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IV. Economic Dimensions of Tests


India and Pakistan Should Focus on Weak Economies

India's Economy
India's economy was already weakening at the time the country conducted its nuclear tests. The value of the rupee had declined by about 10 percent since 1997 and then another 10 percent since then. The stock market has been in the doldrums. Prospects for inflows of foreign direct investment have been bleak. Exports have been stagnant if not declining and general business sentiment has been gloomy. Finally, the budget deficit is likely to be larger than expected. However, correlation is not causality and in fact sanctions have played very little role in the weakening of the Indian economy.

Four factors generally explain the weak state of India's economy. First, the broader Asian financial crisis has spurred a sell-off by foreign institutional investors across the board. India has been also affected by this trend. Second, the weak domestic Indian stock market reflects the failure of governance of the stock market. Stock market scams such as those revealed in 1992 have undermined confidence in the stock market. Third, political uncertainty accompanying the new government has appeared to put a break on economic reforms, especially in the power sector. Finally, and perhaps most critically, the newly announced budget was below expectations and the market and other observers regarded the new budget as a missed opportunity for moving reforms forward. This populist budget seemed protectionist and corrupt and appeared to suggest that the government expected to go back to the electorate fairly soon. The government's response to the imposition of sanctions was not helpful in this regard. By minimizing the potential negative effects of the sanctions, the government could not argue that there was an incipient crisis that required recalcitrant political partners to support reforms, thereby undercutting the political capital it needed to push through difficult reforms.

Defense spending, which has increased by 14 percent, is not really related to the nuclear tests. Rather it is linked with the recommendations of the fifth pay commission report. Civil service salaries were raised in 1997, and therefore this year military salaries had to be increased. Actual defense expenditures remain about 2.5 percent of the GDP.
The effects of sanctions can best be understood by making a distinction between the official and private sector or market responses. On the official front, quite apart from the rhetoric, the impact of sanctions has been relatively mild thus far. Within a month of the announcement of U.S. sanctions one of two billion dollars in loans from the World Bank have been approved on humanitarian grounds. The World Bank has some discretion in deciding what prevails as humanitarian-related loans. Indeed, after the government in Beijing crushed protestors at Tianamen Square the G7 announced a halt in loans to China, but within six months or so loans began to be made on humanitarian grounds. Such precedents give reason to believe that the World Bank can be flexible if it chooses to be.
On the other hand, Japan, unlike the United States, has not been soft on making loans and this has serious implications for the infrastructure sector in India. Unlike other sectors, infrastructure projects requires quasi-government guarantees, which come from institutions such as the Overseas Private Investment Council (OPIC) and the Export-Import Band (EXIM). Finally, in term of official bilateral aid, the impact has been low because there simply was not much of this type of aid being given to India.
In terms of the impact of the sanctions where the market is concerned, there have been two kinds of effects. First is what might be called a "signaling effect." This is reflected in Moody's downgrading and a direct result is that the cost of borrowing money in India increases sharply. Due to the depreciation of the rupee, Indian corporations have been reluctant to borrow money outside the country because of the unfavorable exchange rate.
The second effect is that in terms of the impact of the sanctions on reforms, it seems that India only responds to crisis. The BJP really has three enemies in terms of reform: its coalition partners; extremist social movements within the larger BJP family such as the VHP; and the Bombay industrialists, the so-called Bombay Club who see reforms and economic liberalization as a threat to their interests.

The sanctions appear to have helped the cause of economic reform, against significant opposition, allowing the government to take several positive steps:

• The government appears to be intent on liberalizing foreign direct investment.
• It has created four new states--another strong signal in favor of reforms.
• By repealing the Urban Land Ceiling Act the government has taken away a considerable source of rent-seeking in urban India.

It should be emphasized that underlying specific policy changes is a psychological shift. As the prestige of the Indian Administrative Service fades, middle-class Indians no longer look upon government employment so avidly. Rather, they want to start their own companies and be involved in software development and make money.

All this is not to suggest that fundamental problems have disappeared. The fiscal deficit is still a problem and expenditure priorities, which reflect social development, are grossly warped. Social development expenditures depends mainly on state budgets and most states are bankrupt. The quality of the bureaucracy remains quite poor and in fact is getting worse as fewer of the qualified look to enter state employment. Those who want to join the government do so either because they lack of alternatives or see opportunities for self-enrichment. Even if the state sector is less central to the country's economic life, the poor quality of the civil service remains a cause for worry.

