Financial Liberalization, Economic Growth, and Capital Flight: The Case of Pakistan Economy

This chapter takes a historical overview of financial liberalization, and its subsequent impact on economic growth of Pakistan. Canada’s Fraser Institute publishes the “Economic Freedom of the World (EFW)” Index every year, ranking the countries according to the developments occurring in selected areas. There are five major areas, namely “Size of the Government,” “Legal Systems and Property Rights,” “Sound Money,” “Freedom to Trade Internationally,” and “Regulation.” The final ranking bifurcates countries in four quartiles, from “Most Free” to “Least Free.” Pakistan does not fare well in economic freedom as Pakistan ranks a lowly 136 out of the 162 countries evaluated in the 2019 report. From 1947 to 1951–52, trade and exchange policies were comparatively liberal as Pakistan enjoyed current surplus account, mainly driven by high demand for cotton due to Korean War. But as the war ended and demand fell drastically, leading to CA deficits, policy for the remaining decade changed completely. The fifties were marked by stringent “direct” controls on trade and exchange rates. The stringent trade and exchange rate controls were deregulated to a large extent in the Ayub Khan era. Price controls and restrictions on profit margins were largely done away with, and a liberal trade regime was followed with fewer restrictions upon imports. However, an overvalued exchange rate was maintained through government intervention, ostensibly to help importers import latest capital equipment (like machinery and raw material). Studies that look at post-1971 instances of exchange and trade controls normally assume four distinct phases; phase I (1972–1981): Fixed exchange rate regime and partial lifting of trade controls, phase II (1982–1998): Managed floating exchange rate and liberalization initiatives, phase III (July 1998–July 2000): Multiple exchange rate and dirty float regimes, and phase IV (July 2000–2009): Flexible exchange rate regime and trade liberalization. There have been numerous studies on the various aspects of financial sector and financial liberalization on economic growth in Pakistan's case. For example, Khan and Qayyum (Economic Analysis Working Papers, 2007), Awan et al. (International Journal of Economics and Finance, 2(4):75, 2010), Munir et al. (Pakistan Journal of Social Sciences (PJSS), 33(2), 2010) have found a positive correlation between financial liberalization and economic growth. It would perhaps be safe to state that the link between financial liberalization and economic growth in Pakistan is still debated. Especially controversial/debatable are the distributional issues surrounding financial liberalization, an aspect upon which there is scant quality research. The first important variable/aspect that majority of these studies ignore is the issue of Trust. Put another way, Pakistan lacks credibility in terms of its policies, which imparts a negative image upon the country, thus limiting chances of foreign and domestic investment coming in. Also, the inflows under the CPEC are to large extent government-to-government arrangements rather than led by private sector participants. A third and equally important aspect of the debate regarding financial liberalization and economic growth in Pakistan is the monopolistic structure dominating the financial sector in Pakistan. A sector characterized by monopolistic tendencies is highly unlikely to attract much investment. Given that the major source of profit of banks in Pakistan is an investment in government treasuries and that there is a widespread of rate between the profit obtained and the one given to account holders, Pakistan’s financial sector is by and large indulging in an adverse distribution of wealth (from populace to a group of individuals, i.e., financial industry) rather than helping propel economic growth. For any proper assessment of Pakistan’s financial sector and its role in economic development, the factors discussed above will have to be considered in future studies, along with other variables that affect the outcomes in this sector.