Is Pakistan Economy Ready To Embrace The Worse?

It seems that the flood-nightmare in Pakistan is not over yet. Although the Indus River is already at its 50-year high, it is expected that the water level will continue to rise. With the scale of such calamity, Pakistan is now officially known as the sickest economy in South Asia. Although millions have been contributed by international agencies and governments, still it is insufficient to restore homes, food, buildings and casualties which were washed away by the flood. In some areas, people complain that the aid has not reached them

Potential problems with Pakistan economy:

(1) Militants recruit. There is no perfect atmosphere other than now for jihadists to exploit the situation by spreading seeds of anger and recruiting militants. It is reported that some Islamist charities with suspected links to militant groups have stepped up by providing tents and food for those victims particularly in the northwest, an area dominated by the terror groups. If the Pakistan government does not act fast enough to reduce the scale of the disaster and reach those areas where help is needed the most, I strongly believe that they will have more problems to deal with in the future. Once the number of militant increases, Pakistan and US government will have to spend more money to strengthen the defence

(2) Disruption to economic activities. Pakistan has a broad primary sector where it mainly produces wheat, rice, cotton, sugar and livestock. It contributes to about 22% of her GDP and is the largest employer, hiring 45% of total workforce. Unfortunately, the flood has hit the agriculture heartland very badly. 500 000 tonnes of wheat, 2 million bales of cottons and 200 000 livestock were gone just like that. It affects the livelihood and income of thousands of farmers as well as employment in related sectors such as food processing. Decline in the farming output will probably put Pakistan’s economy to a halt and say ‘goodbye’ to the targeted growth of 4.5%

(3) Reduction in potential capacity. Most of the productive economic resources like land, labour and capital are devastated in just a matter of two weeks. Up to date (27th August), the flood has officially claimed 1600 lives and it is strongly believed that this figure will rise significantly once the water level recede, allowing for other bodies to be counted. It will also further rise due to the slow emergency aid for clean water supply and considering the fact that many are consuming from contaminated water, thus carving path for water-borne diseases. On the other hand, the flood has engulfed huge arable farming pastures. As such, many types of agricultural activities will be ‘forbidden’ in many seasons to come, due to the drastic change in the structure of soil e.g. water-logged. The government’s official assessment estimates that roughly 5000 miles of roads and railways, 7000 schools, 400 health facilities and thousands of agricultural tools like water mills are washed away. This has many implications. Without roads and railways, agricultural output cannot be delivered to designated areas. Factories output will be stranded while waiting to be sent to port. Inability to acquire basic education and healthcare will further reduce the productivity of the people while not having sufficient machineries to work with further reduce Pakistan’s output. It is best illustrated by an inward shifting PPF

(4) Inflation and ballooning deficit. Inflation is defined as a sustained increase in price level. In June, inflation rate was at 12.67% higher than a year earlier, while in July it rose another 12.34%. With such scale of destruction, consensus is now somewhere around 20% in the nearest future. It is largely contributed by escalating food prices and the destruction of food supply distribution network. While it is a great relief to hear that the Pakistani government will gear towards an immediate reconstruction, such news must be treated with great caution. Due to the insufficient foreign assistance, the rise in fiscal expenditure will have to be borrowed from the Central Bank, leading to the increase in money supply thus potentially push the inflation higher. Even the initial forecasted budget deficit for the year 2010/11 is considered as far too optimistic. With the inevitable rise in government spending and fall in tax receipts due destroyed output, it may be at least 6% of GDP now. The deficit reduction was part of the agreement between the government and IMF due to the extension of loan in 2008. Seems that the noble goal has to be brushed aside for a more severe humanity crisis

US Is A Step Closer To Japanification

To me 2010 is a ‘fascinating’ year. It represents economic threats as well as opportunities for countries around the world that are closely linked to one another via international trade. Heat of debates seem to have moved from topics like ballooning national debt, possibility of hyperinflation through quantitative easing, current account deficit to one where deflation is inevitable

Deflation vs. disinflation
Before I go into the details, it will be interesting to explore the difference between disinflation and deflation. They are not quite the same. The former means prices of goods and services are rising but at a slower rate. Meanwhile deflation is a complete fall in prices of goods and services, hence is a negative inflation rate. If disinflationary period continues until inflation rate is zero, only then the economy is said to have entered into a deflationary period

The Japanese experience
The word deflation is synonymous with the Japanese economy and I mean VERY. Before the so called Long-Lost-Decade which began in early 1990s, Japan had gone through a period of economic miracle until late 1980s. Savings in the banks were at all time high. Since loans and credits were easily available, speculation was imminent particularly in the real estate market and Tokyo Stock Exchange. At the peak of the bubble, Nikkei stock index was over-rated and value of real estates was extremely over-valued fetching up to USD $139, 000 per square foot. It was acknowledged that property prices in Japan were the highest in the world at that time

There are many versions of arguments surrounding the meltdown of Japanese economy. The most popular is that income did not grow fast enough to service the increasing debt load which resulted in growing defaults and delinquencies. People and companies that had borrowed from the banks to invest in real estate were unable to repay the banks when property prices fell. Even banks became insolvent due to credit shortage and lack of liquidity in the entire financial system

Recession to depression and deflation

Recession is generally known as two successive quarters of negative economic growth while depression is viewed as a sustained long term decline in economic activities which is followed by events like shrinking consumption, bankruptcies, large scale unemployment and banks on the run. It is lengthier than recession. Somehow, there is no consensus over how long an economy should be in recession before turning into a depression

Source: economicshelp

It is strongly associated with collapsed of spending into the economy, thus driving AD leftward. This is usually followed by a fall in price level. To be honest, deflation/ disinflation is much more difficult to be tackled than inflation. It is extremely difficult to revive consumer and business confidence once it had totally collapsed. The Great Depression in US and Japan tell all the tales.

