period Tarbela Dam on the Indus helped unleash unprecedented agricultural growth, while fertiliser and cement investments undertaken under Bhutto contributed to industrial growth. Yet this by itself would not have sufficed either to increase the rate of growth or for reducing the pressure to raise resources for investment. In 1977, Pakistan's GDP was only USD 15 billion. It was the increase in remittances by Pakistani workers in West Asia upto USD 2-3 billion over the next few years that served as a powerful source of economic expansion, providing strong support to balance of payment..In the first half of the 1980s workers remittances exceeded the total earnings from merchandise exports. This provided a boost to economic activity, and rose to a peak of USD 3 billion in 1982-83. In 1982-83, these remittances were equivalent to 10 percent of Pakistan's GNP (Table 3). Zia also successfully negotiated with the United States for external assistance on a scale unprecedented in the history of Pakistan. In addition to direct assistance to Pakistan, Washington DC and allies funnelled about USD 5-7 billion to the Afghan mujahideen via Pakistan, providing a further boost to the local economy. Similarly, the narcotic trade, which gathered momentum in the 1980s, strongly supported the service sector of Pakistan..Unlike Ayub, Zia did not have a clear long-term vision of the economic future, and consequently, lacked a long term strategy. He left the day-to-day management of the economy to his finance minister, Ghulam Ishaq Khan who abandoned Bhutto's strategy of increasing state intervention and public sector investment. A modest plan of de-nationalisation was initiated and economic policies became market-oriented. Buoyant remittances and aid eased the foreign exchange constraints on the economy and helped Zia-Khan to move to a flexible exchange rate regime, improving the incentives for exports. The de-nationalisation and loosening of the controls also led to a surge in private investments for both agriculture and industry, which had fallen sharply during Bhutto (Table 2)..Unfortunately, the remittance boom did not translate into higher rates of national savings and investments. Most of the remittances were directed towards consumption, and this played a major role in reducing poverty. Notwithstanding the substantial additional taxation imposed in 1979-80 and 1986-87, fiscal policy had only limited success in increasing the proportion of GDP mobilised through tax revenue from 11.9 percent in 1976-77 to 13.3 percent in 1987-88. As a result, public savings remained negative and fiscal deficits persisted at a high level. The gap was partly filled by generous foreign aid, and largely by domestic borrowings..Thanks to the expansion of irrigation investment initiated by ZA Bhutto, agricultural growth increased to 4 percent per annum from a dismal 2 percent during 1972-77, and played an important role in accelerating GDP growth in the Zia era. Many factors contributed to this. Production during the Bhutto years had been adversely affected by exceptional weather conditions, both droughts and floods. The additional water availability from Tarbela Dam after 1976, augmented irrigation water supply by more than 10 percent. Domestic production of nitrogenous fertiliser nearly tripled during the first half of the 1980s. Fertiliser use per hectare increased from 30 kg in the mid-1970s to 80 kg by the mid-80s. The increase in support prices for wheat and cotton improved agricultural incentives. The livestock sector too grew by more than 5.5. percent in the 1980s thanks to the increasing demand for milk, meat and poultry. The share of livestock in the agricultural sector increased from 26 percent in 1980-81 to 32 percent in 1994-95..Industrial growth and exports.The expansion of the industrial sector under Zia was equally impressive. Manufacturing sector growth during 1977-88 was over 9 percent per annum (Table 2) and compared very favourably with the 3.7 percent growth of the Bhutto period, 1972-77. Several factors explain this rapid industrial expansion. First, the large public sector investments, which started under Bhutto and continued in the early Zia period, resulted in a major increase in steel, cement, fertiliser and vehicle production. The public sector steel mill started production in 1982 and reached a high capacity utilisation by 1984-85. Second, incentives for manufactured exports were strengthened by the introduction of a flexible exchange rate policy in 1982, and by the introduction of direct export subsidies in 1978-79, which increased the rebates on custom duty and sales tax for exports. Manufactured export grew by 13 percent per annum in the 1980s. Third, the investment climate for the private sector was improved by de-nationalisation of medium and small enterprises and a few large units..Further de-nationalisation was held back due to the former owners insisting on the writing-off of losses incurred during the period of nationalisation and on the right to fire surplus workers. This was unacceptable to a regime still fighting for legitimacy. However, the government provided guarantees against future