Current State of Oil Market and its Impact on the Pakistan Economy

Written By: Dr. Zafar Mahmood

The current spectacular drop in the oil price that began in the summer of 2014 brought the price down to $34 per barrel this month. This is a result of a number of factors that increased supplies and brought down demand. The decrease in demand can be traced back to declining economic growth in China, the recession in Japan, economic downturns in Germany and other parts of Europe, and increased energy efficiency in the United States and Europe. Conversely, the increase in supply was caused by the unanticipated and sharp increase in US and Canadian oil production, the increase in oil production from Russia in recent years and the ability of producers such as Iraq and Libya to maintain output despite their political instability. Added to this is that Organization of the Petroleum Exporting Countries (OPEC) and Russia are determined not to cut production to shore up prices. And now Iran has started pumping crude oil in large quantities for export markets.

The US crude oil stockpiles climbed to the highest level in more than 85 years, giving a bearish outlook to the market. This is a confirmation of a larger physical supply surplus. The slump has slashed earnings of Royal Dutch Shell and Chevron, while Exxon Mobil has reduced its drilling budget to a 10-year low.

Oil is traded globally at a single price, with small adjustments for transportation costs and oil type. Thus, major changes in oil supply or demand in one part of the world change oil prices around the globe. Most of the oil is traded on spot markets between commercial entities with little or no government involvement. Oil prices are quite volatile. This is mainly due to the lag time inherent in the oil industry’s capacity to respond to changes in supply and demand.

The supply of oil is dependent on geological discovery, the legal and tax framework for oil extraction, the cost of extraction, the availability and cost of technology for extraction, and the political situation in oil producing countries. Both domestic political instability in oil producing countries and conflicts with other countries can destabilize the oil price.
Global trends in oil prices since 1987 are worth noting (Figure 1) that reveal the oil price shocks are invariably followed by 2 to 3 years of weak economic growth.

From 1999 till mid-2008, the price of oil rose significantly. It was due to rising oil demand in countries like China and India. In the middle of the Great Recession of 2007–2008, the price of oil underwent a significant decrease after the record peak of US $145 a barrel in July 2008. On December 23, 2008, West Texas Intermediate (WTI) crude oil spot price fell to US $30.28, the lowest since the beginning of (2007-2010) recession. The price sharply rebounded afterwards and rose to US $82 in 2009. On January 31, 2011, it hit $100 for the first time since October 2008 on concerns about the political turmoil in Egypt.

For about three and a half years the price largely remained in the $90–$120 range. In the middle of 2014, price started declining due to a significant increase in oil production in USA, and declining demand in the emerging countries. By January 2015 the price of oil reached below $50. A record dip below $44 was reached in mid-March 2015. The price increased upto $60 in the following months. Oil prices decreased to a six-year low to $36 on December 11, 2015 and to $34.09 on February 5, 2016. Some analysts speculate that it may continue to drop further.

Figure 1: Trends in Crude Oil Price

Interestingly, oil prices are not at a historic low. Oil price cycles are quite normal. Throughout the past century of trade, there have been instances in which the price of oil has swung from high to low and then back up again. Therefore, while low prices will likely to continue in 2016, we are sure that they will eventually follow the normal cycle and rise – though not necessarily back to the historical highs of the last three years.


currstate.jpgThus, while various economic trends and geopolitical factors will inevitably impact the global oil market, changes in oil prices should be seen as not unprecedented or unpredictable but as the result of basic economics, driven only by the two mechanisms of supply and demand. However, to understand the factors that affect supply and demand, a deep understanding of geopolitics and the producers of oil around the globe is also necessary.

Proven reserves of crude oil in Pakistan are 247.5 million barrels (1 January 2013). Pakistan’s annual consumption of petroleum products is around 23 million tons. Indigenous crude oil meets only 16% of total requirements while 84% requirements are met through imports in the shape of crude oil and refined petroleum products. Pakistan now follows a market-based policy, in general, for the oil sector. OGRA is maintaining reserves equivalent to 20 days of petroleum demand and is making all efforts to enhance this capacity. Pakistan’s petroleum consumption is about 22.9 million metric tons per annum. Sustained low oil prices will spur shifts in consumer behaviour and industry performance. The overall trend of cheaper oil is likely to have deep implications for the Pakistan economy.