Why deflation is disastrous?

(1) Exacerbate depression. When general prices fall, consumers will expect goods and services across the economy will be cheaper somewhere in the near future. As such they choose to defer current consumption. It will not be the case of one or two individuals but the entire nation will think alike. As people defer spending, consumption which is one of the drivers of economic growth falls, further shifting AD to the left. It does not take a genius to see that price level falls. They cycle continues

It is also worth to note that, in such period return from savings is higher. Even when the nominal interest rate is 0% and deflation is say, 3%, the real interest rate is would be 3%. What I’m trying to say is that, although the value of money does not grow (0%), prices of things in the economy become cheaper (-3%). In other words, for every 100 yen, one gets to purchase more goods. Purchasing power has increased. No wonder there is an incentive to save!!!

(2) Increasing the value of debts. During inflation, value of debts will be eroded since the same amount of money that bank receives worth lesser over the time. On the contrary, deflation causes mortgage repayment to be a problem. In depression, wages are falling. Assuming that one owes the same amount of money, the monthly commitment expressed as a percentage of total income will rise

(3) The end of monetary policy. During the period of high inflation, interest rates can be raised indefinitely to slow down spending and investment. However, in deflation, interest rates cannot go lower than 0%. It just does not make sense to have negative nominal interest rates. Therefore this marks the end of the conventional monetary tool and the Central Bank will have to depend on non-conventional method like quantitative easing (print more money). Such new monetary policy action belongs to the realm of experimentation (considering the Fed consulted Japan last year over this) and therefore is prone to error. Policymakers are now left with fiscal tools

Will US turn Japanese this round?

I hate to say this but too bad US is no longer an engine for global economy. Despite still being the world’s largest consumer, it began to lose its steam few years ago. Its dominance is gradually shadowed by the emergence of China and India which easily register an 8% to 10% real GDP growth every year. To make things worse, US economy seems to inherit the Japanese-style meltdown ‘disease’. There are just too many evidence leading to this

(1) Similar origin. Both economies experienced a period of unsustainable economic growth which eventually led to a drastic rise in income. High consumer confidence coupled with liquidity rush in financial institutions largely explain why Americans and the Japanese dare to assume debts beyond their appetite. Rise in income however wasn’t for long but too much debt had already been taken to finance the purchase of residential and commercial properties. One by one began to default in loan repayment. Banks now face cash shortages and hence unable to generate lending. Demand for real estate falls. The property bubble finally burst. Arguably the condition in US is said to be worse due to the introduction of various unsafe loans as well as mutation of debts

(2) Ageing population. Although population is still growing in US, its rate is slowing down markedly, somewhere close to 1%. This is exactly what Japan had experienced in the 1990s. The only difference is that Japan has entered into the era of shrinking population and it may not be too distant in the future before US joins the league. Why is this bad? We first look at the population pyramid. Too many elderly people indicate more trouble for government finances. Bulk of the money will be channelled towards unproductive use like pension payments and the setting up of certain healthcare department to address elderly-related disease. This way of spending will not lead any economy out of trouble. Secondly, where to get the needed finances? Raising the income tax is a big NO-NO from me. Shrinking workforce may mean that working individuals will have to devote 50-60% of their wages to tax so that it can sufficiently cover the expenditure for the retirees. Finally, shrinking population means US will no longer be a consumption driven economy. All these points to frail recovery

(3) Forever rising debt. The current level of US national debt is about USD $ 13 trillion or 89% of her GDP. It is the sum of all the outstanding debt owed by the Federal Government when it runs budget deficit every year (G>T). Two-thirds of the debt is owed to firms, people and foreign governments who bought the bonds issued by US government while the rest is owed to itself via Social Security. Whatever money that has been borrowed will have to be paid back some dates in the future. Right at the moment, there is still no clear solution over the pension payment to Baby Boomers. Number of retirees will increase significantly over the next two decades. Theoretically, taxes must increase. It is just a matter of time before US discovers that foreign government will gradually shy away from all those bonds. Fall in the demand for these securities will cause its price to fall (law of demand) and interest rates to go up (inversely related). This will eventually worsen the state of economy. Furthermore, lessening of demand for bonds will put downward pressure for dollar. Therefore, foreign holders get paid back in currency which worth lesser. Demand for bonds fall further. In a nutshell, ballooning national debt will put a brake to US economic growth

(4) End of traditional monetary policy. Policy makers is US seem to head towards a ‘dead-end’. It faces almost the identical problems experienced by Japanese economy. Like I mentioned earlier, zero interest rate policy does not do any good. Economic activities remain weak partly because some of the banks are still reluctant to pass on the rate cut or while some others just make it more difficult to get credit by imposing various conditions. On the other hand, consumer confidence is at record low. Job losses are on the rise which further undermine borrowing and spending into the economy. Perhaps the Fed will have to keep interest rate low (0% -0.25%) until certain level of inflation is achieved. Although quantitative easing has been aggressively conducted, credit growth and broader money creation still fall. Velocity of circulation for money slows significantly

All these are clear indicators that US economy is ‘ushering’ an era of deflation. It will not happen today, tomorrow or next few months. But for sure, it is underway