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Pakistan: Failing Economy, Failed State?

Pakistan's standoff with the U.S. over terrorism is heightening tensions. The government's failure to pursue economic reforms poses an arguably greater risk to the country's future.

In the wake of the killing of Osama bin-Laden five months ago, Pakistan increasingly appears to be a country on the brink. The daring raid by U.S. Navy Seals on Pakistani territory has fueled public opposition to the war on terror. The ability of the government to control the country appears shakier than ever, with terrorist attacks on the rise and ethnic violence besieging the economic capital of Karachi. Relations between Islamabad and Washington hit a new low following the damning accusation last month by Admiral Mike Mullen, chairman of the U.S. Joint Chiefs of Staff, that Pakistan’s Inter-Services Intelligence agency had provided support to the Haqqani terrorist group that attacked the U.S. embassy in Afghanistan.

As daunting as the political and security risks are, Pakistan’s economic problems are every bit as bad. Growth has slowed to a crawl in recent years, unemployment and inflation are both high and rising, and investment has plunged to a 40-year low. Fully 60 percent of the country’s 187 million people are getting by on less than $2 a day. President Asif Ali Zardari and Prime Minister Yousaf Raza Gilani have done little to combat the country’s endemic corruption. External support to help Pakistan deal with its problems is drying up. Last year the International Monetary Fund halted payments to Pakistan under an $11 billion economic stabilization program because of the government’s failure to cut its deficit and pursue economic reforms.

The danger is that the weak economy and dysfunctional political system will feed on each other, with corruption and mismanagement fostering stagnation and poverty that, in turn, fuel more extremism. It’s no wonder analysts talk of Pakistan as a failed state.

“There are three key, fundamental issues on which economic development and foreign direct investment in any country are based,” says Saad Amanullah Khan, vice president of the American Business Council of Pakistan, a chamber of U.S. businesses and one of the largest groups of single-country overseas investors. “They are consistency of government policy, infrastructure availability and general law and order. Unfortunately, all three have gone down in the past four years.”

Daniel Wagner, chief executive of Country Risk Solutions, a U.S. political and economic consulting firm, is even more blunt, arguing that the government has lost control over its borders. “My perspective on Pakistan is that it does not have to worry about becoming a failed state because it already is a failed state,” he says.

The current situation is a far cry from the halcyon days in the middle of the past decade, when a technocratic government led by Shaukat Aziz succeeded in reviving the economy — and hopes for a better future. Aziz, a former Citibank executive, was drafted as finance minister by General Pervez Musharraf after a military coup in 1999. Both men promised to root out corruption and provide the fiscal discipline and stability for economic growth. Musharraf’s decision to stand with the U.S. in its war on terror after the attacks of September 11, 2001, also paid rich dividends. Western governments agreed to write off $1.7 billion of the country’s debt and reschedule a further $12.5 billion, easing Pakistan’s debt service burden, while Washington stepped up economic and military aid.

The results were impressive. Pakistan’s economy grew at an average rate of just over 7.25 percent a year between 2004 and 2007, according to the IMF. Exports nearly doubled, as did foreign exchange reserves. The government embarked on a privatization campaign, helping the country attract $8.4 billion in badly needed foreign direct investment. The ultimate seal of approval, seemingly, came in 2005 when Goldman Sachs Group named Pakistan as one of its “next 11” emerging markets, a group that the bank asserted would follow the BRIC nations to become among the leading economic powers of the 21st century.

Instead of capitalizing on the good times, however, Pakistan reverted to its old ways. Aziz, who served as prime minister from 2004 to 2007, did little to develop the country’s infrastructure or reduce costly subsidies. Political instability accelerated the economic downturn. Former prime minister Benazir Bhutto returned from exile in 2007 to lead her Pakistan Peoples Party in parliamentary elections, only to be assassinated at a political rally in December of that year. President Musharraf declared a state of emergency, then resigned and went into exile in 2008 after the PPP and its rival, the Pakistan Muslim League, called for his impeachment. Bhutto’s widower, Zardari, was elected president in September 2008, but his government has done little to stem the decline.

