Economic development is fundamentally about enhancing a nation‘s factors of productive capacity,
i.e., land, labour, capital, and technology, etc. By using its resources and powers to reduce the risks
and costs, which could prohibit investment, the public sector often has been responsible for setting
the stage for employment-generating investment by the private sector. The public sector generally
seeks to increase incomes, the number of jobs, and the productivity of resources in regions, states,
counties, cities, towns, and neighbourhoods. Its tools and strategies have often been effective in
enhancing a community's:
labour force (workforce preparation, accessibility, cost)
infrastructure (accessibility, capacity, and service of basic utilities, as well as
transportation and telecommunications)
business and community facilities (access, capacity, and service to business
incubators, industrial/technology/science parks, schools/community colleges/universities,
environment (physical, psychological, cultural, and entrepreneurial)
economic structure (composition)
Institutional capacity (leadership, knowledge, skills) to support economic development
However, there can be trade-offs between economic development's goals of job creation and wealth
generation. Increasing productivity, for instance, may eliminate some types of jobs in the short-run.
Economic development encompasses a broad and expansive set of activities and tools that assist
communities in growth and prosperity. The best economic development practitioners strive to bring
quality jobs, new businesses and increased services (along with numerous other benefits) to
communities through innovative approaches and outcome driven strategies.
Technology development has added a new dimension to the role of economic development
professionals. The quest for increased technology can be confusing and challenging from many
perspectives. Communities must judge to what extent they should strive to recruit and support the
technology industry, how to determine the proper role of advanced technology on the organization‘s
everyday activities and design ways to help local businesses tap into technology opportunities. Many
communities have been able to incorporate technology into both their practices and programs while
others have struggled to understand the capabilities of this industry. As the information age and
technology sector maintain steady growth, the need for more advanced economic development
activity is expanding as well. Technology development encompasses increased infrastructure
capabilities, advanced financing options, innovative marketing processes and start-up business
Economic Development vs. Economic Growth
Development is a qualitative change, which entails changes in the structure of the
economy, including innovations in institutions, behaviour, and technology
Growth is a quantitative change in the scale of the economy - in terms of
investment, output, consumption, and income.
According to this view, economic development and economic growth are not necessarily the same
thing. First, development is both a prerequisite to and a result of growth. Development, moreover, is
prior to growth in the sense that growth cannot continue long without the sort of innovations and
structural changes noted above. But growth, in turn, will drive new changes in the economy, causing
new products and firms to be created as well as countless small incremental innovations. Together,
these advances allow an economy to increase its productivity, thereby enabling the production of
more outputs with fewer inputs over the long haul. Environmental critics and sustainable development
advocates, furthermore, often point out that development does not have to imply some types of
growth. An economy, for instance, can be developing, but not growing by certain indicators. Indeed,
the measure of productivity should not be solely monetary; it should also address the issues like how
effectively scarce natural resources are being used? How well pollution is being reduced or
Stages of Economic Development
Professor W.W. Rustow has defined and analysed in his book ‗The stages of economic growth‘, the
five stages of economic development:
1. The traditional society: In the traditional long-lived social and economic system, the output per
head is very low and tends not to rise. There are still few examples of traditional societies in this 21 st
century, that is, Afghanistan, Somalia, Ethiopia, etc.
2. The pre-conditions for take-off: sometimes also referred to ‗preparatory period‘. It covers a
long period of a century or more during which the preconditions for take-off are established. These
conditions mainly comprise fundamental changes in the social, political and economic fields; for
example, (i) a change in society‘s attitudes towards science, risk-taking and profit-earning, (ii) the
adaptability of the labour force; (iii) political sovereignty; (iv) development of a centralised tax system
and financial institutions; and (v) the construction of certain economic and social overheads like rail
roads and educational institutions.
3. The take-off stage: This is the crucial stage which covers a relatively brief period of two or three
decades in which the economy transforms itself in such a way that economic growth subsequently
takes place more or less automatically. The take-off is defined as the interval during which the rate of
investment increases in such a way that real output per capita rises and this initial increase carries
with it radical changes in the techniques of production and the disposition of income flows which
perpetuate the new scale of investment and perpetuate thereby the rising trend in per capita output.
4. The drive to maturity: It is the stage of increasing sophistication of the economy. Against the
background of steady growth, new industries are developed, there is less reliance on imports and
more exporting activity. The economy demonstrate its capacity to move beyond the original
industries which powered its takeoff, and to absorb and to apply efficiently the most advanced fruits
of modern technology.
5. The stage of mass production and mass consumption: The fourth stage ends in the
attainment of fifth stage, which is the period of mass production and consumption. The economy is
characterised by affluent population, availability of durable and sophisticated consumer goods, hi-
tech industries, and production of diversified goods and services. USA, UK, Canada, France,
Germany, Japan, Spain, Italy, etc are the examples.
Characteristics of Developing Economies
A developing country is one with real per capita income that is low relative to that in industrialised
countries like US, Japan and those in Western Europe. Developing countries typically have
population with poor health, low levels of literacy, inadequate dwellings, and meagre diets. Life
expectancy is low and there is a low level of investment in human capital.
1. Deficiency of capital: One indication of the capital deficiency is the low amount of capital per
head of population. Shortage of capital is reflected in the very low capital-labour ratio. Not only is the
capital stock extremely small, but the current rate of capital formation is also very low, which is due to
low inducement to invest and to the low propensity to save. Thus low level of per capita income limits
the market size.
2. Excessive dependence on agriculture: Most of the less-developed countries are agrarians. In
Pakistan, most of the people are engaged in agriculture. Whereas in developed countries 15% of the
population is engaged in agriculture. The excessive dependence on agriculture in less developed
countries is due to the fact that non-agricultural occupations have not grown in proportion with the
growth in population. Hence, the surplus labour is to be absorbed in agriculture.
3. Inequalities in the distribution of income and wealth: In under-developed countries, there is a
concentration of income in a few hands. In other terms, the income is insufficient to meet the
requirements of the whole economy. Such income is diverted to non-productive investments such as
jewellery and real-estates, and unproductive social expenditure.