In addition, there are some 400 million Indians living in poverty. Roughly 20 million Indians enter the work force each year. If one assumes that 50 percent of business costs are employee costs, then India will require some $50 billion a year in investment just to ensure that 10 million new jobs are created each year. India's most optimistic stated goal for investment is just $10 billion a year--a figure that represents only 20 percent of what is required. This is why India's strategic economic focus should be on attracting foreign direct investment. Similarly, Pakistan's key strategy should be economic development as well, with an emphasis on foreign investment.

Pakistan's Economy
With an economy as poor and as weak as some African states, Pakistan's economy is on the brink of collapse if sanctions are strictly enforced. While the shell of Pakistan's state will survive, the country is headed for internal implosion.

The positive note is that the present situation may constitute a unique opportunity for Pakistan to pursue fundamental structural reforms of its economy. Indeed, a deal should be pursued that in return for no punitive sanctions, Pakistan will restructure its economy. Whatever ensues, the international community should not support Pakistan's current economic structure.

Pakistan's economy is at a particularly critical stage. The country's economy is basically stagnating when one takes into account both GDP and population growth rates. Pakistan has the highest population growth rate for a country with over 10 million people. To add to the crisis, inflation is rising rapidly, especially on commodities that are critical to the poor, moving income inequality to the worst levels in Pakistan's history. This situation is compounded by the fact that there is deep plunge in remittances from their peak in 1983. This lack of economic development is matched by social underdevelopment as well, with literacy levels at only 30 percent.

In terms of public finances, the key point is not that defense spending has increased so much (in fact, it declined in real terms in the early 1990s before the nuclear tests), but that there has been a huge increase in the percentage of the GDP owed for interest payments. This has had the effect of squeezing public spending on social and economic development, especially in the health and education sectors. For example, interest payments on domestic debt alone have gone up from 2.1 percent of GDP to 6 percent of GDP. Half of export earnings are required to offset debt servicing.

Pakistan's economy is not one that can cope with sanctions. This is the context in which fundamental structural economic reforms must be undertaken. These reforms must include several specific initiatives: fiscal reforms, extension of the agricultural tax net, privatization of state-sector industries, retirement of domestic debt, and the removal of the financial sector from control by the elites. The tax revenue as percentage of GDP is only close to 13 percent and the savings rate varies from about 12 percent to 14 percent. Public sector savings have been negative since 1972. Due to the high debt servicing levels, net aid inflows are actually very small. Moreover, export led growth is very problematic because of the state of chaos in the main commercial and port city of Karachi. So, export earnings cannot really substitute for net aid revenues. In terms of foreign assistance inflows, Pakistan has received around $2.4 billion annually. However, if one takes into account debt servicing amounts that vary from about $1.4 billion to $1.6 billion annually, then the net aid inflow is only about $800 million. In per capita terms this means only about $5 per Pakistan citizen compared to some $30 per person in Africa.


Discussion

Impact of Sanctions on India
On the whole, India is less vulnerable to sanctions than Pakistan. The current account deficit is 1.3—1.5 percent of GDP. The external debt service to export ratio is about 23 percent, an all-time low in the 1990s, and India has a healthy level of foreign exchange reserves at around $26 billion.

Another inadvertently positive factor for India is that there is some $15—$16 billion of committed but unutilized funding in the pipeline, a reflection of India's notoriously inefficient bureaucracy. Of course, if the sanctions are severe and persist for a long time, then funding in the pipeline will dry up and India will have to face the negative consequences.

Yet another positive factor has been some significant inflow of private investment, including investments by U.S. energy and insurance companies. To maximize the impact of these private investment infusions, the government of India has been very vigorous in clearing various projects.

However, a factor that could adversely affect India would be a sharp drop in exports resulting from reduced demand in the wake of the financial crisis in Asia. Also, if sanctions proved to be long-lasting and very severe then India might face very serious difficulties. One area of particular vulnerability is infrastructure development. Government borrowing for infrastructure for India has been a disaster. Because the government has proved itself to be incompetent in running infrastructure projects, its ability to borrow funds for infrastructure development has been historically poor.