Impact of Declining Oil Prices on Pakistan
Economic Growth: Fall in oil prices are expected to stimulate economic growth in Pakistan. A study analyzing changes in GDP growth shows that if oil prices drop from $84 to $40, it would result in GDP growth of 0.5% to 1.0% for developing countries like Pakistan. Many sectors of the economy would directly benefit from the resulting lower cost of fuel (the agricultural and automotive sectors in particular would benefit).

Current Account Balance: Oil imports account for one third of Pakistan’s total imports. For this reason, the price of oil affects Pakistan a lot. A fall in oil price would drive down the value of its imports. In 2013-14, Pakistan’s petroleum import bill was $15.36 billion, which has come down to $11.86 billion in 2014/15, a 22.8% decline. This would certainly help narrow the current account deficit and increase foreign exchange savings.

The fall in global oil prices may be beneficial for the consumers and economy, but it also has its pitfalls. Directly, it affects the exporters of petroleum producers in the country. Besides petroleum products, Pakistan is also currently exporting condensate crude oil due to lack of its refining capacity in the country. Any fall in oil prices thus negatively impact exports and current account balance.
Many of Pakistan's trade partners and buyers of its exports are net oil exporters. A fall in oil price may impact their economy, and in turn hamper demand for Pakistani products. This would adversely affect the Pakistan economy and companies.
Inflation: A fall in oil prices comes as a windfall to consumers. Low oil prices, along with other factors, have helped reduce inflation. A 10% fall in crude oil prices results in 1% fall in inflation, a study concluded. A decrease in inflation could lead to further cuts in interest rates, increasing credit availability and boosting overall growth prospects since there would be more money available for infrastructural and corporate investment. The decrease in inflation, and the overall improved economic outlook would boost investor sentiment.

Fiscal Impact: The Government of Pakistan makes sure that its budgetary tax collection target fixed for oil sales is met irrespective of crude oil prices. It uses various means and measures (implicit taxation) to meet its revenue targets. As there are no subsidies given on oil sales to any of the users and tax revenue targets are met; therefore, there is no fiscal impact of fall in oil prices. However, a fall in oil prices reduces public sector companies' losses, like PIA and Pakistan Steel Mills, and thus should help narrow fiscal deficit, though marginally.

Rupee Exchange Rate: Exchange rate depends, beside other factors, on the extent of changes in the current account deficit. A high deficit means the country has to sell rupees and buy dollars to pay its bills. This reduces the value of the rupee. A fall in oil import bill is a good omen for the rupee. However, the downside is that the dollar strengthens every time the value of oil falls. This should negate any benefit for our currency from a fall in the current account deficit.


Foreign Direct Investment: Foreign countries whose economies may be adversely affected by the fall in oil prices may reduce FDI flows to Pakistan. Default in loans given to Russia and shale gas developers in USA could lead to instability in the global banking industry, which could cause investors to err on the side of caution and pull money out of developing countries like Pakistan.

Petroleum Producers: Low global crude oil prices limit incentives for the upstream oil sector. Consequently, it would adversely affect the current exploration policy in the country. Investment in domestic oil production is likely to be negatively affected by low prices leading to lower contribution from this sector to GDP growth. For the past few months, the slide in oil prices has pulled down PSO share price from Rs. 441.75 on June 19, 2014 to Rs. 292 on October 1, 2015, with some revival to Rs. 337 on February 14, 2016 (see Figure 2). Likewise, the share price of OGDCL experienced a free fall from a high of Rs. 280 on August 1, 2014 to Rs. 102 on February 14, 2016 (see Figure 3).


Environment: Low oil prices impose a challenge for policymakers to achieve some of their environmental targets. Following the collapse of oil prices, the government may get slow in adjusting natural gas prices. With lower prices in place for oil, natural gas demand may be further affected. The proliferation of private vehicles, which run on diesel and petrol, could significantly increase emissions; unless, changing technologies and tightening environmental controls introduce low oil-intensive growth, significantly reducing energy-intensity levels.