4. Dualistic economy: Dualistic economy refers to the existence of two extreme classes in an
economy, particularly less-developed economy. There are old and new production methods,
educated and illiterate population, rich and poor, modern and backward, capitalists and socialists,
donkey carts and motor cars existing side by side. This situation creates an atmosphere of great
conflict and contradiction, and hampers the economic development in the long-run.
5. Lack of dynamic entrepreneurial abilities and highly skilled labour
6. Inadequate infrastructure: like airports, rail roads, highways, overheads, bridges,
telecommunication facilities, sewerage and drainage, power generation, hospitals, etc.
7. Rapid population growth and disguised unemployment
8. Under-utilisation of natural resources
9. Poor consumption pattern: In less-developed countries, most of the people‘s income is spent on
basic necessities of life. They are too poor to spend on other industrial goods and services.
Determinants of Economic Growth
(Factors of Economic Development in UDCs / Reasons of Failure of Under-Developed
The process of economic development is a highly complex phenomenon and is influenced by
numerous and varied factors, such as political, social and cultural factors. The supply of natural
resources and the growth of scientific and technological knowledge also have a strong bearing on the
process of economic development. From the standpoint of economic analysis, the most important
factors determining the rate of economic development are:
1. Availability of natural resources: The availability and use of natural resources within a country
play a vital role in the economic development. Many poor countries have enormous amount of
natural resources, but they are failed to explore them. The reason is that the government has not
provided necessary incentives to the farmers and landowners to invest in capital and technologies
that will increase their land‘s yield. In natural resources, minerals, oil and gas, forests, oceans and
seas, livestock, land‘s fertility, and mountains are generally included. It must be noted here that the
existence of natural resources is not a sufficient condition of economic growth. Many poor and
under-developed countries are rich with natural resources but there is a problem of availability of
capital required for their extraction. Such countries include Pakistan, India, Afghanistan, and several
African and Latin American countries.
2. Rate of capital formation: The second important factor of economic development is the rate of
capital formation. Keynes also ascribed the economic development of Europe to the accumulation of
capital. According to him, Europe was so organised socially and economically as to secure the
maximum accumulation of capital. The crux of the problem of economic development in any under-
developed country lies in a rapid expansion of the rate of its capital investment so that it attains a rate
of growth of output which exceeds the rate of growth of population by a significant margin. Only with
such a rate of capital investment will the living standards begin to improve in a developing country.
Capital formation or inducement to invest depends on the propensity to save. In less-developed
countries, there is a very low saving tendency because of low income. Developed countries
managed to save 20% of their output in capital formation. Whereas only 5% of the national income is
saved in UDCs. Much of the savings goes to housing and basic needs and, therefore, a very small
amount is left over for development.
Capital formation is the basic tool for economic development. It may take decades to invest in
building up a country‘s infrastructure, information technologies, power-generating plants, and other
capital goods industries. Developing countries must have to build up their infrastructure, or social
overhead capital in order to set path for economic glory.
If there are so many obstacles in finding domestic savings for capital formation, then the country
depends on foreign sources of funds. Less-developed countries have to welcomed the flow of
foreign capital or foreign borrowings. As long as the exports of these countries grew at the same rate
as borrowings, it is a favourable condition. But several poor countries needed all their earnings
simply to pay interest on their foreign debts. This is an adverse situation. Such countries need to
boost up their production in order to cope with their current indebtedness.
3. Capital-output ratio: Apart from the ratio of capital formation to the aggregate national income,
the growth of output depends upon the capital-output ratio. The capital-output ratio may be defined
as the relationship of investment in a given economy or industry for a given time period to the output
of that economy or industry for a similar time period. The productivity of capital depends on many
factors such as the degree of technological development associated with capital investment, the
efficiency of handling new types of equipment, the quality of managerial and organisation skill, the
existence and the extent of the utilisation of economic overheads and the pattern and rate of
investment. For instance, the higher the proportion of investment devoted to the production of direct
commodities, the lower the capital-output ratio, and higher the proportion of investment devoted to
public utilities, i.e., economic and social overheads, the higher shall be the capital-output ratio, and
vice versa. Higher the investment devoted to heavy industry, the higher will be the capital-output
ratio, and vice versa. Higher the rate of investment and greater the technological progress, the lower
will be the capital-output ratio. The capital-output ratio also varies with the prices of inputs.
4. Technological progress: The key to economic development for any country is the technological
progress. Greater the technological progress, the higher will be the economic progress. The great
importance of technological progress in the economic progress of Western European countries was
recognised by Karl Marx himself. The technological progress of a country includes development in
research and development, means of transportation, telecommunication, energy-generation, oil and
gas exploration, information technologies, integrated circuits manufacturing, etc. Again, without
capital formation, the technological progress is impossible, because building huge hi-tech industries
requires a huge investment and a favourable economic condition.
5. Dynamic entrepreneurship: The modern economists recognise the dynamic role of
entrepreneurs in promoting the economic growth of the country. The efficient utilisation of
entrepreneurial skills can only be ensured when there is presence of considerable profit motive. The
entrepreneur maximises his profit by making innovations, i.e., by bringing out a new product, new
technologies, new product lines, new market, new sources of raw materials and by adopting an
optimum combination of factors of production. Thus he is making the most significant contribution in
the national income and in the technological progress.
The private enterprises in UDCs like India and Pakistan, has not taken them any far on the road of
economic development. There is a lacking of entrepreneurial skills in under-developed countries.
There is a lack of innovation. Entrepreneurs are more attracted by commerce than by industries. So
it becomes the government‘s duty to ensure the supply of required type of entrepreneurship.
6. Human Resources: Besides efficient entrepreneurs, the economic development of a country
depends on the supply of skilled and semi-skilled labour, and requires government‘s greatest
contribution to the development of human resources. The development of human resources depends
on the availability of hygienic food; quantity and quality of education centres and health centres; clean
water; means of transportation and communication; entertainment; counselling services; loan
facilities; scholarship; job security and old age benefits; etc.
In poor countries GDP rises but at the same time the population also grows. Several developing
countries are facing high birth rates with stagnant national income per head. It is hard for poor
countries to overcome poverty with birth rates so high. In under-developed countries, the economic
planners emphasise the following specific programmes:
(a) Control disease and improve health and nutrition,
(b) Improve education, reduce illiteracy and train workers, and
(c) Ensure that the labour force is well-equipped with necessary and competing skills.
