The current account deficit is getting out of hand. Yet, the debate continues on how to create external financing to fund this deficit and how to reduce this deficit through monetary tightening and exchange rate adjustment. There is an elephant in the room which is not debated much but is directly and indirectly contributing to burgeoning external imbalances. It's the growing fiscal deficit.

The twin deficit dilemma is nothing new to Pakistan. Time and again, higher fiscal deficit leads to high current account deficit, and vice versa. Thus, to curtail current account deficit, the fiscal house has to be put in order. And that is the most politically-tough decision to take, especially when it is close to the elections.

Let's delve into the fiscal realities of the country and see where things can be rationalized to control external imbalances and what all that trimming and slashing can do to other economic variables.

The good news is that during the ongoing PML-N government, the fiscal revenues have increased from 13.3 percent of GDP in FY13 to 15.5 percent in FY17. That is primarily attributed to growth in tax revenues, from 9.3 percent of GDP in FY13 to 11.6 percent in FY17. There is not much to talk about on non-tax revenues, as privatization, coalition support fund and other non-tax revenues are hard to come by. On the expenditure side, the control is visible. Spending equated to 21.5 percent of GDP in FY13 and stood at 21.3 percent in FY17. The fiscal deficit was lowest in FY16 in the current regime at 4.6 percent, primarily due to restricting expenditures to 19.9 percent while the revenues were growing.

But in FY17, the revenue growth slowed down as low-hanging fruits are extracted. Now tough tax reforms are required to further inch up the revenues, which is a difficult proposition in years close to elections. Concurrently, curtailment of expenditure (mainly development) is a hard thing to ask near the elections.

This implies, supposedly, that fiscal deficit ought to be higher close to elections. That happened during FY09-13, when deficit increased from an average of 6 percent of GDP (FY09-11) to 7.5 percent (FY12-13; it happened earlier as well in FY04-08 when deficit increased from an average of 3.0 percent of GDP (FY04-06) to 5.7 percent of GDP (FY07-08).

The history is repeating itself in FY14-18 as deficit increased from an average of 5.2 percent of GDP (FY14-16) to 5.8 percent in FY17. Now it may cross 6 percent in FY18. This growing fiscal deficit is making it difficult to control the increase in current account deficit.

What does the government have in hand to control the fiscal deficit? The revenues are growing; but the problem is half of the revenues are going to the provinces after the Seventh NFC awards. Provinces have no political and economic incentive or compulsion to curtail their spending hands while they do lack incentive on raising tax revenues that fall in their domain.

Prior to the Seventh NFC award, on average, 62 percent of revenues (FY04-10) were at the disposal of federal government – a figure that has since reduced to 50 percent (FY11-17). The accumulation of deficit has resulted in growing debt-servicing cost over the period of time. Thus, the federal government loses the control on expenditure.

The debt-servicing was, on average, 3.8 percent of GGDP (FY04-10) prior to the Seventh NFC award and it has increased to 4.4 percent of GDP (FY11-17) thereafter. Now, with growth in both external and domestic debt, along with currency depreciation (some of it has happened and more is to come soon) and hike in domestic interest rates, the servicing cost may increase further. The federal hands are tied when it comes to controlling debt servicing. Similar story is for defence spending and general administration expenses, albeit, these are relatively declining in terms of GDP. Another inflexible expenditure is government employees' pensions (including those of military personnel), and unlike others, it is growing fast. This spending head has increased from an average of 0.5 percent of GDP in FY04-10 to 0.7 percent of GDP in FY11-17.

The pension expenditure was the highest ever at 1 percent of GDP in FY17. The increase in pension of government employees amid more public servants reaching retirement stage would be a cause of concern in years to come. Yet, there is no narrative on how to control it.

Phew, too much untouchable expenditure; does the government have any room to cut? It's in development expenditure and in grants (read subsidies). The PSDP was by far the highest at 5 percent of GDP in FY17 versus the average of 3.4 percent of GDP in FY02-16.

The bulk of increase in PSDP came from provinces, which spent 2.7 percent of GDP on it in FY17 versus an average of 1.5 percent (FY02-16). And they may not be shy to spend in FY18 as provinces are sitting on accumulated cash surplus so close to the elections. How much of the trillion-rupee federal PSDP can be trimmed? Not much; but the next federal government ought to do so in FY19. The catch is how to put reins on provincial spending. Well, if IMF programme becomes a reality, the fund may come up with a contingency fund condition for federal government from provincial pie. It's a complicated subject and is easier said than done, considering polarized provincial political realities. Apart from development expenditure, the grants can be thinned. The grants (subsidies) were too high in FY10-11 when electricity related subsidies were steep. They were reduced subsequently owing to clearance of circular debt and low oil prices.

Now oil prices are heading north again, and power capacities are adding to increased capacity charges. Besides, imported RLNG, which is expensive than domestic gas, is increasing in the gas mix. At prevailing tariffs (both for electricity and gas), the subsidies ought to increase unless tariffs are revised up.

Thus, the fiscal challenge for a new government in FY19 would be to cut development expenditure and raise energy prices substantially to control fiscal deficit and, in turn, curb current account deficit. There is no way around it. But by doing that, growth spurred by enhanced energy at affordable prices amid heightened development spending would be compromised.

In a nutshell, FY19 would be a tough first year for a new government.

Copyright Business Recorder, 2018