In the end, while Pakistan waits for a more opportune time to make upstream oil projects viable, it should speed up crude procurement to build its strategic reserves. In addition, revive the Iran-Pakistan gas pipeline project and secure long-term contracts commensurating low expected future oil prices.

The writer is a Professor of Economics at School of Social Sciences and Humanities at NUST, Islamabad. This email address is being protected from spambots. You need JavaScript enabled to view it.


Written By: Dr Sania Nishtar

Privatization has become an intensely polarized subject in Pakistan with politically charged rhetoric dominating discussions. Substantive debates around its policy rationale and the institutional prerequisites necessary for its success have not been given priority. With this, as a context, five questions are being flagged to further objective discussions on the subject.

First, are we getting the framing on privatization right? Privatization is generally viewed through the narrow lens of 'sale of state enterprise' in Pakistan. This is evidenced by a covenant of the Privatization Policy, which envisages it to be “...a mechanism for the reduction of debt...” In effect privatization is linked to the fundamental question of the role of state in the economy. It is part of a broader policy choice involving deregulation and liberalization. Privatization is part of a set of policy changes, a government can espouse to make private sector the engine of growth, with the understanding that the role of the government is to provide an enabling policy, impartial oversight, transparent regulation and a level playing field for market operators.

Public-private engagement in state governance happens on a spectrum, at the extreme end of which is total transfer of ownership of enterprise, or public property from government to the private sector, which is what privatization entails. Opening up of a sector, previously a government monopoly to the private sector can also be labelled as such. At the other end of the spectrum is out-sourcing or contracting-out of certain functions, from the government to private entities. Although this also involves private-private collaboration, it is distinct from 'privatization'. To understand what a government can, and what it cannot, privatize and where public-private engagement in a contractual format becomes relevant, the functions of government should be brought to bear. Policy-making is an essential government function and cannot be privatized. Regulation is also a core function of the state, but can be out-sourced to an autonomous entity, with a public mandate. Several regulatory functions are currently being performed by autonomous entities in Pakistan, with the Oil and Gas Regulatory Authority (OGRA), Pakistan Electronic Media Regulatory Authority (PEMRA), Pakistan Telecom Authority (PTA), being examples. Countries also have experience in contracting out other government functions such as revenue collection to private entities. Governments can opt to contract out service delivery in areas such as health and education to private entities on the premise that the private sector has better outreach and/or management capacity to deliver a pubic mandate if it is financed publicly. In policy parlance, this approach is referred to as 'purchasing services from the private sector', an approach Pakistan has already experimented with. Running industrial enterprise is not a core function of the government unless certain exceptions compel it to do so. These exceptions must be clearly appreciated. When there is no incentive for the market to play a role in an area that needs to be served; when an equality gap needs to be bridged; where a strategic objective stands to be gained for the country; or when a specific impetus needs to be lent to open a sector, government involvement in market activity/enterprise may be justified, otherwise activities should be left to market operators.

This brings us to the second question of how privatization becomes relevant in Pakistan. Over the years, Pakistan has established a long list of Public Sector Enterprises (PSEs) which do not fall under the list of exceptions mentioned above. They are additionally inefficient and are a burden on the national budget. Billions of rupees, which could have been spent on welfare, national development, and debt retirement, are being used to pay for their inefficiencies. The government, therefore, has to make a choice between two options, both of which could potentially improve the efficiency and effectiveness of sick PSE's – either reforming governance arrangements while continuing to have state control or by opting to transfer them to the private sector through privatization. For Pakistan, both options remain challenging. The country has a bad track record of introducing corporate culture in PSEs on the one hand and has also been unable to auger public confidence in the process of privatization, on the other. This notwithstanding, the list of ineffective PSEs must be examined to explore which option fits best to reform each. As privatization is a complex procedure and not an ordinary auction, a robust and transparent process becomes critical for its success

The third question, therefore, focuses on the process safeguards, which are necessary for the privatization process. Many PSEs listed on the privatization list do qualify to be there. It is not the rationale that is questioned but the process, which becomes a point of contention. Today the opponents of privatization in Pakistan may not be ideologically opposed to the idea but are fearful that the transactions may be carried out in a non-transparent and/or unfair manner, state assets could be sold at throwaway prices, political cronies could be rewarded for allegiances, that in the process of 'stabilizing' these enterprises state resources may be unnecessarily spent and that strategic objectives could be compromised. Privatization vests enormous power of patronage in governments and these concerns are a real risk.