Economic growth will average just under 3 percent a year between 2008 and 2011, according to IMF figures, while India has grown at an annual rate of nearly 7.75 percent over that period. Investment slumped to 13.4 percent of GDP in the 2010–’11 fiscal year from a peak of 22.5 percent just four years earlier. With inflation running at an official rate of 14 percent and food prices soaring, employers say some blue-collar workers are asking to be paid in wheat instead of money.

Pakistan agreed to an IMF stabilization program in 2008 and has drawn nearly $8 billion in loans. The Fund also provided an additional $478 million in emergency aid last year after floods devastated a fifth of the country’s territory. The IMF has suspended further loans, however, because of the government’s failure to rein in its deficit, expand the country’s notoriously porous tax base and shrink bloated state-owned companies. “Pakistan needs to focus on growth and reduce poverty and raise employment levels,” says Adnan Mazarei, IMF mission chief for Pakistan. “For that you need improved institutions and hopefully an improvement in security, which is not entirely in the hands of the government.”

Zardari is known in the country as “Mr. 10 Percent” because of allegations that he took kickbacks when his wife was in power. Criminal charges against him for corruption, money laundering and murder were dropped as part of a 2007 agreement with Musharraf that enabled Zardari and Bhutto to return from exile.

The president has been accused of cronyism for surrounding himself with a kitchen cabinet of politicians with dubious credentials. Babar Awan, a PPP heavyweight who once served as minister of Law, Justice and Parliamentary Affairs, claimed to hold a doctorate degree from Monticello University in the U.S., but that “school” turned out to be an unaccredited diploma mill that was fined and ordered to stop offering degrees by a Hawaii court. “These guys have no qualifications. They have fake degrees and don’t do anything for the country,” says one Karachi-based chief executive, who spoke on condition of anonymity. “Why are they in these positions of power? Because they are yes men, high school friends of Zardari’s.”

Zardari has appointed a number of credible professionals to key economic and financial posts, but none of them has managed to stay in his job for very long. Within the past year first Salim Raza and then Shahid Kardar resigned as governor of the State Bank of Pakistan, the central bank. Shaukat Tarin resigned as finance minister in 2010 and was replaced by Hafeez Shaikh, a Boston University–trained economist who had worked at the World Bank in the 1990s and served as privatization minister under Musharraf.

Insiders say the technocrats are frustrated. Tarin, for instance, drafted a nine-point plan to boost the economy, including tax reforms and infrastructure development, only to resign when the government disregarded his proposals. Kardar has refused to comment publicly on his resignation, but he made his views clear in a column in Dawn, a leading English-language newspaper, contending that the government needs to privatize state companies to increase efficiency and combat corruption and cronyism. He accused politicians and bureaucrats of blocking privatization “because of the resulting reduced opportunities for patronage or earnings.”

The stagnant economy provides a fertile environment for growing militancy. Without schools, parents turn to madrassas, or religious institutions, to provide instruction and food to their children. “If you go to a madrassa, there will be a ten-year-old who doesn’t know how to do math or history but knows how to blow himself up or hold a Kalashnikov,” says Shehrbano Taseer, a Newsweek journalist whose father, Salmaan Taseer, served as governor of Punjab province until he was assassinated by his own security guard in January because of his opposition to the country’s blasphemy law. Taseer and her family have been active campaigners against Islamic militancy. Her brother, Shahbaz, was recently kidnapped, and his whereabouts are unknown.

Finance minister Shaikh acknowledges concerns about political resistance to reform but insists that the government has taken some positive steps, including measures to expand the tax base, freeze expenditures and deregulate oil prices. “I am a great believer in Pakistan’s future,” he says. “Its geographic location, its abundance of natural resources and underexploited potential make it a serious candidate for doing well in the medium term.”

