By Dr. Ishrat Husain
The author is the Director, Poverty and Social Policy Department, World Bank. The views expressed in this article are personal and do not represent those of the World Bank.
Most of the discussion and debate on economic issues in the media has largely been focussed on budgetary deficits, rate of inflation, size of cotton crop, fluctuations in level of exports, changes in foreign exchange reserves, etc. Other than that, the pages of our newspapers are filled with comments on the agreements with the IMF or structural adjustment loans from the World Bank. In other words, short-term issues have taken the center place while more important fundamental questions have receded into the background.
It is natural that, when any government or group of concerned citizens is faced with immediate and urgent unresolved problems of daily life and hundreds of constituents and party supporters are knocking at the doors of the ministers and leaders every day, the preoccupation with short term issues will take precedence.
But an elected government is also the custodian and trustee of the financial, natural and human resources it inherits and therefore, has the obligation to bequeath these resources to the fututre generation in ways that are qualitatively and quantitatively superior. For this to happen, economic policy reforms, institutional strengthening and investment in human and physical capital have to take place simultaneously. The successive governments have, on their volition or under pressure from external donors, made attempts, albeit with mixed results, to reform economic policies and to promote foreign and domestic investment.
There is also a widespread consensus, starting from the President of Pakistan to the ordinary citizen, that the key institutions of the country are in a state of serious disarray and decay and need to be fixed. But there have been hardly any serious efforts to reform our institutions at the scale that is comparable to the efforts on the policy reform or in attracting investment. The appointment of various commissions and committees since 1947 has been the standard response but the actual results of this approach are obvious to everyone.
The argument of this paper is that good economic policies such as sound fiscal and monetary policies, liberal trade and foreign exchange arrangements, privatization of state enterprises, financial sector restructuring and foreign and domestic private investment are necessary but not sufficient to bring about rapid, equitable, and sustained transformation of the economy. Basic reform of the institutions has to be carried out concomitantly and vigorously along with the policy changes and investment in physical and social infrastructure. To neglect this crucial aspect of economic and political management will mute or neutralize the expected positive response from good economic policies and investment making no perceptible change in the life of the ordinary citizen of Pakistan.
Pakistan inherited and subsequently established a number of solid institutions at various levels in diverse areas of the economy policy. However, with the passage of time, the tendencies of overcentralization, excessive control, increased government interference and arbitrary instructions from the top made most of them ineffective and impotent, rendering them unable to perform the tasks for which they were set up. The basic configurations which underpin most of these institutions have become fragile. The top-down nature of the administrative fabric, the control mind-set of the decision makers and the centrally commanded ways of doing things are major factors accentuating this fragility.
The agenda for institutional reform is both broad and deep-seated as the decades of neglect and disrepair have done irreparable damage. It may be manageable to implement if there is greater selectivity in the choice of institutions that need to be fixed in the first instance. A real start can be made if a broad political consensus is reached in reforming three key institutions - judiciary, educational, and financial institutions. What should be the nature of this consensus? A consensus must be reached among the two major political parties that these three areas of institutions, the judiciary, the educational and financial institutions, would be completely insulated from the intrusion of political interference and will remain out of bound as far as exercise of political patronage is concerned. This should not be interpreted to mean that setting sound objectives, policies, and performance standards and enforcing practices of supervision and accountability should be abandoned either by the legislature or the ministries concerned but as subsequent discussion demonstrates the areas of discretion should be limited, confined, and clearly defined. Why only these three and not others? The beneficial effects and positive spillover from setting right these institutions to other aspects of the economy and policy are so large that they deserve the first shot. Let us examine each one of these in turn.
Judicial System
First, the reform of judiciary requires that the appointment of judges be made on a non-partisan, non-political basis governed strictly by considerations of competence and integrity. The security of tenure and the compensation package are made so attractive that other temptations become totally redundant. The budgetary costs of paying remunerative salaries to the judges at all levels pale into insignificance when compared to overall benefits that the country will derive from a speedy, fair and impartial judicial system. For these benefits to be realized, there are many pre-conditions.