nationalisation and offered tax concessions. Licensing and investment controls were relaxed by raising the limit for units not requiring any sanction from PNR 60 million to 300 million in 1984 and further to 500 million in 1987. As a result of this, private sector investment in manufacturing grew by 9.5 percent per annum during 1978-83 and accelerated further in the last five years of the Zia regime. The private sector's share in the new industrial investment had risen to over 90 percent by 1988 compared to less than 30 percent in 1976-77..The revival of private industrial investment helped to expand capacity in traditional industries such as cotton textiles and cement. The rapid growth of raw cotton production, thanks to the improved irrigation, gave fresh impetus to textile production, especially cotton yarn production. As in India, cloth production was moving out of the large mill sector towards decentralised power looms. Pakistan soon emerged as a major exporter of cotton yarn, with the 1989-90 yarn exports exceeding that of cloth by more than 50 percent. Over 60 percent of the increase in the value of exports in the 1980s is attributable to cotton, cotton textiles and garment export. The share of cotton and cotton goods export in Pakistan's total export increased sharply from 40 percent in 1979-80 to 60 percent in 1989-90. The gradual depreciation of the Pakistani rupee from PNR 9.9 per dollar in 1981 to PNR 18 per dollar by 1988 provided a valuable incentive to the exporter..Despite the boom in manufacturing and exports, the industrial sector in Pakistan suffered from many weaknesses. Industrial development was constrained by the small size of the home market, particularly after the creation of Bangladesh. The industrial base in Pakistan was narrow and undiversified. Even in 1990-91, food and textiles alone contributed more than 40 percent of the industrial value added. The share of industries exclusively based on indigenous raw materials still accounted for 60 percent of value added. The removal of quantitative restrictions on imports along with the reduction in import tariff on raw materials and intermediate goods during the 1980s led to some diversification of manufacturing output. However, the reduction in import barriers undermined the import substitution strategy of industrialisation in Pakistan..Investment and savings.The high growth during the Zia period was not accompanied by any great increase in investment. Gross fixed capital formation as a percentage of GDP was about 17 percent during 1977-88, marginally below the level in the Bhutto era. How was it possible to achieve an annual growth of 7 percent with such a relatively modest investment rate? Was Pakistan extraordinarily efficient in the use of capital resources?.To some extent the pattern of growth in Pakistan, especially the expansion in the service sector, which requires lower investment levels, lowered the capital output ratios and pushed up the growth rate. Some analysts argue that the shift in industrial investment from public to private may also have contributed to some gain in efficiency. Zia also reaped the fruits of long-gestation investments made by Bhutto. The use of remittances for consumption fuelled a boom as output expanded to meet new demand. Despite all these, there is no doubt that the investment level under Zia was inadequate in relation to both current needs and future requirements. Serious shortages of infrastructure, especially energy, transport and urban development had already developed by the mid-1980s. Unlike Bhutto, Zia left no large-scale projects under implementation that his successors could benefit from..The low rate of investment during the 1980s was due to the failure to mobilise sufficient domestic resources in the public sector. Despite the massive increase in remittances, the national saving rate only moved up marginally to about 14 percent of GDP (Table 4). It appears that while private savings increased, public savings declined during the Zia era. Domestic savings (excluding worker's remittances) declined to about 6 percent of GNP by 1980 or financed only about 40 percent of gross domestic investment. This performance of Pakistan's economy is particularly perplexing because even neighbouring countries like Bangladesh, India and Nepal, all had domestic savings rates between 18-25 percent..The fiscal crisis that gripped the economy in the latter half of the Zia era can be largely explained by the surge in military expenditure. In nominal terms, military expenditure rose from PNR 8 billion (or 5.4 percent of GDP) in 1976-77 to PNR 47 billion in1987-88 (7 percent of GDP). Combined with the major increase in the size of the economy, this meant a growth in real defence spending of over 160 percent or more than 9 percent per annum (Table 5). This rate of growth in military spending was faster in the Zia years than in any other period in Pakistani history..Zia justified this increase in military spending by citing the compulsions arising from the Soviet occupation of Afghanistan. He also increased the salaries and privileges of the armed forces, which were a critical part of the constituency