Business executives say other government actions are more telling. In January, for example, Dubai-based Abraaj Capital, which had acquired a controlling stake in Karachi Electric Supply Co. in 2009, decided to cut 4,500 workers in a bid to increase efficiency. The workers attacked the utility’s offices, trapping management inside, and destroyed parked cars. One employee held up a sign that said, “Do not force us to become suicide bomber.” Under pressure from unions, the government intervened and prodded the company to reinstate the workers. Business executives rolled their eyes.

“The government backed the unions publicly. Just look at the signal that sends out,” says Muddassar Malik, chief executive of BMA Capital Management, a Karachi-based fund management firm. In the meantime, the country’s power situation remains dire, with frequent outages of up to 12 hours infuriating business owners and residents alike.

The government has also demonstrated little willingness to back the efforts of the Federal Board of Revenue to increase the tax take. Pakistan has one of the lowest income tax rates in the world at about 10 percent, and the government has said it is committed to increasing revenue. However, senior members of the government, including Prime Minister Gilani, Punjab Chief Minister Shahbaz Sharif and Interior Minister Rehman Malik are among those who did not pay a penny in income tax between 2004 and 2007, according to a report in the Express Tribune newspaper.

“We’ve been talking about raising tax revenues for the last 64 years, and every year there are these completely unrealistic targets which are bandied about in the budget,” says Adnan Aziz Ahmed, managing partner of Alpha Capital Partners in London and former economic adviser to Benazir Bhutto.

Notwithstanding their frustration with the government, business leaders insist that Pakistan still has great potential. “We’ve had war, we’ve had natural disasters, and we are in a time when Pakistan’s export markets are in a recession,” says BMA Capital’s Malik. “It’s remarkable that the economy has actually grown and not gone into a tailspin.”

Remittances from Pakistanis working abroad, especially in the oil-rich Gulf, have helped. Those funds quadrupled in eight years to reach $7 billion, or 4.2 percent of GDP, in 2008, according to the IMF.

“We’ve been lucky in the sense that agricultural commodities picked up last year and we got compensated,” says Nasim Beg, chief executive of Arif Habib Investments, one of the country’s largest asset management companies. “There is no serious pressure on the currency. The stock market is doing well on the back of good earnings of listed companies and also sustained growth.”

Another bright sign is the fact that the asset management industry continues to grow, albeit from a low level. Between 2001 and 2010 the number of investment funds in Pakistan grew to 135 from 38 and their combined assets rose to $2.3 billion from $331 million, according to BMA Capital. Pension funds’ assets grew by 48 percent in 2010, driven largely by the performance of the Karachi stock market.

Those gains could easily go out the window, though. In Karachi, the commercial hub that generates 80 percent of the country’s economic growth, ethnic violence has left more than 100 people dead in recent weeks. The city’s deteriorating security, a symptom of Pakistan’s growing instability, could be the last straw for the economy.

The ethnic violence is occurring partly along political lines. The Muttahida Quami Movement (MQM), which represents Mohajirs, or immigrants, who came to Pakistan after the partition of India in 1947, is in conflict with the Awami National Party (ANP), which represents the Pashtun community that has moved more recently from the north of the country to Karachi. The PPP has its own activists who are involved in the fighting. Gangs and drug cartels have added themselves to the mix, allying with different political groups. The fact that the ANP is part of the PPP’s governing coalition, and that the MQM has gone in and out of the coalition several times in recent months, helps explain the government’s dysfunction. The main opposition power, the Pakistan Muslim League, led by former prime minister Nawaz Sharif, offers no credible power-sharing alternative or much in the way of an economic policy. Instead, all the parties rely on cults of personality. Every campaign poster for the PPP has Zardari’s face as well as those of his murdered wife and her father, Zulfikar Ali Bhutto, a former prime minister who was executed in 1979 after a coup by General Muhammad Zia-ul-Haq.

Bringing order to such a turbulent political environment is daunting. Politicians should heed the advice of James Carville, the campaign strategist to former president Bill Clinton: It’s the economy, stupid.

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