One participant warned against trivializing the potential impact of sanctions on India, and identified four issues that could affect the impact of sanctions. First, the lack of political stability affects the ability to pursue economic growth. Second, the Asian financial crisis impacts India's import-export ratio. Third, impact of sanctions on the stock market and foreign direct investment will be of concern. And finally, the specific nature of sanctions will have their own effect on India's economy.

The ancillary effects of sanctions on India were highlighted. For example, the United States Trade Development Authority (TDA) provides funding for feasibility studies for investment in India. When this funding is stopped, corporations become reluctant to even explore opportunities in India. Another such example is OPIC guarantees. The withdrawal of OPIC guarantees has an enormous psychological impact on corporations with plans to do business in India. These ancillary impacts mean that the effect of sanctions must be considered not only in terms of their impact on concrete projects already underway, but also in terms of the impact on business organizations considering involvement in the Indian market. Many would-be projects have simply been aborted before they even started as a result of halts in support for the TDA, EXIM Bank, and OPIC.

One participant suggested that the role of official financial assistance, whether bilateral or multilateral, is overrated, and that, for example, an offer of Japanese government loans or aid to India as an inducement to undertake non-proliferation commitments is unlikely. In fact, the real key is the private sector. Specifically, if overseas Indians invest in India as much as the overseas Chinese invest in China--only about 10 percent of the $40 billion invested in China in the last decade has been from non-Chinese--then the impact of sanctions will be considerably lessened in yet another way.

Impact of Sanctions on Pakistan
There was a strong consensus that Pakistan would face very adverse effects from sanctions. One reason for this is the very low level of foreign exchange reserves in Pakistan. At the time of the tests these reserves were around $1.4 billion and since the tests and at the time of this writing they have fallen to around $900 million. In fact, without fast-disbursing loans from the IMF and the World Bank, it is possible that Pakistan soon will go into arrears.

One participant noted that Pakistan's government has already defaulted on $11 billion in short-term deposits held by Pakistan residents and non-residents. Moreover, many public sector corporations, whose deficits used to be included in the federal deficit figures but are no longer, owe around 60 billion rupees. This is one reason why the Pakistan government wants to terminate all independent power projects (IPPs) immediately. They do not have enough money to pay the IPPs. The government is therefore trying to cancel the sovereign guarantees given to the IPPs.

The prospects for a total default by the government of Pakistan are strong. The country has a trade deficit of about $2 billion. Another $3 billion is owed in annual debt payments. Pakistan needs a minimum figure of $5 billion to get through the next financial year--an amount that it does not have. Reserves have decreased from $1.2 billion to about $800 million. Before sanctions, Pakistan used to be able to count on another $1 billion in new deposits from both resident and non-resident, as well as about $1.5 billion in foreign remittances. Another $700—$800 million could come from foreign investment, whether direct or indirect, $700—$800 million from the World Bank, $500—$600 million from the IMF, $200—$300 million from the Asian Development Bank, and finally another $1.4—$1.5 billion from the Pakistan Development Forum.

But now, in the wake of the sanctions, not a penny of these prospective sources of funds will come to Pakistan. First, no Pakistani working abroad will remit money through the Pakistan banking system because the difference between the Pakistani curb rate of the dollar and the official rate is 6 or 7 rupees. The only way that major foreign remittances will return to Pakistan is if the government devalues, but that is unlikely in light of official pronouncements to that effect. Second, there will be no foreign investment in Pakistan. The withdrawal of funding for projects from OPIC, EXIM Bank, and the Pakistan Development Forum will have a huge psychological impact on foreign investors, many of whom sent in funds only because of these American institutions. Without the support of these organizations, no new investment projects, IPPs or anything else, will take root in Pakistan. Even if the government were to privatize some state assets--such as possibly Pakistan Petroleum Limited and a couple of other major assets--the fact that the Moody investment rating for Pakistan is at rock bottom, and given that there is no new funding coming from international financial institutions, the prospects for new investment are near zero. Darkening the picture further is that the IMF has not even been prepared to release, for the time being, the third tranche of its loan. Finally, there is simply no confidence left in the economy on the part of the Pakistani investor, the Pakistani worker, or the foreign investor who might at one time been interested in investing in privatized assets, because there is no guarantee that they will be protected. The government has reneged on sovereign guarantees to IPPs and it has reneged on constitutional guarantees to deposit holders, leaving everyone on guard.