7. Rate of growth of population: The size and rate of population growth has an important bearing
on the economic development of a country. A rapidly growing population aggravates the food
problem, worsens the unemployment situation, adds to the number of unproductive consumers,
keeps down per capita income and labour efficiency, and militates against capital formation. A rapid
rate of population growth acts like a drag on economic development and slows down the pace of
8. Price Mechanism: In under-developed economies, a very little emphasis is placed on price
mechanism. The disequilibrium of prices has severe consequences on the efficiency of the
economy. The resource utilisation becomes lack of optimality. The productive machinery of the
community is hampered. There is no guarantee as regard to the quantity and quality of the
In order to speed up the economic development, price mechanism must go or confined to
unimportant sectors of the economy like the purchase and sale of consumer goods.
9. Non-economic factors: Non-economic factors include social factors, demographical factors,
institutional factors and political factors. The economic development depends on the political
sovereignty, the complexion and competence of government, quality of administration, and political
ideology of government.
Vicious Cycle of Poverty
Many developing countries are caught up in vicious cycle of poverty. Low level of income prevents
savings, retards capital growth, hinders productivity growth, and keeps income low. Successful
development may require taking steps to break up the chain at many points. Other points in poverty
are also self-reinforcing. Poverty is accompanied by low levels of education, literacy and skill; these
in turn prevent the adaptation to new and improved technologies and lead to rapid population growth.
The vicious cycle of poverty is depicted as below:
Overcoming the barriers of poverty often requires a concentrated effort on many fronts and a ‗big-
push‘ is required to break the ‗vicious cycle‘ into ‗virtuous circle‘. If the country has stepped to invest
more, improve health and education, develop labour skills, and curb population growth, she can
break vicious cycle of poverty and stimulate a virtuous circle of rapid economic growth.
Approaches to Economic Development
The following approaches are developed in recent years to explain the economic development and
answer the question how countries break out of the vicious cycle of poverty to virtuous circle of
1. The Take-off Approach: Take-off is one of the stages of economic growth. Different economies
have been benefited from ‗take-off‘ approach in different periods, including England at the beginning
of eighteenth century, the United States at the mid of nineteenth century, and Japan in early twentieth
century. The take-off is impelled by leading sectors such as a rapid growing export market or an
industry displaying large economies of scale. Once these leading sectors begin to flourish, a process
of self-sustained growth (i.e. take-off) occurs. Growth leads to profits, profit are reinvested, capital,
productivity and per capita income spur ahead. The virtuous cycle of economic development is under
2. The Backwardness Hypothesis and Convergence: The second approach emphasises the
global context of economic development. Poor countries have important advantages that the
pioneers of industrialisation had not. Developing nations can draw upon the capital, skills and
technologies of advanced countries. Developing countries can buy modern textile machinery,
efficient pumps, miracle seeds, chemical fertilisers and medical supplies. Because they can lean on
the technologies of advanced countries. Today‘s developing nations can grow more rapidly than
Great Britain, Western European Countries and United States in past. By drawing upon more
productive technologies of the leaders, the developing countries would expect to see convergence
towards the technological frontier.
3. Balanced Growth: Some writers suggest that growth is a balanced process with countries
progressing steadily ahead. In their view, economic development resembles the tortoise making
continual progress, rather than the hare, who runs in spurts and then rats when exhausted. Simon
Kuznets examined the history of thirteen advanced countries and conceived that the balanced
growth model is most consistent with the countries he studied. He noticed no significant rise or fall in
economic growth as development progressed.
Note one further important difference between these approaches. The ‗take-off‘ theory suggests that
there will be increasing divergence among countries (some flying rapidly, while others are unable to
leave the ground). The ‗backward‘ hypothesis suggests ‗convergence‘, while the ‗balanced-growth‘
model suggests roughly ‗constant‘ differentials. In the following diagrams, advanced countries are
represented by curve A, middle income countries by curve B and low-income countries by curve C.
The curves show per capita income:
Strategies of Economic Development
Following are the strategies commonly applied in economic planning:
1. Balanced vs. Unbalanced Growth: Currently there are two major schools of thoughts regarding
the process of growth, i.e., balanced growth strategy and unbalanced growth strategy:
(a) Balanced Growth Strategy: Economists like Ragnar Nurkse and Rosenstsein-Rodan
strongly advocate balanced growth strategy. According to them, the pattern of investment
should be so designed as to ensure a balanced development of the various sectors of the
economy. They advocate simultaneous investment in a number of industries so that there
is a balanced growth of different industries.
(b) Unbalanced Growth Strategy: Economists like H.W. Singer and A.O. Hirschman, on the
other side, believe that rapid economic growth follows ‗concentration‘ of investment in
certain strategic industries rather than an even distribution of investment among the
various industries. In the view of these economists, unbalanced growth is more conducive
in economic development than a balanced one.
2. Big-Push Strategy: The big-push strategy is associated with the name of Rosenstein-Roden
and Harvey Leibenstein. It is contended that a big-push is needed to overcome the initial inertia of a
stranger economy. Rosenstein-Roden observes that there is a minimum level of resources that must
be devoted to a development programme if it is to have any chance of success. Launching a country
into self-sustaining growth is like getting an airplane off the ground. There is critical ground speed
which must be passed before the craft can become airborne.
3. Balanced, Unbalanced and Big-Push (BUB) Strategy: The advocates of this strategy suggest
that no single strategy will take us to the goal of economic development. Not only has the strategy to
be changed from time to time as the situation may require, but it may be necessary sometimes to
strike a balance between the alternative strategies. In the initial stage, which is characterised by
unbalances, counter-unbalance strategy is to be adopted. But once an appropriate balance is
attained by a fair dose of big-push, the strategy of balanced growth may be applied to further
Issues in Economic Development
Following are the important issues in under developed countries:
1. Industrialisation vs. Agriculture: In most countries, incomes in urban areas are almost more
than double in rural areas. Many nations jump to the conclusion that industrialisation is the cause
rather than effect of affluence. To accelerate industrialisation at the expense of agriculture has led
many analysis to rethink the role of farming. Industrialisation tends to be capital intensive, attract
workers into crowded cities, and often produces high level of unemployment. Rising productivity on
farms may require less capital, while providing productive for surplus labour.