If allowed to develop as such, an independent, well-paid, and efficient judiciary is a strong safeguard against the repression of the state, excesses of the law enforcing agencies, contrived tyranny of the feudal landlords, and other influential classes and exercise of arbitrary powers by overzealous politicians and bureaucrats. The common citizen will exude confidence that he or she can obtain due justice from the system and there will be no discrimination or bias in favour of the rich and powerful. This, in turn, will be a source of empowerment for the majority of the population who, under the present system, feel completely detached and disconnected from the apparatus of the state. The behavior of the officials of the executive and legislators will perforce improve under the fear of reprisal and accounting for their actions before an independent judiciary.
The vindictiveness and vengeance of the government in power will be restrained by a fair judicial system. For example, the executive will have second thoughts when it attempts to arrest a dedicated and honest customs collecter for doing his job right and not yielding to the pressures of the higher ups. The protection of individual human rights will confer a new dimension. The mere implicit understanding in the minds of citizens that they will be able to obtain relief if wronged by fellow citizens or the state will change the "psyche" of the nation in a forceful way - from feelings of insecurity, anxiety, uncertainty and constant worry to those of confidence, trust, calmness, and tranquility.
Occasions will arise when extraordinary circumstances to preserve law and order and security of the state will require exceptional measures. Ordinary laws of the land may have to be modified on such occasions but the expectation that an independent judiciary will interpret and administer these laws in a fair and judicious manner will mitigate the fears of human rights and civil rights activists. Under this scenario, the state will be able to tackle these extraordinary circumstances successfully, without much resistance, criticism and possibilities of backlash.
The delays in enforcing contracts, and obtaining redressal of grievances and incurring large costs have negative impact on the speed and quality of economic transactions. The reduced transaction costs in enforcing contracts through expeditious disposal of cases will not only improve the efficiency of the markets but also reinforce confidence among the private economic actors. This link between strong judicial institutions and expansion of private sector is becoming apparent in a large number of developing countries which are undertaking major reforms of their judicial systems.
The uniform application of law for all citizens, irrespective of their status and position triggered by the proposed reform of the judiciary in place of the present selective application of law (what I described in my earlier article as a system based on "you show me the person and I will show you the law") will, over time, eliminate the wide gulf in the citizens’ access to government services. This will precipitate the disintegration of the tendencies that have led to strong tilt and capture of government by the elites and well-to-do segments of society and nurture a more balanced system in which the poor citizens can also participate and have access to basic government services. Of course, clear accountability of the judiciary under a pre-specified set of conditions will be sine qua non for the success of these reforms and to avoid transfer of "monopoly of powers by the executive" at present to "monopoly of power to the judiciary" in the future.
Educational Institutions
Second, there is an urgent need to reform the educational institutions including those engaged in scientific research and technology development. The accumulation of human capital that takes place through the educational institutions and research bodies in any civilized society has been set in a reserve gear in this country. Politically motivated recruitment of teachers right from the primary school stage, favoritism and partisanship in promotions and appointments at the senior level, strong arm tactics, intimidation and the use of fire arms by a minority of students backed by political parties have become the normal features of academic life. The quality of instruction, curriculum improvement, hard work by students and teachers, inquisitiveness, and search for knowledge have all disappeared from the scene except in a few isolated instances. We are failing to equip our future generation with the skills that are demanded in a country in transition to a modern path. The technological revolution that is sweeping the frontiers in microelectronics, telecommunications, genetic engineering and biotechnology, fibre optics, space technology has hardly touched the fringes of Pakistani production structure.
What needs to be done to salvage the educational institutions from the present morass? First, all the political parties should reach a compact that they would adopt a hands-off approach and that they would desist from interference in educational institutions either by influencing administration, teachers or students. Appointment of teachers should be made in an open, transparent, and merit-based system. Admission of students to higher educational institutions will be based on factors that result in attracting the best and the brigthest of our younger generation. Career advancement of teachers will take palce on highest standards of professional achievement and integrity. Second, the delivery of educational services will be open to all segments of the society - the government, private sector, NGO's, community organizations, religious bodies, etc. But the content and standards will be uniform throughout the country and the division between the madarsah and modern educational system will be eliminated.
This will also eliminate the present dichotomy between the children of the rich, affluent and the privileged who get best possible instruction at top private schools and the majority of the children who are served poorly by an overextended and undersupervised public school system. Those graduating from Karachi Grammar School and Aitchison College can easily find their way to the MITs, Harvards, and Oxfords of this world while the output from the thousands of government schools ends up in clerical, semi-skilled or other low-paying jobs perpetuating the existing inequities between the elites and the majority of the population, giving rise to potential social disharmony and unrest.