In essence, Pakistan is staring in the face of default whereby it will not have enough money to pay for all of its imports. The country's exports will not increase by the amount hoped for because of decreased world demand, especially from Asia, and even the U.S. economy is expected to slow. The real question then is how the rest of the world will deal with Pakistan's default.

If Pakistan defaults, the implications for future lending are huge. Therefore, a minimum strategy would be to have a "soft default" in which loans that cannot be paid are rolled over, especially with the international financial institutions. It should also be noted that the Gulf states and other Islamic countries are not in a position to stimulate Pakistan's economy or to lend them money on the substantial scale necessary.

The political response for Pakistan must be to de-link its policies from those of India. Pakistan must make its security decisions in a wider context, and not only with reference to the military aspect of relations with India. Pakistan missed a marvelous opportunity to de-link its policies from India on the question of nuclear testing. If India wishes to take a so-called principled stand in not signing the CTBT, Pakistan need not do the same. Pakistan should have shown restraint and started negotiations with the United States or with any other country that was receptive. Some in Pakistan are claiming that the United States offered a lot of money to Pakistan not to test. If Pakistan de-links itself from India, for example, on the CTBT, how might America respond?

Already Pakistan has made two concessions to India that it was unwilling to do for the last 10 years. The first concession, made by Prime Minister Nawaz Sharif, was to begin bilateral discussions with India. Until then, Pakistan had insisted that it was necessary to have multilateral discussions. Second, Pakistan reversed a 10-year precedent and allowed that progress in other areas of bilateral relations could proceed even though the issue of Kashmir was still unresolved. Although Kashmir was still a major irritant in bilateral relations, the understanding was it would be overshadowed by discussions involving trade and other issues.

But now, in the wake of the nuclear tests Pakistan's policy has essentially returned to the state it was in 1990: Pakistan now wants to multilateralize the India-Pakistan issue and, other than discussing the issue of Kashmir, Pakistan will not talk to India bilaterally. The more that India and Pakistan lose sight of a larger international issue and base their policies on each other, the less likelihood there will be for progress. Yet most agreed, however, that in order for Pakistan to be able to de-link its policies from those of India, it would be necessary for India to do the same.

It was also asserted that a nuclear-armed Pakistan on the verge of collapse presents the worst possible scenario for India and indeed for the rest of the world. Pakistan as a "nuclear Somalia" could be driven to take drastic actions that would not be in its or any other country's interest. By this logic, the sanctions on Pakistan, which might lead to such a grave scenario, are not in India's interest either. In light of this it was asserted that only a jingoist in India, completely blinded by hatred for Pakistan, would support crippling sanctions on Pakistan.

Defense Expenditures in India and Pakistan
At the time of this workshop, defense expenditures in both Pakistan and India appear to be contained. In Pakistan, defense expenditures last year decreased to 4.8 percent of GDP and are expected to be marginally lower at 4.6 percent during the next fiscal year. In the case of India, defense expenditures are approximately 2.5 percent of GDP and expected to remain steady. A projected increase of 0.1 percent for the nuclear sector is supposed to be offset by the decision to reduce by 0.1 percent the purchase of fighter aircraft. This will essentially have the effect of keeping the defense budget a constant percentage of GDP. It was also pointed out in dollar terms the defense budget is around $11 billion and when inflation of about 5.5 percent is taken into account along with the pay raise, Indian budget increases are marginal. Although percentage increases of the defense budget spent for missile and nuclear development seem hefty, in real dollar terms, they do not amount to significant increases.

As for the costs of India's nuclear program, it was argued that the costs of nuclear weapons has declined because of the use of existing facilities. When command and control, intelligence, passive measures, and delivery systems (especially the most expensive five sea-based submarine delivery systems over the next 10 years) are taken into account, then annual cost will be about $1 billion per year. This appears modest when compared to $5.4 trillion that has apparently been spent on the U.S. nuclear weapons program, according to a Brookings Institutions study. The difference in cost is in part explained by the fact that India's program is based on the concept of minimum deterrence while the United States and the former Soviet Union pursued a much more expensive policy of mutually assured deterrence.

In light of such relatively modest expenditures, it does not appear fair to say that there is an arms race underway in South Asia.


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