2. Inward vs. Outward Orientation: This is a fundamental issue of economic development towards
international trade. Should the developing countries be self-sufficient? If yes, the country has to
replace imported goods and services with domestic production. This strategy is known as „import
substitution‟ or „inward orientation‟.
If the country decides to pay for imports it needs by improving efficiency and competitiveness,
developing foreign markets, and giving incentives for exporters. This is called „outward orientation‟
strategy. It is generally observed that by subsidising import substitution, competition is limited,
innovation is dampened, productivity growth is slow down and country‘s real income falls to a lower
level. Whereas, the outward orientation sets up a system of incentives that stimulates exports. This
approach maintains a competitive FOREX rate, encourages exports, and minimises unnecessary
government regulation of businesses esp. small and medium sized firms.
3. State vs. Market: The cultures of many developing countries are hostile to the operation of
markets. Often competition among firms or profit seeking behaviour is contrary to traditional
practices, religious beliefs, or vested interest. Yet decades of experience suggest that extensive
reliance on markets provides the most effective way of managing an economy and promoting rapid
The government has a vital role in establishing and maintaining a healthy economic environment. It
must ensure law and order, enforce contracts, and orient its regulations towards competition and
innovation. The government plays a leading role in investment in human capital through education,
health and transportation, but the government should minimise its intervention or control in sectors
where it has no comparative advantage. Government, should focus its efforts on areas where there
are clear signs of market failure.
Models of Economic Growth
Classical Model of Economic Growth
Every nation strives after development. Economic progress is an essential component, but it is not
the only component. Economic development is not purely an economic phenomenon. In an ultimate
sense, it must encompass more than the material and financial side of people‘s lives. Economic
development should therefore be perceived as a multidimensional process involving the
reorganization and reorientation of entire economic and social systems. In addition to improvements
in incomes and output, it typically involves radical changes in institutional, social, and administrative
structures. Finally, although development is usually defined in a national context, its widespread
realization may necessitate fundamental modification of the international economic and social system
The classical theories of economic development consist of following four schools of thought:
1. Linear-stages-of-growth model: Theorists of the 1950s and 1960s viewed the process of
development as a series of successive stages of economic growth through which all countries must
pass. It was primarily an economic theory of development in which the right quantity and mixture of
saving, investment, and foreign aid were all that was necessary to enable developing nations to
proceed along an economic growth path that historically had been followed by the more developed
countries. Development thus became synonymous with rapid, aggregate economic growth.
This linear-stages approach was largely replaced in the 1970s by two competing economic schools of
thought – theories of structural change and international-dependence theories.
2. Theories and patterns of structural change: Theories and patterns of structural change uses
modern economic theory and statistical analysis in an attempt to portray the internal process of
structural change that a ―typical ‖developing country must undergo if it is to succeed in generating
and sustaining a process of rapid economic growth.
Structural-change theory focuses on the mechanism by which under-developed economies transform
their domestic economic structures from a heavy emphasis on traditional subsistence agriculture to a
more modern, more urbanised, and more industrially diverse manufacturing and service economy. It
employs the tools of neo-classical price and resource allocation theory and modern econometrics to
describe how this transformation process takes place. Two well-known representative examples of
the structural-change approach are the ‗two-sector surplus labour‘ theoretical model of Sir W. Arthur
Lewis, and the ‗patterns of development‘ empirical analysis of Hollis B. Chenery and his co-authors.
3. International-dependence revolution: The international-dependence revolution was more radical
and political in orientation. It viewed underdevelopment in terms of international and domestic power
relationships, institutional and structural economic rigidities, and the resulting proliferation of dual
economies and dual societies both within and among the nations of the world. Dependence theories
tended to emphasize external and internal institutional and political constraints on economic
development. Emphasis was placed on the need for major new policies to eradicate poverty, to
provide more diversified employment opportunities, and to reduce income inequalities.
International-dependence models view developing countries as troubled by institutional, political, and
economic rigidities, both domestic and international, and caught up in a dependence and dominance
relationship with rich countries. Within this general approach there are three major streams of
thought – the neo-colonial dependence model, the false-paradigm model, and the dualistic-
4. Neoclassical or free-market counterrevolution: This theory is also known as neo-liberal theory.
Throughout of the 1980s and 1990s, the neoclassical or free-market counterrevolution approach
prevailed. It emphasizes the beneficial role of free markets, open economies, and the privatisation of
inefficient public enterprises. Failure to develop, according to this theory, is not due to exploitive
internal and external forces as expounded by dependence theorists. Rather, it is primarily the result
of too much government intervention and regulation of the economy.
In the 1980s, the political ascendancy of conservative governments in the United States, Canada,
Britain, and West Germany brought a neoclassical counterrevolution in economic theory and policy.
In developed nations, this counterrevolution favoured supply-side macroeconomic policies, rational
expectations theories, and the privatisation of public corporations. In developing countries it called
for freer markets and the dismantling of public ownership, central planning, and government
regulation of economic activities. Neo-classicists obtained controlling votes on the boards of the
world‘s two most powerful international financial agencies — the World Bank and the International
Monetary Fund. In conjunction and with the simultaneous erosion of influence of organizations such
as the International Labour Organization (ILO), the United Nations Development Program (UNDP),
and the United Nations Conference on Trade and Development (UNCTAD), which more fully
represent the views of LDC delegates.
The neo-classical approach states that underdevelopment arises from:
Poor resource allocation due to incorrect price policies, and
Government‘s intervention in the economic activities.
Neo-classical or neo-liberal approach states that economic growth can be put to spur by:
Permitting competitive free markets to flourish,
Privatising state-owned enterprises,
Promoting free trade and export expansions,
Welcoming investors from developed economies, and
Eliminating the plethora of government regulations and price distortions in factor, product and
1. Linear-stages-of-growth model:
Following are the growth models studied under linear-stages:
(a) Rostow’s Stages of Growth: The stages-of-growth model of development is taken by
most of the newly independent countries. According to Walt W. Rostow doctrine, the transition
from underdevelopment to development can be described in terms of a series of steps or
stages through which all countries must proceed. According to Rostow, it is possible to
identify all societies, in their economic dimensions, as lying within one of five categories:
The traditional society,
The pre-conditions to take-off into self-sustaining growth,
The drive to maturity, and
The age of high mass-consumption.