that supported his regime. This increased defence outlay combined with the increase in the debt burden and interest payment to squeeze the expenditure on development..Public development expenditure declined from about 10 percent in 1976-77 to 6.9 percent by 1987-88. At the beginning of Zia's rule, public sector development outlay had been nearly double the level of defence spending. A decade later, defence spending was as large as the development outlay. A part of the increase in military spending was related to liberal benefits and amenities for military personnel. Similarly, the enormous increase in domestic debt, which rose from PNR 58 billion in 1981 to 290 billion in 1988 and further to 900 billion in 1996, led to a sharp increase in interest payments. During the Zia era interest payments increased from PNR 4 billion to 32 billion..Ghulam Ishaq Khan's effort to impose heavy taxation in 1979 met with strong public resistance and was soon abandoned and the government shifted to large scale borrowing towards the close of the Zia regime. The un-sustainability of large fiscal deficits and growing domestic debt undermined future growth and monetary stability. Despite these shortcomings, however, rising incomes and increasing transfer payments, thanks to the remittances from workers, led to a sharp reduction in poverty. Real wages in agricultural industry rose rapidly and outward migration helped increase urban wages..In 1980, Zia unveiled the plan for an Islamic economic system. He institutionalised zakat and introduced interest free banking. Zakat, is one of the pillars of Islam according to which well-to-do Muslims are required to distribute two and half percent of their wealth annually. Under Zia's zakat ordinance, the financial assets in the banking system and saving instruments were subject to 2.5 percent deduction annually. By 1988, this had provided PNR 2.5 billion and was diverted by Zia to the poverty alleviation programmes for vulnerable groups..Zia had managed to bring back private industrialists into the mainstream, and rising private investment compensated for part of the decline in development expenditure. The period was also marked by rising industrial production and agricultural output, thanks to the commissioning of heavy industry projects and a major dam and irrigation network. Though the support for the regime can only be a conjecture since Zia did not contest any elections, it is clear that the dictator general managed to keep the powerful groups in Pakistan happy and compromised..Civilian governments and economic management.The period after Zia's death, till the takeover by General Pervez Musharraf, was marked by a great deal of political instability under civilian governments, slow economic growth and recurring foreign exchange crises. Pakistan had to go thrice to the IMF for bail-out packages. Successive elections following the frequent dismissal of governments did not provide for a strong and clear mandate or stability. Elected governments were not only politically weak but also dominated by vested interests..Benazir Bhutto was elected in December 1988 and dismissed by President Ghulam Ishaq Khan in August 1990. Nawaz Sharif became the prime minister after another election in 1990 and was dismissed in April 1993, but was restored to office by a supreme court ruling. Both Nawaz Sharif and Ghulam Ishaq Khan resigned in 1993 and after a three-month long caretaker government, Benazir Bhutto became the prime minister till she was dismissed by President Farooq Leghari in November 1996. In 1997 Nawaz Sharif again won with a large majority and ruled till 1999, when General Musharraf ousted him..In these circumstances, the serious economic and social problems inherited from the Zia period only worsened. The period after 1988 witnessed a sharp decline in the growth rate, acceleration in inflation, worsening income distribution and increasing poverty. The most serious manifestations of this deteriorating situation were the crises in the foreign exchange position in 1993 and 1996. Both Benazir and Nawaz were either unwilling or unable to stem the rot..Benazir inherited a bankrupt government that was no longer as important to the West as Zia's regime was, since by then the Soviet occupation of Afghanistan had ended. The macro-economic imbalances in Pakistan had assumed huge dimensions. The fiscal deficit had risen to a new peak of 8.5 percent of GDP and the current account deficit in balance of payments was growing. The investment rate had stagnated for more than 10 years and spending on social development had fallen. The latter half of the 1980s had seen a gradual decline in workers' remittances. In addition, interest payment on foreign debt was continuously on the rise. With growing interest payments, the room for manoeuvre in public finance was limited. The agreement with the IMF, negotiated by the transitional government of President Ghulam 'shag, which had fiscal deficit reduction as a key target, was not seriously implemented by the Benazir government..When Nawaz Sharif came to power in 1990 he embarked on a fundamental liberalisation of the foreign exchange