The opening of access to talented and qualified students from less well-endowed families will ensure a level playing field where the antecedents of birth, privilege and connections do not play havoc and reinforce the tendencies of worsening income inequalities. The student unrest in our universities is in fact a symptom of the fundamental malaise - the ordinary and unconnected students do not find any light at the end of the tunnel. They realize that the entry into the job market is not dependent on the skills, knowledge of the subject matter and on hard work, but on "who you know." To compensate for the lack of familial privilege, that is the lubricant for the rich and the affluent, they resort to goondaism and hooliganism to attract the attention of the political parties and are thus able to strike the right connections. The more notorious a student leader is in disrupting peace and harmony on the campus, the better are his chances for earning an entry ticket to an important position in one of the main political parties.
Third, the heavy subsidies provided for higher education by the state in form of ridiculously low tuition fees creates serios distortions and disincentives. Why do the parents of children in private institutions such as the Lahore University of Management Sciences and the Aga Khan University care so much about the standards and quality of education while those at public universities do not? The answer is simple. Those sending their children to the private universities have incurred substantial financial costs and would like to get adequate benefits for their children in return. They therefore insist that classes are held regularly, teachers prepare and present their materials diligently, and the students work late in the night in the library or computer labs. The students are aware that if they do well they would succeed in securing good jobs and careers. The management and teachers know that if they do not have satisfactory customers, they will have no one to pay them and may have to close down the facilities. In the public universities, admission is not based on merit and the financial costs to the families of the students are non-existent, the job prospects of graduating students are pretty grim and the reward system for the teachers is disconnected from their performance. No wonder, there is such a tremendous difference in the quality of graduates coming out of these two streams.
Does this mean that higher education should be priced so high that it would be available only to the rich and affluent? On the contrary, admission in institutions of higher learning should be based purely on the ability of individual applicant and blind to the applicant's financial status. In addition to the results of college examinations there should be entrance examinations that are objective in nature. Instead of fully subsidizing each and every University student, adequate financial aid, grants, scholarships, loans, etc. should be provided to those who cannot afford to pay the higher tuition fees.
Finally, the method and content of teaching, the course coverage, the testing and evaluation procedures should be revised drastically and linked more directly to skill formation and labour market conditions. Theoretical understanding is essential but neglect of practical and hands-on instruction is criminal. Our engineers can talk for hours on the theory of soil mechanics but shun jobs requiring them to design engineering projects. Until the relationship between education they receive and jobs they obtain at the end of their education is not fully visible and transparent the relevance of higher education would always remain questionable.
There is a very legitimate and real role for the government in the education sector. The government should be actively involved in the training of teachers, testing and evaluation, curriculum development, inspection of schools and financing of scholarships, stipends and subsidies for promoting the education of backward areas of the country and providing opportunities to those gifted but less fortunate children who cannot afford access to quality education. But the management and operation of the educational institutions should be entrusted to autonomous boards of professionals, private sector, NGOs, and community representatives.
Financial Institutions
The third set of recommendations relate to the reform of financial institutions. Economic theory and empirical evidence from other successful countries indicate that efficient mobilization and allocation of financial resources play an important role in growth and development. Since the nationalization of commercial banks and the mushrooming of development financial institutions (DFIs) the performance of the financial sector has not only been unimpressive but definitely inimical to capital formation and equitable distribution of benefits of growth. In an earlier article (the Economics of Patronage) the economic and political consequences of transgressions in the financial institutions have been amply spelled out. Suffice it to say, that the continued interference by political parties in power in the affairs of the financial institutions gives rise to the enormous difficulties in economic management. Not only that, their political interests also suffer considerably as the general unpopularity caused by inflation, unemployment, capital flight, investor uncertainty is a heavy price to pay for apeasement of a small and narrow group of party supporters and inflentials.
The financial sector reforms should be built on twin pillars of competition and prudential supervision and regulation. The abandonment of policies of mandatory credit targets, subsidized interest rates and preferential sectors, and the privatization of nationalized banks are steps in the right direction but it does not imply that the Government will have no role in the financial sector development. Competent central bank supervision, enforcement of prudential regulations and sanction against undesirable business practices are very much an integral part of the new approach to develop banking and non-banking institutions. Capital market authorities also have a major responsibility in ensuring disclosure of full information by entities raising equity from the public, or borrowing through long-term bond issues, preventing insider trading, expediting settlement and delivery of scrips. But the government must resist the temptation of intervening in individual business decisions made by the financial institutions and stop yielding to interest group pressures for special treatment and access to financial resources which they do not deserve on commercial considerations.