Rostow also clarified that these stages are not merely a way of generalising certain factual
observations about the sequence of development of modern societies. He argued that the
advanced countries had all passed the stage of take-off into self-sustaining growth and the
under-developed countries that were still in either the traditional society or the pre-conditions
stage. One of the principal strategies of development necessary for any take-off was the
mobilisation of domestic and foreign saving in order to generate sufficient investment to
accelerate economic growth.
(b) Harrod-Domar Model: This model, developed independently by RF Harrod and ED
Domar in the l930s, suggests savings provide the funds which are borrowed for investment
The model suggests that the economy's rate of growth depends on:
the level of saving
the productivity of investment i.e. the capital output ratio
For example, if $10 worth of capital equipment produces each $1 of annual output, a capital-
output ratio of 10 to 1 exists. A 3 to 1 capital-output ratio indicates that only $3 of capital is
required to produce each $1 of output annually.
The Harrod-Domar model was developed to help analyse the business cycle. However, it was
later adapted to 'explain' economic growth.
2. Structural-change theory:
Following economic growth model represents the structural-change theory:
(a) Lewis Theory of Development: It is one of the best-known early theoretical models of
economic development that focused on the structural transformation of a primarily subsistence
economy was that formulated by Noble-prize winner Sir W. Arthur Lewis in the mid 1950s. His
theory was later modified by his followers. The Lewis two-sector economy model became the
general theory of the development process in surplus-labour Third-World nations during most
of the 1960s and 1970s. In the Lewis model, the underdeveloped economy consists of two
A traditional, overpopulated rural subsistence sector characterised by zero-marginal
labour productivity. Lewis classify this as ‗surplus-labour‘ in the sense that it can be
withdrawn from the agricultural sector without any loss of output, and
A high, productivity modern urban industrial sector into which labour from the
subsistence sector is gradually transferred.
The primary focus of the model is on both the process of labour transfer and the growth of
output and employment in the modern sector. Both labour transfer and modern-sector
employment growth are brought about by output expansion in that sector.
(b) Patterns of Development: The patterns of development analysis of structural change
focuses on the sequential process through which the economic, industrial and institutional
structure of an underdeveloped economy is transformed over time to permit new industries to
replace traditional agriculture as the engine of economic growth.
In addition to the accumulation of capital both physical and human, a set of interrelated
changes in the economic structure of a country are required for the transition from a traditional
economic system to a modern one.
These structural changes involve virtually all economic functions, including the transformation
of production and changes in the composition of consumer demand, international trade and
resource use as well as changes in socio-economic factors such as urbanisation, and the
growth and distribution of a country‘s population.
3. International-dependence revolution:
Within this general approach, there are three major streams of thought:
(a) Neo-Colonial Dependence Model: It is an indirect outgrowth of Marxist thinking. It refers
to the existence and continuance of underdevelopment in a highly unequal international
capitalist system. The international system is dominated by unequal power relationships
between the centre (the developed nations) and the periphery (the less developed countries).
The poor nations attempt to become self-reliant and independent but this system makes it
difficult and sometimes even impossible.
According to this theory, certain groups in the developing countries (including landlords,
entrepreneurs, military rulers, merchants, salaried public officials, and trade union leaders)
who enjoy high incomes, social status, and political power constitute a small elite ruling class
whose principal interests are in perpetuation of the international capitalist system of inequality.
Directly and indirectly, they serve (are dominated by)and are rewarded by (are dependent on)
international special-interest power groups including multinational corporations, national
bilateral-aid agencies, and multilateral assistance organizations like the World Bank or the
International Monetary Fund (IMF). Therefore, a major restructuring of the world capitalist
system is required to free dependent developing nations from the direct and indirect economic
control of their developed-world and domestic oppressors.
Curiously, a very similar but obviously non-Marxist perspective statement was expounded by
Pope John Paul II in his widely quoted 1988 encyclical letter:
“One must denounce the existence of economic, financial, and social mechanisms which,
although they are manipulated by people, often function almost automatically, thus
accentuating the situation of wealth for some and poverty for the rest. These mechanisms,
which are manoeuvred directly or indirectly by the more developed countries, by their very
functioning, favour the interests of the people manipulating them. But in the end they
suffocate or condition the economies of the less developed countries.”
(b) False-Paradigm Model: The second and less radical international-dependence approach
to development, the false-paradigm model, attributes underdevelopment to faulty and
inappropriate advice provided by well-meaning but often uninformed, biased, and ethnocentric
international ‗expert‘ advisers from developed-country assistance agencies and multinational
donor organizations. These experts offer sophisticated concepts, elegant theoretical
structures, and complex econometric models of development that often lead to inappropriate
or incorrect policies. Because of institutional factors such as the central and remarkably
resilient role of traditional social structures (i.e., tribe, caste, class, etc.), the highly unequal
ownership of land and other property rights, the disproportionate control by local elites over
domestic and international financial assets, and the very unequal access to credit, these
policies, based as they often are on mainstream, Lewis-type surplus labour or Chenery-type
structural-change models, in many cases merely serve the vested interests of existing power
groups, both domestic and international.
(c) Dualistic Development Thesis: Dualism is a concept widely discussed in development
economics. It represents the existence and persistence of increasing divergences between
rich and poor nations and rich and poor peoples on various levels. One of the elements of
dualism is that there is a coexistence of wealthy, highly educated elites with masses of
illiterate poor people within the same country or city. According to this theory, there is a
coexistence of powerful and wealthy industrialized nations with weak, impoverished peasant
societies in the international economy.
This coexistence is chronic and not merely transitional. It is not due to a temporary
phenomenon, in which with the capacity of time, the discrepancy between superior and inferior
elements would be eliminated.
4. Neo-classical counterrevolution:
This approach can be implemented through the following three models:
(a) Free-Market Analysis: Free-market analysis argues that markets alone are efficient if:
Product markets provide the best signals for investments in new activities,
Labour markets respond to these new industries in appropriate ways,
Producers know best what to produce and how to produce it efficiently, and
Product and factor prices reflect accurate scarcity values of goods and resources.