regime, relaxation of investment controls, privatisation of public assets and increased incentives for domestic and foreign investment. In 1992, the government also allowed Pakistani residents to hold foreign exchange in designated accounts if the funds were received from overseas. An increasing part of monetary assets came to be held in the form of foreign currency deposits. The exemption of these deposits from zakat and other taxes, attractive interest rates compared to those available on foreign currency deposits abroad and, above all, the rapid erosion in the value of domestic monetary assets through inflation encouraged the 'dollarisation' of the economy..In 1993, Pakistan negotiated an agreement with the IMF and agreed to reduce the fiscal deficit to 4 percent in 1994-95 and 3 percent in 1995-96. However, Pakistan could only reduce the deficit to 5.8 percent in 1994- 95. As the fiscal and balance of payments crises continued, the government had little option but to succumb to donor pressures. Under pressure from the IMF, successive elected governments made serious efforts to raise the tax revenue. Heavy taxes were imposed between 1991 and 1998. The level of additional taxation ranged from a high of 2.4 percent of GDP in 1994-95 to a low of 0.6 percent in 1995-96. Altogether, the additional taxation proposed amounted to an extraordinary 8.2 percent of GDP in a relatively brief period of six years. The increasing tax burden and declining social spending added greatly to the unpopularity of elected governments. The continuing pressure from IMF and the rising debt forced the governments to accept these high levels of taxation in preference to reducing non-development spending or military expenditure. Despite this heavy taxation, tax revenue did not increase and undermined the credibility of the government. There are few parallels where additional taxation of this magnitude has been successfully introduced year after year under a democratic regime. As the fiscal crisis grew, defence spending declined from 7 percent of GDP in 1988 to 5.5 percent in 1996, but development expenditure dropped even more sharply from 7 percent to 4.3 percent of GDP. The installation of civilian governments had clearly done nothing to restore the balance between military and development spending..However, the liberalisation of the foreign exchange regime and the opening of foreign currency accounts did improve the balance of payments position. But foreign aid declined, as the governments continuously failed to meet the targets set by the IMF. The situation was partly mitigated by the increasing deposits in foreign currency accounts. Workers remittances were diverted to these foreign exchange accounts with the total deposit rising to USD 4 billion by 1996 and to USD 7 billion by 1998 (Table 6)..The rates of GDP growth declined sharply in the 1990s as political instability and declining public expenditure on development eroded the stimulus for growth. Despite unfavourable climatic conditions, agricultural output expanded by 4 percent per annum during the 1990s, a remarkable rate of growth. But, industrial growth declined from 8.2 percent in the 1980s to 4.6 percent in the 1990s, with large-scale manufacturing showing a more acute decline in growth rates. Overall, the total GDP growth rate came down from 6.5 percent in the 1980s to 4.5 percent in the 1990s..More alarmingly, there was a sharp increase in the incidence of poverty in Pakistan, from a low 17 percent in 1988 it doubled to 33 percent in 1999 (Table 7). Declining public expenditure, IMF-driven fiscal adjustment, as well as poor harvests and declining remittances, all played a part in this unfortunate trend. Meanwhile, a serious problem was emerging on the export front. On one hand, Pakistan's exports stagnated at about USD 6.5 billion during the 1990-95 period and fluctuated up to USD 8 billion between 1996 and 2001. On the other hand, imports rose from USD 7.6 billion in 1990 to about USD 12 billion in 1996-97, although they came down to an average of USD 10 billion in the period up to 2001..Bomb and after.When Pakistan carried out its nuclear tests in 1998, its trade and balance of payments were in disarray. Workers' remittances had stagnated at the USD 1 billion mark and the current account deficit was USD 2.5 billion. With the West imposing sanctions on Pakistan and the IMF cutting off its assistance, the crises in balance of payments deepened. Nawaz Sharif's government faced difficult choices. As withdrawals from the foreign currency accounts mounted, the government panicked and froze them. This single act of the government undermined its credibility and accentuated capital flight from the country. Pakistan's official statistics show declining levels of foreign trade and workers' remittance, which fell to as low as USD 700 million in 1999-2000. It is likely that many of the transactions moved to unofficial channels. Indeed, the current finance minister, Shaukat Aziz, estimates that the total remittance of workers to Pakistan is approximately USD 6.5 billion of which only USD 1.5 billion moves through the official banking network..The Musharraf government