AN odd sort of recovery seems to be taking shape in the economy. Although most projections are that the GDP growth rate will come in around two per cent by the end of this fiscal year, in some areas the dynamism is racing ahead. And even as the government talks of further stimulus, it is in fairly advanced stages of its talks for revival of the IMF programme.

The greatest dynamism is right now in the construction sector, with cement dispatches rising sharply every month as the incentives offered to property developers start kicking in. The government’s plan is that this will activate demand in allied industries and serve as an engine of growth. But the projection of 2pc growth is still anaemic, and the rest of the manufacturing sector has the shadow of the IMF looming over it.

A number of things cloud the outlook. First among them is the future direction of interest rates. In its last monetary policy statement, the State Bank made it clear that real interest rates at the moment are negative, which means a massive monetary stimulus is already being applied to the economy. But this raises an obvious question: for how long will the State Bank keep real interest rates negative? The IMF usually frowns on negative rates, and it is reasonable to expect that, with the revival of the Fund programme, rates might need to be adjusted upwards.

To some extent, the market is already beginning to price this in. Government debt auctions are the best barometer for market expectations on the direction of interest rates. Whenever the market expects rates to rise bids in government debt auctions start clustering towards shorter tenors, and whenever the market expects rates to have peaked bids move towards longer tenors to lock in the peak rates for the maximum time. This is standard bidding behavior.

Whatever dynamism in the economy we are seeing depends crucially on cheap money and government handouts.

Recent auctions show banks increasingly casting their bids for the shortest three-month tenors, suggesting they expect rate hikes in the near future. The expectation does not seem to be firmly in place though, given the high rates of participation in all auctions since July. The auctions in October will be interesting to watch to see how the market is viewing the prospect of rate hikes.

The second thing to cloud the outlook on the economy is power and fuel pricing. As part of its talks to restart the IMF programme, the government has drawn up a plan to bring down the circular debt, which has spiralled beyond Rs2.2 trillion, doubling in a matter of two years. If left to its own devices, it can, by some estimates, double again in the next three years. Controlling this increase is at least as big a priority in the IMF talks as raising revenues, and some reports suggest a plan has been drawn up that calls for very tough decisions to be made.

The single biggest contributor to the circular debt is inefficiency of the distribution companies. Having seen the circular debt come and go for little over a decade now, it is clear that without deep-rooted reform of the distribution companies and the pricing regime, the circular debt cannot be controlled for very long. The coercive renegotiation of capacity payments that the government has invested significant time and political capital in will help only to a limited extent. Eventually, the question of bringing in market-based reforms in pricing and distribution will have to be faced. The alternative is near continuous tariff increases, by some estimates as much as Rs6 per unit by 2023.

But the problem at the moment is not what happens over the long term. The problem at the moment is whether the government can convince the IMF that it has a credible plan for circular debt curtailment and is not forced to increase power tariffs as a condition for restarting the Fund programme. If power tariffs are raised in the near term to help stem the rising circular debt, it will have the obvious impact on inflation and competitiveness of the country’s exports.

Besides power, the other element clouding the outlook is fuel, particularly gas. The warnings coming from the prime minister himself about impending gas shortages this winter are serious. The government is scrambling to arrange LNG cargoes this winter, but with LNG comes difficult pricing decisions because it costs more than double the price of domestic gas, which is heavily subsidised. Power and fuel pricing regimes are in increasingly urgent need of reform if the inefficiencies and losses that plague both sectors are to be tackled. Without reform, the result is either continuous build-up of inter-corporate debt in both sectors or steep tariff increases.

The third shadow on the outlook comes from the revenue plan, or the lack thereof. The government is committed to increasing tax revenues by almost one trillion rupees or 25pc in this fiscal year alone, but at the moment has no clear plan for how to do this. They announced the target in the budget but left it to later to develop a revenue plan, citing large-scale uncertainty as the reason. But if they are to resume with the Fund programme, a revenue plan will be required. And squeezing out 25pc more revenues from an economy projected to grow by only 2pc will present some challenges, especially since whatever dynamism they are seeking to impart through their stimulus depends at least in part on tax breaks.

So whatever dynamism in the economy we are seeing depends crucially on cheap money and government handouts, both of which are looking increasingly difficult to sustain. Revving the engines of growth while applying the brakes at the same time via a Fund-supported stabilisation will yield very mixed results. This is the awkward growth process that seems to be getting under way these days.

The writer is a member of staff.

khurram.husain@gmail.com

Twitter: @khurramhusain

Published in Dawn, October 1st, 2020