The Need for a Not-so Friendly Budget

Over the past few days, both Prime Minister Shehbaz Sharif and Finance Minister Ishaq Dar have told the media that the “upcoming budget will be a business and people friendly budget”. Initial estimates from Finance Ministry suggest that the outlay (expenditure) for the federal budget 2023-24 will be around Rs 14.6 trillion. While FBR’s tax target is projected to be at Rs 9.2 trillion.

Overall, the proposed budget might include a small primary surplus of about 0.3% of GDP. This is necessary to stabilize the ballooning fiscal debt, but may not be enough given a contracting economy, record-high inflation, and failures in meeting tax targets over the past few years. Perhaps, Pakistan would be better off with an ‘unfriendly’ budget.

Debt servicing costs are expected to eat up Rs 7.5 trillion in the budget which has prompted many commentators to endorse domestic debt restructuring. However, one must note that the high debt servicing costs are temporary due to interest rate hikes from the State Bank. When interest rates fall back to normal levels, the government’s debt servicing bill will recede given that most of the debt is of floating rate or in treasury bills which mature quickly. But the real question is when will inflation begin to fade so that interest rates can fall?

The State Bank has been vigorously hiking interest rates in the hope that inflation starts to budge downwards. However, inflation has only gone up after each interest rate hike. Analysts have given many reasons for this such as rising petroleum prices, higher taxes, revision of electricity and gas tariffs following mini-budget or the depreciating rupee. But these factors only look at nominal computing of inflation and ignore the demand side of credit.

As per SBP, July to April FY23 government borrowing stood at Rs 3 trillion while private sector borrowing stood at Rs 194 billion. During the same period in FY22, government borrowing was at Rs 1 trillion, while private borrowing was at Rs 993 billion.

It is clear that private sector credit demand has fallen dramatically as a result of interest rate hikes, showing that monetary policy has been effective. However, the massive rise in government borrowing has erased any gains that were to be made from monetary tightening.

It seems like the government is borrowing as much as it wants – the true source of inflation in Pakistan. Another factor to note is that cash in circulation stands at Rs 8 trillion while total banking deposits are Rs 23 billion. That puts Pakistan’s cash to M2 money supply ratio at 30% – the highest in the region. 

This ratio has been going up for many years now. This means Pakistanis are unlikely to convert their cash holdings to interest-yielding accounts even when interest rates are going up. All this makes fiscal policy ever-more important in fighting inflation. A fiscal contraction will lead to a far greater decline in inflation than an equal amount of monetary tightening.

For FY23, the government had set a primary surplus target of 0.3% of GDP, in line with IMF’s demands. However, FBR has missed their tax targets by quite a margin as has been the case over the last few years. This has led to a 0.8% variance in the primary budget which now comes in at a deficit of 0.5% of GDP. The effects of this can be seen in the debt-to-GDP ratio which will rise above 80% at the end of FY23.

Considering the fact that Pakistan’s economy is contracting, the government needs to target a primary surplus of at least 1.5% of GDP in the budget. This will allow a reasonable, in-built buffer of 1.2% of GDP.

So where can the government slash their expenditures? For one, Rs 1.1 trillion is being budgeted for PSDP which can be drastically trimmed. Much of the spending in PSDP is on negative NPV projects which have political motives anyways.

Another Rs 1.2 trillion is being budgeted for gas and power subsidies – mostly to industries. These subsidies have been largely unproductive and rent seeking in nature. These subsidies can be decreased significantly as well, which would have the spillover benefit of pushing businesses to become more competitive.

Both these measures will allow the government to push down their outlay to Rs 13 trillion at the very least. Although there would be more potential for expenditure reduction once more budget details come to light.

But it is clear, fiscal contraction or at the very least, avoiding fiscal expansion is necessary in dealing with Pakistan’s current issues: high inflation and rising fiscal debt. A smaller government would be better for Pakistanis.