Under free-market, competition is effective not necessarily perfect. Technology is freely
available and nearly costless to absorb. Information is correct and nearly costless to obtain.
(b) Public-Choice Theory: Public-choice theory, also known as „new political economy
approach‟, goes even further to argue that government can do nothing right. This is because
that politicians, bureaucrats, citizens and states act solely from a self-interested perspective,
using their powers and the authority of government for their own selfish needs. Citizens use
political influence to obtain special benefits (sometimes also referred to as „rent‟) from
government policies, for example, import licenses, or rationed forex. Politicians use
government resources to consolidate and maintain positions of power and authority.
Bureaucrats use their positions to extract bribes from rent-seeking citizens and to operate
protected business on the side. And finally state uses its power to confiscate private property
from individuals. The net result is not only a misallocation of resources but also a general
reduction in individual freedoms. The conclusion, therefore, is that minimal government is the
(c) Market-Friendly Approach: The third approach is market-friendly approach, which is the
most recent variant on the neoclassical counterrevolution. It is associated principally with the
writings of the World Bank and its economists, many of whom were more in the free-market
and public-choice camps during the 1980s. This approach recognizes that there are many
imperfections in LDC product and factor markets and that governments do have a key role to
play in facilitating the operation of markets through ‗non-selective‘ (market-friendly)
interventions — for example, by investing in physical and social infrastructure, health care
facilities, and educational institutions and by providing a suitable climate for private enterprise.
Karl Marx’s Model
Czarist Russia grew rapidly from 1880 to 1914; it was considerably less developed than industrialised
countries like US and Great Britain. World War I brought great hardship to Russia and allowed the
communists to seize power. From 1917 to 1933, the Soviet Union experimented with different
socialist models before settling on central planning. Most economists believed until recently that the
Soviet Union grew rapidly from 1928 until the mid 1960s. After the mid 1960s, growth in Soviet Union
stagnated and output actually began to decline. In the late 1980s and early 1990s, open inflation
erupted. Prices were well below market-clearing levels and acute shortages arose in what is called
„repressed inflation‟. The repressive political system was unacceptable to the people in Soviet Union
and some countries in Eastern Europe and was universally rejected in 1989.
The father of this repressive political system – Communism is Karl Marx (1818 – 1883). The
centrepiece of Marx‘s work is an incisive analysis of the strengths and weaknesses of capitalism. He
argued that it is the only labour power that gives value to a commodity. By imputing all the value of
output to labour, Marx hoped to show that profits, which is the part of output that is produced by
workers but received by capitalists, amount to „unearned income‟. According to Marx, this unearned
income is unjustly received by capitalists. This injustice can be eliminated by transferring the
ownership of factories and other means of production from capitalists to workers.
Marx saw capitalism as inevitably leading to Socialism. In Marx‘s world, technology enables
capitalists to replace workers with machinery as a means of earning greater profits. As a result
unemployment increases with the increased use of technological advances. This increasing
accumulation of capital will reduce the rate of profit and investment opportunities, and therefore, the
ruling capitalists will become imperialists. Karl Marx believed that the capitalist system could not
continue this unbalanced growth. Marx predicted increasing inequality under capitalism. Business
cycles would become ever more violent as mass poverty resulted in macro-economic under-
consumption. Finally, a cataclysmic depression would sound the death knell of capitalism. The
economic interpretation of history is one of Marx‘s lasting contributions to Western thought. Marx
argued that economic interests lie behind and determine our values. His arguments against
capitalism suggested communism would arise in the most highly developed industrial countries.
Instead, it was backward, feudal Russia that adopted the Marxist vision.
Features of Karl Marx’s Socialist Model:
1. Government ownership of productive resources,
2. Planning is centralised,
3. Equal distribution of income,
4. Peaceful and democratic evolution,
5. Labour theory of value – value of a product represents the human labour used in production,
6. Theory of surplus value.
Theory of Surplus Value:
Marx propounded his theory of surplus value on the basis of his theory of value. He said that in order
to enable labour to carry on the work of production, he should have some instruments of production
and other facilities but he lacks these facilities. Hence, he has to sell his labour to the capitalist. It is,
however, not necessary for the capitalist to pay labour the full value of the product produced by him.
Here Karl Marx supported his theory on the basis of a classical theory, viz., the subsistence theory of
value, according to which the level of wages is determined by the subsistence of the worker. The
work of labour force is not merely to produce value equal to its price but much more. This surplus
value is the difference between the market value of the commodity and the cost of the factors used in
the production of commodity. Karl Marx says that the manufacturer gets for his commodity more than
what he has spent on labour and other costs. The excess of market value over the costs is the
surplus value. This surplus is created because labour is paid much less than is due to it. He
characterises the appropriation of the surplus value by the capitalist as robbery and exploitation. The
capitalist class goes on becoming richer and richer through exploitation of the working class.
Harrod Domar Growth Model
As we know that one of the principal strategies of development is mobilisation of domestic and
foreign saving in order to generate sufficient investment to accelerate economic growth. The
economic mechanism by which more investment leads to more growth can be described in terms of
Harrod-Domar growth model, often referred to as the AK model.
Every economy must save a certain proportion of the national income, if only to replace worn-out or
impaired capital goods (buildings, equipment, and materials). However, in order to grow, new
investments representing net additions to the capital stock are necessary. If we assume that there is
some direct economic relationship between the size of the total capital stock, K, and total GNP, Y –
for example, if $3 of capital is always necessary to produce a $1 stream of GNP – it follows that any
net additions to the capital stock in the forms of new investment will bring about corresponding
increases in the follow of national output, GNP. This relationship is known as „capital-output ratio‟
and is represented as „k‟. in the above case „k‟ is roughly 3:1.
If we further assume that the national savings ratio „S‟ is a fixed proportion of national output (e.g.