Private ownership of financial institutions is by no means an unmitigated blessing unless it operates in an environment of competition and market forces. The trend toward privatizing large state-owned banks is indeed welcome but entry for newcomers should be based on meeting criteria and standards of financial soundness and professional competence. Once this hurdle is crossed, entry should be relatively easy to avoid concentration of market power and emergence of oligopolistic practices.
The beneficial effects of competition can be gauged from Pakistan's own experience of the 1980's in allowing foreign banks to enter the market. The return on equity for the average foreign bank fell from over 30 percent in 1978 (when there were a few foreign banks) to around 15 percent during the 1980's (when the number of foreign banks rose significantly). On the other hand, the lack of competition and market protection allowed to five NCBs led to a decline in their profitability - from 15 percent to 8 percent return on equity.
Just as in the educational institutions, the student groups backed by political parties have contributed to indiscipline and deviation from academic pursuits the unions in the NCBs with political affiliation and special protection have promoted and influenced unjustified hiring, renumeration bonuses and other questionable practices that have unduly inflated the expense side of the NCB accounts. This combination of poor credit decisions and the strong-arm pressure tactics by the Bank unions has led to the malaise in the banking sector.
What kind of reforms are needed to restructure the financial sector? First, the issue of non-performing assets should be resolved. Non-performing assets are normally rolled over. As credit is not withdrawn from defaulters it is not available to new promising firms. Estimates of non-performing assets vary widely but it is generally agreed that the figure is close to one-third of total assets. If interest rates on new commercial loans are on average 21 percent, then almost 7 percent increase in volume of credit every year is simply channelled to finance overdue interest charges. Some of these charges are 20 years old and carried on the books as pertaining to sick industries. Such a large infusion of finance to "unproductive" and "unremunerative" businesses is in fact a waste of scarce resources and hampers expansion of legitimate and economically feasible activities.
Second, the integrity of the original credit decision needs to be preserved by only recruiting qualified and competent staff and allowing them to make the decisions on the basis of credit appraisal rather than other extraneous considerations. At present, resources are allowed to flow in line with political and non-economic priorities. The privatization of NCBs would at least bring to an end the present state of affairs when the bank managers cannot be held accountable for unwise credit decisions and blame the political leadership for all the bad credit outcomes. But private ownership and management are no guarantee for efficiency if the political heavyweights continue to cajole, coerce or pressurize the new owners to succumb to their wishes.
Third, most of the project financing by the DFIs in Pakistan has been carried out on a non-recourse basis, i.e. the project is set up as a legal entity and the sponsor's liability is limited to the extent of the project alone. Assumption of such a large part of business risks by the DFIs does not carry corresponding high rewards as the project loans are not adequately priced. The high rewards are in fact captured by the recipients of these loans who bear much lower risk. No wonder there is so much political pressure in approval of the loans by the DFIs. The proliferation of DFIs in the country would have led to intense competition, better risk management and appropriate pricing of products but lack of professional standards and poor quality of human resources have led to disastrous and in cases almost situations of bankruptcy. The sooner the government gets out of DFI business the better off the taxpayers in the country would be.
Conclusion
The reforms in these three areas of institutions are strategic, and if carried out, will ensure that capital is mobilized and allocated efficiently; human resources are developed and utilized to meet the changing demands of the economy; and property rights are enforced and the rule of law is respected providing a conducive environment for transactions to take place among millions of economic agents in the country. These reforms will, in turn, create pressure points in other institutions or alter the norms and behavior of participants in some other institutions. This agenda is practicable and manageable as it focuses on only three areas of endeavor and thus economizes on the administrative capacity of implementation. But this agenda is also daunting and highly demanding in the sense that it requires consensus among major political parties to give up some tools, to which they are used to, without gaining anything tangible for their own parties' narrow interests. But the more enlightened among our political leadership would recognize that the broad-based and widely shared gains do not only promote sustainable, equitable economic and social well being but also lay the foundation for a more healthy and strong political system. The choice between pleasing the party influentials and implementing this agenda of institutional reform by no means is easy if the sights are fixed at five year election cycle alone.