Government can hedge against these risks by ensuring full legal safeguards and water tight procedures and by upholding the highest standards of transparency and accountability in the privatization process. A number of imperatives emerge. As a starting point, the governing norms of privatization in Pakistan should be revisited. These include the Privatization Commission Ordinance 2000, the Privatization Policy 1994, and the privatization programme paper, which also lists the names of the units/entities to be privatized alongwith respective divestment strategies to be adopted.

The policy has been amended once in 2009 and needs to be revisited since it has been two decades since its formulation. It does, however, outline several robust principles but the key question is one of their implementation, as discussed later in this comment. The 2000 Ordinance provided for establishment of the Privatization Commission. It is being inferred that legislative authorization for individual privatizations are implicit in the framework, in other words it is being taken as a 'framework authorization act'. However, lessons from other countries show that legislative authorization is usually needed to change the status of individual PSEs as well. A legislative cover can have beneficial impact with reference to transparency and policy support for privatization.

In terms of the process, measures to avoid conflict of interest assume great importance while appointing board members of the Privatization Commission and the agencies to be privatized, which is where due diligence becomes critical. In the case of evaluators and external advisors involved in the privatization process conflict of interest concerns are equally relevant and can be mitigated through a strong contractual process. Also in relation to the process, due attention to job security, wages and benefits of incumbent staff become important, with the general rule being that their contractual rights should continue to be honoured after transfer of ownership. The Pakistan post-privatization experience has been plagued by inconclusive resolution of labour issues, with the case of the PTCL pensioners being illustrative.

The fourth question relates to the institutional arrangements necessary for the success of privatization. Adequate capacity assumes importance in this respect. Pakistan has vested administrative responsibility for privatization in the Privatization Commission and in doing so it has become compliant with the internationally recommended policy, which requires countries to have independent privatization units. But does the Commission have adequate capacity? Does it has a culture of promoting accountability and transparency? Is it adequately resourced to engage private actors who have the capability to negotiate and safeguard their interest in privatization transactions, as they should? Since engagement with the private sector demands certain institutional capabilities within the government system, the government should privatize a PSE only after an appropriate regulatory framework for the privatized entity has been created. Given Pakistan's past performance with regulatory arrangements, a massive effort needs to be put in place to step up government regulatory capacity and develop it for sectors and mandates which are being privatized.

Also, in terms of institutional arrangements, when a government retains an influence in the PSE following privatization, it is critical that it creates the right accountability of state functionaries who represent the government's interest on board – it isn't entirely appropriate to give government functionaries per diems several times their monthly salary as this could potentially undermine their impartiality. The fifth question: have we taken stock of evidence and are we drawing on lessons from the past whilst planning for something this large? There has always been a tendency in the country to make sweeping policy-changes without regard to evidence. Since decisions need to be evidence-guided past experiences become important. Pakistan has vacillated between several waves of privatization and nationalization. Since its inception in 1991, there have been two phases of privatization between 1992-94 and then 2001 onward, with 167 transactions to-date. It would be important to draw lessons from these experiences. There are many principles of privatization articulated in the 1994 policy against the backdrop of which impact could be gauged. For example, was there any net benefit to the government with privatization? What was the quantum of increase in revenue? What percentage of this was used for debt retirement and was the 10% meant to be committed for welfare in the 2000 Privatization Ordinance actually channelled towards it? The policy stated that “monopolistic trends will be curbed” and that “safeguards will be introduced to achieve broad based ownership and prevent concentration of resources in a few hands”. To this effect did our past experiences in privatization lead to cartelization? Did they concentrate assets in a few hands? What has been the impact of privatization on narrowing the wealth gap? Was there any collusion in the valuation of assets? What value did the injection of resources into the PSEs prior to their privatization bring? Was there ever a precedent in terms of giving minority share-holders precedent over majority share-holders? How many privatized units actually functioned after they were handed over to the private sector? Has there been an analysis of the motivation of the buyers? There have been reports, which allege that the primary motivation in some of the privatization deals was to strip the assets of their real estate value – to what extent are these true? The policy also intended to mobilize investment for PSEs from overseas Pakistanis and foreign investors. To what extent was that enabled? Have we prioritized privatization of the loss making enterprises before putting the profit making ones up for sale, which is a cardinal rule in privatization?