is left to grapple with the worsening economic situation. Fiscal and balance of payment deficits plague the economy. Pakistan's total budgetary resources were 15 percent of the GDP. Out of this, 5 percent went into civil administration, 4 percent to defence and the rest to debt servicing. Therefore, nothing was left for development expenditure. A poor harvest due to a severe drought in 2000-01 led to a decline in agricultural production by 2.5 percent and brought the GDP growth down to 2.2 percent, the lowest in 25 years. All this as Pakistan's exports have stagnated for a decade..General Musharraf has used the pretext of the continuing economic crisis to justify Pakistan's participation in the American campaign in Afghanistan. (In 1999, he had used the economic crisis as the pretext for toppling the Nawaz Sharif government.) He has promised that liberal aid from international agencies such as the World Bank and the IMF, as well as from Western governments, will help turn the economy around. As did his predecessors, Musharraf has made efforts to impose the general sales tax and to speed up collection and check evasion. And, as promised by the West, aid has once again begun to flow into Pakistan. The IMF has sanctioned a short-term facility of USD 300 million while the Aid Pakistan Consortium has rescheduled Pakistan's debt load of USD 28 billion. In addition, assistance from the Asian Development Bank, the World Bank and the governments of Japan and the United States has been resumed. It is likely that in the current year Pakistan will be able to ease its balance of payments situation and resume imports to speed up growth..However, serious problems remain to be tackled. With IMF-induced trade liberalisation, the large-scale manufacturing industry is in the doldrums. The various disputes with multinational power producers, such as the Hub Power Company, and the worsening climate for foreign investment has led to a reduction in Portfolio investment. The fiscal deficit continues to be large and despite the use of force the government has failed to meet its target of tax collection..Initially, the government's effort to prevent capital flight and persuade non-resident Pakistanis to remit money through official channels had little impact. Then came September 11 and the war against terrorism, which included a crackdown on illegal money flows through hundis or the parallel non-official money transferring mechanism. Thanks to these efforts, flow of remittances through official banking channels have risen sharply and in 2001-02 may touch the USD 2 billion mark from a low of 1 billion in 1999-00, the first year of the Musharaff regime. Increased foreign aid and the rescheduling of debt has helped Pakistan increase its foreign exchange reserves to above USD 5 billion..However, the growth performance of the economy in the three years of the military regime has touched a new low. The growth rate has hovered between 2.5 to 3.5 percent. The finance minister blames it on the poor performance of agriculture due to bad weather. He has succeeded in reducing the fiscal deficit to below 4.9 percent, but this has been at the expense of development expenditure. The budget presented in June 2002 has pegged next year's development expenditure at about 4.3 percent of GDP..The strong-arm methods used by the military regime to increase tax collection and reduce outstanding loans by banks to private industrialists are unlikely to continue if a democratically elected government assumes power in October this year. The changes in the constitution regarding the president's power and Gen Musharraf's threat that he will not let a democratically elected government undo his economic policies do not inspire confidence. An elected government will be under pressure from the electorate to reduce the burden of high taxes and high prices for public sector services and goods such as electricity, gas etc imposed on the common citizen by Shaukat Aziz. A conflict between a president not answerable to the public and a government that has to meet the expectations of those who voted it to power, is likely. This could further erode private sector confidence and increase capital flight..The challenge facing Pakistan is to reduce its dependence on foreign resources and increase domestic investment and savings. Very few countries can sustain current account deficits as large as 4-6 percent of GNP. Joining the American camp may facilitate a transition but in the long run Pakistan can only grow on domestic savings and resources. The increase in military expenditure in recent months due to the mobilisation of forces on the India-Pakistan border is likely to worsen the fiscal crisis as well as keep away private foreign investors. The future depends on the restoration of confidence in the government, and its ability to bring forth private investment, both indigenous and foreign. It is unlikely that without full restoration of democracy, an end to the militarisation of society and reduction in military expenditure, Pakistan can resume its march towards growth and prosperity. Only peace and democracy can lay the foundation of a new growth strategy.