6%) and that total new investment is determined by the level of total savings. We can construct the
following simple model of economic growth:
· Saving (S) is some proportion, s, of national income (Y) such that we have the simple
S = s .Y ---------------------------- (i)
· Net investment (I) is defined as the change in the capital stock, K, and can be represented
by ΔK such that:
I = ΔK ----------------------------- (ii)
But because the total capital stock, K, bears a direct relationship to total national income or output,
Y, as expressed by the capital-output ratio, k, it follows that:
K = k
ΔK = k
ΔK = k.ΔY ------------------------------- (iii)>
· Finally, because net national savings, S, must equal net investment, I, we can write this
S = I ------------------------------- (iv)
But from equations (i), (ii) and (iii), we finally get the following equation:
I = ΔK = k. ΔY
Therefore, we can rewrite the equation (iv) as follows:
S = s.Y = k.ΔY = ΔK = I --------------- (v)
s.Y = k.ΔY -----------------------------------(vi)
Dividing both the sides of equation (vi) first Y and then by k, we obtain the following expression:
ΔY = s -------------------------------------- (vii)
Note that the left-hand side of the equation i.e., ΔY / Y represents the rate of change or rate of
growth in GNP (i.e., the percentage change in GNP).
The Harrod Domar Model, more specifically says that in the absence of government, the growth rate
of national income will directly or positively related to the savings ratio (i.e., the more an economy is
able to save and invest out of a given GNP, the greater the growth of that GNP will be. Harrod
Domar Model further states that the growth rate of national income will be inversely or negatively
related to the economic capital-output ratio (i.e., the higher k is, the lower the rate of GNP growth will
The additional output can be obtained from an additional unit of investment and it can be measured
by the inverse of the capital-output ratio, k, because this inverse, 1 / k, is simply the output-capital or
output-investment ratio. It follows that multiplying the rate of new investment, s = I / Y, by its
productivity, 1 / k, will give the rate by which national income or GNP will increase.
For example, the national capital-output ratio in an under-developed country is, let say, 3 and the
aggregate saving ratio (s) is 6% of GNP, it follows that this country can grow at a rate of 2% (i.e., 6%
/ 3 or s / k or ΔY / Y). Now suppose that the national saving rate increased from 6% to 15%
through increased taxes, foreign aids, and / or general consumption sacrifices – GNP growth can be
transferred from 2% to 5% (15% / 3).
According to Rostow and other theorists, the countries that were able to save 15% to 20% of GNP
could grow at a much faster rate than those that saved less. Moreover, this growth would then be
self-sustained. The mechanisms of economic growth and development, therefore, are simply a
matter of increasing national savings and investment.
The main obstacle or constraint on development, according to this theory, was the relatively low level
of new capital formation in most poor countries. But if a country wanted to grow at, let say, a rate of
7% per annum and if it could not generate savings and investment at a rate of 21% (i.e., 7% × 3) of
national income but could not only manage to save 15%, it could seek to fill this saving gap of 6%
through either foreign aid or private foreign investment.
Limitations of the model:
1. Economic growth and economic development are not the same. Economic growth is a
necessary but not sufficient condition for development
2. Harrod Domar model was formulated primarily to protect the developed countries from chronic
unemployment, and was not meant for developing countries.
3. Practically it is difficult to stimulate the level of domestic savings particularly in the case of
LDCs where incomes are low.
4. It fails to address the nature of unemployment exists in different countries. In developed
countries, the unemployment is ‗cyclical unemployment‘, which is due to insufficient effective
demand; whereas in developing countries, there is ‗disguised unemployment‘.
5. Borrowing from overseas to fill the gap caused by insufficient savings causes debt repayment
6. The law of diminishing returns would suggest that as investment increases the productivity of
the capital will diminish and the capital to output ratio rise.
The Harrod-Domar model of economic growth cannot be rejected on the ground of above limitations.
With slight modifications and reinterpretations, it can be made to furnish suitable guidelines even for
the developing economies.
Schumpeter’s Model of Economic Growth
Joseph Schumpeter was a famous Austro-Hungarian economist, but never followed Austrian school
of thought. His famous book was the Theory of Economic Development (1912), in which he first
outlined his famous ‗theory of entrepreneurship‘. He argued that only daring entrepreneurs can create
technical and financial innovations in the face of competition and falling profits, and that it was these
spurts of activity which generated economic growth. After the World War I, Schumpeter joined the
German Socialization Committee in Berlin - which then was composed of several Marxian scholars,
and the Kiel School economists.
In 1919, Schumpeter became the Austrian Minister of Finance - unfortunately, presiding over the
hyperinflation of the period, and thus was dismissed later that year. Schumpeter migrated in 1921 to
the private sector and became the president of a small Viennese banking house. Ill luck dogged him:
his bank collapsed in 1924. He drifted once again back into academia - taking up a teaching position
at Bonn in 1925. In 1932, Schumpeter took up a position at Harvard, succeeding the Marshallian
F.W. Taussig. Schumpeter ruled Harvard during the period of the ‗depression generation‘ of the
1930s and 1940s - when Samuelson, Tobin, Heilbroner, and Bergson were his students. His famous
publications include Theory of Economic Development (1912), Business Cycles (1939), Capitalism,
Socialism and Democracy (1942) and History of Economic Analysis (1954). He presented the theory
of entrepreneurship, theory of business cycles, and theory of evolutionary economics.
In order to understand the Schumpeter‘s theory of economic development, it is necessary to
understand the theory of evolutionary economics. The concept of evolution is an offspring of late
18th and early 19th century debates within philosophy and the social sciences. The theory of
evolutionary economics is much more inspired by the Darwinian theory of natural selection. The
general definition of evolution is the self-transformation process over time of a system. Such a
system may be a population of living organisms, a collection of interacting individuals as in an
economy or some of its parts, or even the set of ideas produced by the human mind. Therefore, an
evolutionary theory is:
Dynamic — such that the dynamics of the processes, or some of their parts, can be
Historical — in that it deals with historical processes which are irrevocable and path-
Self-transformation — in that it includes hypotheses relating to the source and driving force of
the self-transformation of the system.
Schumpeter‘s theory of economic development is considered as a radical theory. It is considered
radical in the context that it described the capitalist system as an evolutionary system. According to
Schumpeter, capitalism is the system that internally generates changes and technological
progresses. According to him, the process of economic development is inherently dynamic, as
opposite to static nature of the theory of equilibrium. This does not mean that Schumpeter is against
the theory of equilibrium. On the contrary it is the underlying base for his own capitalist dynamic
Schumpeter‘s model of economic development is not a substitute for the theory of equilibrium but
rather a necessary complement. Without it, it is impossible to understand the functioning of an
economic system. Schumpeter started through the ‗circular flow‘ as an essential block for building
dynamic model. Schumpeter describes the circular flow with the following assumptions:
somewhere in the economic system a demand is ready awaiting every supply, and
nowhere in the system are there commodities without complements.