Have we insulated sectors and organizations that are strategically dangerous and economically unjustifiable to privatize? Some enterprises have been subject to the privatization processes, but have not been transferred to private ownership in their entirety. What have been the determinants of that? What has been the private sector's experience with the privatization process, overall and have we ever factored their side of the story into analysis? Have we conducted any analysis on this subject at all? How many Masters and PhD students whose degrees are supported by the Higher Education Commission, and hence tax payer's expense, are conducting research in this area? How many studies have been commissioned by Planning Commission, Privatization Commission or donors interested in this subject? Embarking on the process, without drawing on lessons from the past and making remedial action poses a risk for the process. The greatest risk for the privatization process is the lack of accountability within the state system, as a result of which public sector functionaries cannot be held accountable for their inability to safeguard state and/or public interest in privatization deals. The current state of PSEs is reflective of a style of governance, to which all past regimes are contributory. Years of appalling governance, evidenced in crony appointments at the leadership level, recruitments without regard to competency or organizational needs, rampant procurement collusion and lack of accountability of decision making have landed these organizations in the current state of affairs. Brokering privatization under the same shadow of governance is setting it up for failure.

Privatization is indeed an option for some of the entities listed in the privatization list. It can accrue benefits to consumers, workers, investors as well as government. We need fundamental reform of governance, one that puts decision makers' accountability at the core of state system before expecting to reap its benefits towards the goal of economic reform.

The writer is a former Federal Minister and holds a Fellowship of the Royal College of Physicians of London. A PhD from Kings College, London, she is an eminent social scientist and regularly contributes in national print media on issues of health, governance and public policy.

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Sudden Currency Appreciation of Pak Rupee

Written By: Dr Zafar Mahmood

How is the exchange rate determined in Pakistan?

Exchange rate of Pak rupee with dollar was fixed up to 1982 when the Central Bank (CB) used to intervene in the market to defend the fixed rate. Afterwards, exchange rate was left to the market to determine as is now in Pakistan, of course with occasional intervention by the CB. Under the flexible exchange rate regime, the exchange rate depends on how the demand-supply balance of foreign currencies moves. When the supply for dollars rises with demand staying constant then each dollar cost less rupees to buy it. If domestic markets get reassured about the future of the economy then private holders of dollars sell them, leading to an increase in the value of local currency. Thus, movements in the exchange rate do not always reflect economic fundamentals, but are also driven by sentiments prevailing in the market.

The Pak rupee was exchanged for dollar in the inter-bank market at 105.5 on 4thMarch 2014, at 104.4 on 6th March, at 103.7 on 7th March, at 102.9 on 8th March, at 98.5 on 12th March, at 97.02 on 26th March, and at 98.17 on April 2nd. Concomitantly, Pakistan's total foreign exchange reserves declined to $7.6 billion on 7th February-2014 from $13.5 billion a year ago because of large repayments to the IMF and others. Foreign exchange reserves held by the Central Bank were even lower, at $2.84 billion. But it started rising after mid-February and rose to $4.8 billion by14th March, went down to $4.42 billion on 21st March, but went up to $5.365 billion. Marked improvement in foreign reserves was mainly due to support from bilateral lenders and remittances inflow. It would be pertinent to note that under the IMF guidelines December-2013, the CB undertook some corrective actions including using higher policy rates, purchases in the foreign exchange market, and greater exchange rate flexibility. In the above context, questions are being asked: What caused sudden rupee appreciation? How the economy is being affected by the appreciation? Will this appreciation last for some time to come? This article attempts to answer these questions one-by-one. Causes of Sudden Appreciation:

The source of sudden appreciation is the information spread about improvement in economic fundamentals and future outlook of the economy, which caused a reversal in market sentiments. Positive developments as described in the latest CB Monetary Policy Statement are: almost all major economic indicators have moved in the desired direction over the past few months. Growth of 6.8% in Large Scale manufacturing improved aggregate supply in the country. The fiscal deficit has been contained during the first half of the fiscal year while the private sector credit has increased. Moreover, positive sentiments in the market are due to a noticeable increase in foreign exchange reserves and a larger than anticipated decline in inflation. Another key factor that induced the sentiments has been the IMF's approval of the government's pace and thrust of reforms. Pakistan's Eurobond now trades at a premium, this strong performance on the existing Eurobond should help placement of the new issue. All those who were expecting continued depreciation were surprised by sudden appreciation and quickly took new positions to off-load their dollar holdings which increased dollar supply in the market further appreciating the rupee.

Having seen through the peak period of IMF repayments, there are now numerous inflows lined up in the next few months. This includes an IMF tranche of about $550 million by the end of May, a 3G/4G auction in April, and Eurobond issuance in about 2 months. Meanwhile, the government's decision to use foreign currency deposits held by commercial banks to the tune of US$500 million has also eased dollar supply constraint in the interbank forex market. It may be noted that during this period, US dollar also fell against pound by 0.85%; so some appreciation of rupee is due to dollar depreciation.

Despite IMF repayments of $692 million are due up until end of June, the expected inflows will raise reserves. This indicates of improved external liquidity, thus reducing impending repayment dangers. All these expectations have enabled market to hold rupee at its appreciated level. After-Effects on the Economy: A sudden appreciation of the Pakistan currency is seen by critiques as no good for the economy. They argue that it will cause tremendous job loss in Pakistan due to loss in international competitiveness. Ask importers who have made forward contract, as they always do in advance. Some of them have lost their fortune. Anyways, imports will rise as with appreciation we have to pay less for imported items. Is this a desired outcome for an economy which is struggling to boost exports to create employment and avert a Balance-of-Payments (BOP) crisis? Doubts are expressed over the stability of the currency at current levels. Our major export industry, textile, which is already facing fierce competition from other textile exporting countries, has come under pressure with appreciation. Provided appreciation is translated into a fall in the prices of non-traded goods in the country along with a fall in the prices of imported inputs used in the export-oriented industries, exporters will benefit. Otherwise, they will face the brunt of appreciation.

In case, this sudden appreciation is without the backing of strong macroeconomic fundamentals then volatility in currency will take place in the near future. Consequently, with rising export prices exports will decimate and import-bill will be higher. Remittances inflow will also slow down. Thus, appreciating currency to the point where the country is no longer competitive in the international market can cause the economy to be in the stagnations and will thus have adverse implications for the BOP.

Some one might think that with appreciation of rupee the import price may go down, which may result into lowering of inflation. The appreciation may not solve the inflation problem at all if it is due to large inflow of capital. Net capital inflows will increase the volume of currency in circulation resulting into increased inflation. So a policy of sterilization, whereby government issues domestic bonds to wipe out increased money supply, would be needed to neutralize the adverse implications of foreign capital on inflation. Pakistani residents holding assets in Pak-rupee have become richer as they can buy more foreign goods with rupee-denominated assets. There will be a fall in public debt servicing to the extent of appreciation at the time of servicing. At the same time customs duty revenues will fall with decline in imports in Pak rupee. Therefore, actual net fiscal implications are ambiguous.

Anticipated Length of Appreciation: It all depends on how accurate and credible information market is receiving from different quarters about turn-around in the economy. Even if the information is partially correct the market will reverse its sentiments and rupee will start depreciating to its original position from where it started gaining strength. Despite strict instructions from the CB to exchange companies to reduce the rupee-dollar exchange rate spread in interbank-open forex markets, it is currently about Rs.2.5. It implies there is a shortage of dollar supply in the open market and that unless supply improves, rupee may soon depreciate. This spread is also increasing the possibility that Pakistani expatriates use the illegal Hundi system to remit their money instead of the formal banking system. This will further put a pressure on the rupee for depreciation. Moreover, foreign exchange dealers are not selling dollars though they are buying it as they are anticipating depreciation of the rupee.

