9 Balance of Payments and Exchange Rate Policy

9.1 International Economic Scenario

Global output staged a recovery during 2002, growing by an estimated 3 percent, which is a small improvement over the 2.5 present growth estimated for the preceding year. Although both the advanced economies and the developing countries shared in the recovery during 2002 (see Figure 9.1), the overall performance of the global economy remained well below the potential.

 

The growth in the advanced economies is important, as the progress in these economies gives a stimulus to economic growth in the developing countries as well - the US, EU and Japan, particular, constitute over 50 percent of the world economy. Within the advanced economies, however, it is only the USA (and to some extent the East Asian advanced economies), which contributed in the recovery shown by this group. Japan and the European members of this group showed a dismal performance, with growth decelerating to 1 percent and 0.3 percent respectively (see Figure 9.2). In contrast, developing countries performed turned in an aggregate growth of 4.6 percent, led by the robust 8 percent growth in China. It seems that the rising uncertainty related to situation in Iraq during the latter half of 2002 accentuated the already slow business investment, which had been decelerating following September 11 and latter the corporate scandals in the US. However, the monetary stimulus policy opted by the US (and the EU), prompted by this recessionary tendency, then played a pivotal role in stimulating economic activities.

 

The deceleration in the US economy over the last few years forced the Fed to cut interest rates as the country faced slowdown in sales and production, weakening of consumer confidence affecting consumption and distressed financial markets (see Figure 9.3). The gloom over the economy after the September 11 incident intensified such interest rate cuts, as is evident form the 4 cuts in the federal funds rate in 4 months since the incident. The Fed had been cutting the federal funds rate since May 2000.

Despite the fact that the EU economy, which had been growing slower than the US economy for the last few years, began to show signs of slowdown in 2001, the European Central Bank (ECB), adopted a moderate posture in cutting the interest rates to boost the economy. In contrast to the cuts in interest rates by the Fed (which had begun right in January 2001), the ECB chose to reduce interest rate later (and less aggressively). During the period January 2001 to June 2003, the Fed has cut the interest rate by 5.5 percentage points, while the ECB reduced the rates by 2.8 percentage points.

The slowdown in economic activity dragged inflation downwards both in the advanced economies and developing countries. While inflation level remained significantly higher in the developing countries than the advanced economies in 2002, nevertheless the deceleration was more pronounced in the latter than the former (see Figure 9.4). It must be noted that there has been a continuing slowdown in price hike in the developing countries since 1996. The deceleration in overall world inflation is becoming a matter of concern as a continuing deceleration might turn into a deflationary trend with adverse impact on the global economy. The deflationary trend in Japan and a sharp to moderate reduction in the US and the EU inflation, respectively, is giving fuel to such expectations. Japan has been witnessing deflationary trend since 1999 and is specially a source of concern for the advanced economies. The US and the EU, on the other hand, have been facing deceleration in the inflation since 2000. The reduction in US inflation rate in 2000 has been much stronger than the EU inflation rate (see Figure 9.5).

Though not very significant, the improving global economic activity helped the recovery of international trade in 2002 as well. The trade volumes grew significantly in 2002 (by 2.9 percent) when compared with the preceding year (0.1 percent) but nonetheless, remained significantly lower than the growth observed in the past. In fact, the growth in trade volumes is abnormally low when seen in the perspective of output-trade growth relationship. The growth in trade volumes has been significantly higher than the output growth since 1996 with the exception of 2001 when the trade volume growth was significantly lower than the output growth. The growth performance of trade, however, is still encouraging given the uncertainty prevailing during the latter half of 2002 related to the conflict in Iraq.

9.2 Balance of Payments

The improvement in Pakistan's external sector that began in FYOO and intensified in FY02, gathered further momentum in FY03 as improvements in both, the current and capital accounts, led to yet another record breaking overall BOP surplus of US$ 4.6 billion or 6.7 percent of GDP - nearly 70 percent higher than next largest overall surplus of US$ 2.7 billion that was recorded in FY02 (see Table 9.1).

The dominant contribution to this spectacular performance was from current account components, including: (1) workers' remittances which registered buoyant 79 percent growth during FY03 to reach a new all-time high of US$ 4.2 billion; (2) a sharp fall in interest payments following the retirement of expensive debt and liabilities as well as the partial substitution of expensive debt with soft loans from IFIs; (3) robust non-structural inflows;¹ and (4) tremendous growth in exports earnings, which rose to a record US$ 10.9 billion.

As a result, the current account balance (CAB) posted Pakistan's highest-ever surplus, totaling US$ 4.0 billion, during FY03, easily surpassing the FY02 surplus of US$ 2.8 billion (see Table 9.1). Consequently, the CAB to GDP ratio improved from 4.8 percent to 5.9 percent (see Figure 9.6). More encouragingly, non-structural factors (i.e. potentially non­repeating inflows) comprise only 37.6 percent of the improvement in the CAB during FY03. Even excluding the non-structural factors, the ratio of CAB to GDP for the period is a very healthy 3.7 percent.

 

Although Pakistan has been recording meaningful current account surpluses for the last three years, FY03 marks a watershed, as this is the first year that the CAB remains in surplus even after netting out the non-structural components, suggesting a potentially permanent improvement in the country's current account profile.

The capital account also recorded a sharp reversal, from a deficit of US$ 1.1 billion during FY02 to a surplus of US$ 113 million during FY03.² This capital account improvement needs some clarification; an inflow of approximately US$ 1.1 billion during FY03 in short-term capital (others) represents a contra-entry against forex loans disbursed by the banks. Adjusting for this, the capital account reverts to a deficit of US$ 1.0 billion, but even this is a 23.1 percent improvement over the deficit of US$ 1.3 billion recorded in FY02. This sharp reduction in the (adjusted) capital account deficit is mainly the reflection of higher foreign direct investment, increased suppliers' credit inflows (due to rising economic activity), as well as lower outflows on the account of Special US Dollar bonds and commercial loans, during FY03.

Table 9.1: Balance of Payments- Summary Table