In sum, every one understand the advantage of a strong currency, therefore the CB should carefully manage its revaluation so as not to cause unnecessary and avoidable damage to the economy. The current size of reserves does not provide any comfort to the economy. The net capital inflows remain considerably lower than the current account deficit. There is a need to further build the reserves. A timely influx of anticipated foreign capital inflows is likely to improve the BOP position. The economic situation may have started to improve but everything is not very satisfactory. Unless concerted structural reforms are introduced in the economy supported by appropriate monetary and other economic policies, the BOP position will remain under constant threat. Reliance on bilateral inflows may provide some short-term stability, but it is the persistent private capital inflows that will ensure long-term macroeconomic stability, including a stable exchange rate. Let me close on a cautious note: US dollar has started gaining recently as the Federal Reserve is expected to start hiking the interest rate, which will certainly put a downward pressure on Pak rupee!

The writer is an HEC Foreign Professor and presently on the faculty of NUST Business School, Islamabad.

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GSP Plus Status for Pakistan

Published in Hilal English May 2014

Written By: Dr Zafar Mehmood

The Generalized System of Preferences (GSP) is a formal system of exemption from the more general rules of the World Trade Organization (WTO). Specifically, it's a system of exemption from the Most Favoured Nation (MFN) principle treatment that obliges WTO member countries to treat the imports of all other WTO member countries no worse than they treat the imports of their "most favoured" trading partner. In essence, MFN requires WTO member countries to treat imports coming from all other WTO member countries equally, that is, by imposing equal tariffs on them, etc.

GSP is a system by which developed countries unilaterally grant customs preferences to developing countries and the Least Developed Countries (LDCs) under WTO's Special & Differential treatment of latter. It was established in 1968 by the UNCTAD Resolution No. 21. Goals of the GSP are strengthening of economies of developing countries and the LDCs through increase of their exports, promotion of their industrialization and speeding up of their economic development. Today, in the world, 11 developed countries which grant the GSP are: Australia, Belarus, the European Union (EU), Japan, Canada,

New Zealand, Norway, the Russian Federation, the United States of America, Switzerland and Turkey. To benefit from the GSP Plus scheme of the EU, countries need to demonstrate that their economies are poorly diversified, and therefore dependent and vulnerable. They also need to have ratify and effectively implement the 16 core conventions on human and labour rights and seven (out of 11) of the conventions related to good governance and the protection of environment. At the same time, beneficiary countries must commit themselves to ratifying and effectively implementing the international conventions, which they have not yet ratified. All in all, the 27 conventions have to be ratified and

implemented by the beneficiary countries. Whenever an individual country's performance on the EU market over a three-year period exceeds or falls below a set threshold level, preferential tariffs are either suspended or re-established. Moreover, graduation is triggered when a country becomes competitive in one or more product groups and is therefore considered no longer to be in need of the preferential tariff rates – it is considered as a sign of growing export success. The graduation mechanism is relevant for both GSP and GSP Plus preferences. The GSP is one of the measures of trade policy of the EU, which reduces custom duties on imports coming from developing countries. Since 1971, the EU grants trade preferences through its GSP system, and currently the EU guidelines on the role of GSP are implemented for a ten-year period from 2006 to 2015.

From the perspective of developing countries, GSP programmes have been a mixed success. On the one hand, most rich countries have complied with the obligation to generalize their programmes by offering benefits to a large group of beneficiaries, generally including nearly every non-OECD (---) member state. However, every GSP programme imposes some restrictions. The United States, for instance, has excluded countries from GSP coverage for reasons such as being communist, being placed on the U.S. State Department's list of countries that support terrorism, and failing to respect the U.S. intellectual property laws.

Criticism has been levelled while noting that most GSP programmes are not completely generalized with respect to products, and this is by design. That is, they don't cover products of greatest export interest to developing countries. In the United States and in many other developed countries, domestic producers of "simple" manufactured goods, such as textiles, leather goods, ceramics, glass and steel, have long claimed that they could not compete with large quantities of imports, especially originating from developing countries. Thus, such products have been categorically excluded from the GSP coverage. Critics assert that these excluded products are precisely the kinds of manufactures that most developing countries are able to export, the argument being that developing countries may not be able to efficiently produce things like engineering goods or telecommunications equipment, but they can stitch shirts.

Supporters note that even in the face of its limitations, it would not be accurate to conclude that GSP has failed to benefit developing countries, though some concede GSP has benefited developing countries unevenly. Some assert that, for most of its history, GSP has benefited "richer developing" countries – in early years Mexico, Taiwan, Hong Kong, Singapore, and Malaysia, more recently Brazil and India – while providing virtually no assistance to the world's ‘poorer developing’ countries.

The EU has granted duty free market access under GSP Plus to Pakistani textile, leather and other products to its 27 member countries. This status became effective on January 1, 2014. Pakistan's textile and clothing exports to the EU currently constitute over half of the country's total exports to the bloc worth USD 9.5 billion. Pakistani textile exports to the EU currently attract an 11 % duty. Initial studies by the EU Commission indicate that exports from Pakistan may increase by Euro 574 million (i.e., US$750 million) annually as a result of duty free status on over 90 % of all product categories (that is, 75 products would have duty-free access to EU markets) exported by Pakistan. If Pakistan takes full advantage from this opportunity then it can generate up to 50 thousand new jobs directly in the textile sector, of course more than these jobs will be indirectly created in ancillary sectors.

The above, thus, suggests that Pakistani policymakers should devise a very careful strategy to maximize benefits from this opportunity that would be available for about next ten years. This opportunity should not create inertia among the industrialists and government policy managers; they should utilize this opportunity to further improve competitiveness of exports, so that in the future when this scheme will end then the industry should be ready to stand on its own feet competing with other countries in the EU markets on MFN basis. What government and industry should plan for the future is to introduce quality and value added textiles and other products covered in the GSP scheme so that exporters effectively compete with countries that are permanent beneficiaries of the GSP. This cannot be achieved through ad hoc policies but with careful long-term planning.

To qualify for the recently amended GSP rules, exports from Pakistan to the EU countries would have to account for less than 2 % of the EU's total GSP imports. It may be further noted that, according to the new legislation tariff, preferences for these products will be suspended for a country if EU imports from the country grow by 13.5 % or more in a year or if imports of specific products exceed 6 % of total EU imports of these products. So there will be an upper limit to our export growth in the EU markets. Pakistan has proved that it abides by 27 international conventions in the field of human rights and sustainable development. Any violation of these conventions can cause suspension of the GSP status. Therefore, government will have to very carefully implement its commitments with the EU.

Access to the GSP scheme and benefiting from it is also conditional upon putting into place and maintaining the necessary administrative structures and systems required for the implementation and management of the GSP 'rules-of-origin' and origin-related procedures by Pakistan. Any violation of the rules-of-origin will bring severe penalties. The competent authorities of Pakistan are thus required to cooperate with the European Commission and the customs authorities of the EU Member countries in this context. Thus, Pakistan needs to create an effective institutional infrastructure so as to ensure that commitments are implemented in letter and spirit. Whereas, GSP Plus will raise growth, export earnings and employment, Pakistan will have to invest to develop its institutional infrastructure to ensure full compliance with its commitments.

In light of Pak rupee appreciation, various quarters have been expressing apprehension whether Pakistan will be able to benefit from GSP plus. To answer this one can put a counter question, that is, what if we don't have this facility then perhaps Pakistan would have been in a more difficult situation. With appreciation persisting, if cost of production decreases and export firms improve their productivity and efficiency then it is highly likely that GSP Plus will trigger higher export growth.

I shall conclude on a cautious note that the reduction of MFN tariffs, after successive rounds of multilateral trade negotiations, has diminished the value of the GSP concessions. With a new accord under the WTO, the general level of MFN tariffs may fall in the range of 3-4%, rendering GSP Plus less consequential in the future. It is, however, unfortunate that at present, the prospect for conclusion of the Doha Round appears blurred. In light of this, perhaps a better option would also be to conclude a bilateral trade and investment agreement that Pakistan and the EU have been negotiating for quite some time. A deal on this front might bring sustained gains that are bigger than what the Doha Round or GSP Plus can offer.

The writer is a Professor of Economics at School of Social Sciences and Humanities at NUST, Islamabad.

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