Under these conditions, all goods find a market, and the circular flow of economic life is closed. In a
steady state, costs in this closed system are the price totals of the services of the production factors.
Prices obtained for the products must equal these price totals. The ultimate logical consequence of
this ideal model of the clearing market is that production must flow on essentially profitless – profit is
a symptom of imperfection.
Schumpeter defines production as the combinations of materials and forces that are within our reach.
The producer is not an inventor. All components that he needs for his product or service, whether
physical or immaterial, already exist and are in most cases also readily available. The basic driving
force behind structural economic growth is the introduction of new combinations of materials and
forces, not the creation of new possibilities.
Development in the Schumpeterian sense is defined by the carrying out of new combinations. This
concept covers the following five cases:
(i) The introduction of a new good – that is one with which consumers are not yet familiar –
or a new quality of a good.
(ii) The introduction of a new method of production – that is one not yet tested.
(iii) The opening of a new market – that is a market into which the country in question has not
(iv) The conquest of a new source of supply of raw materials or half-manufactured goods.
(v) The carrying out of the new organisation of any industry, like the breaking up of a
The basic structure from Schumpeter‘s model of economic development has two distinctive spheres.
On the one hand is the semi-closed system of the circular flow that is either in equilibrium or striving
for it. And, on the other hand, is the symbiotic pair of the entrepreneur and the sponsor that is always
looking for ways to induce change in the peaceful yet boring routine-life of the circular flow. Both
spheres function within an endless reservoir of new combinations, for example, scientific knowledge
and technological inventions, but it is only the entrepreneur – backed by the capitalist – who is able to
introduce new combinations and new routines in the circular flow.
According to Schumpeter, entrepreneur who initiates the process of innovation is the central of the
process of economic development. Entrepreneurs are neither capitalists nor inventors; they see the
potential of inventions and assume risk in innovating. Schumpeter regarded the entrepreneur as
something of a social deviant and noted that migrants or aliens in any society have great potential to
behave entrepreneurially. Schumpeter noted that increases of taxes, public policies favouring labour
organisations, price controls, and licensing requirements that increase the costs of doing business
are the greatest impediments to entrepreneurship. Under oppressive conditions, for example, the
former Soviet Union, China, and present day Islamic societies, very few people innovate.
The creation of something new usually requires that something old be eliminated, for example,
changes in the structure of demand or production result in structural unemployment. Economic
growth cannot proceed without structural changes, i.e., economic development. Most technological
progress is a result of activity specifically undertaken to develop new products, reduce costs, improve
quality, or develop new markets.
Economic evolution is based on cyclical disruptions and breaks of economic structures, an
endogenous transformation that results from the ‗process of creative destruction‘ as an essential
feature of modern capitalism. This points at the internal logic of the cyclical restructuring of modern
capitalism for evolutionary change.
Business cycle refers to regular fluctuations in economic activity. In the 19th century, business
cycles were not thought of as cycles at all but rather as spells of "crises" interrupting the smooth
development of the economy. In later years, economists and non- economists alike began believing
in the regularity of such crises, analysing how they were spaced apart and associated with changing
economic structures. Schumpeter divided a business cycle into four process – boom, recession,
depression and recovery. He also classified the business cycles in the following classes:
(a) Seasonal cycles – for a year
(b) Kitchin cycles – covering a period of 3 years
(c) Juglar cycles – covering a period of 10 years
(d) Kuznets cycles – covering a period of 15 to 20 years
(e) Kondratiev cycles – covering a period of 48 to 60 years, for example, Industrial Revolution
(1787 – 1842), Bourgeois Kondratiev (1843 – 1897), and Neo-Mercantilist Kondratiev (1898 –
1950) with the expansion of electric power and the automobile industry.
Economic Planning in Pakistan
History of Economic Planning in Pakistan
The history of national economic planning in Pakistan is divided in the following periods:
1. Period of economic coordination (1947-53)
2. Period of planning board (1953-58)
3. Period of Planning Commission (1958-68)
4. Period of decline of Planning Commission (1968-77)
5. Period of revival of Planning Commission (1978-88)
6. Period of (1988-98)
7. Period of restructuring of economy (1999-todate)
1. Period of economic coordination (1947 – 1953): Pakistan‘s first planning board was
established in 1950 with main emphasis on agriculture. Unfortunately, that plan was not well
implemented on time. There were no targets fixed for the plan and the planning machinery
was so weak to tackle with implementation. Therefore, the economic planning efforts during
this period was a complete failure.
2. Period of planning board (1953 – 1958): The planning board of Pakistan was renamed as
Planning Commission in 1953. The planning commission was facing the following serious
Shortage of trained staff,
Non-availability of accurate and reliable data,
Uncertain conditions in the planning machinery
It was regarded as a rivalry between Ministry of Finance and the State Bank of Pakistan
Annual economic planning was never seriously followed
Most of the economic advices were rejected by implementing authorities
Economic priorities were not given due importance
Budget decisions were also distorted
During this period, the First Five-Year Plan was made. Its implementation suffered due to
rapid changes in government and a lack of political support.
3. Period of planning commission (1958 – 1968): The third period of the planning process
began in October 1958 with the assumption of power by the military government of Ayub
Khan. The new regime chooses to make economic development through a marked economy
and reliance of the private sector as its primary objective. The new government gave proper
attention to achieve the following targets:
Rapid industrialisation in the country,
Removal of food shortage,
Removal of political instability, and
To overcome the problem of deficit of balance of payment.
The status of the Planning Commission was raised to a Division in the President‘s secretariat.
The President himself assumed the chairmanship of the Planning Commission and Deputy
Chairman, with the ex-officio status of a minister, was made the operational head of the
Commission. Provincial planning department was organised. The Planning Commission was
also provided the secretariat for National Economic Council (NEC) which looked after the day-
to-day work of NEC and was also responsible for final approval for annual development.
During this period the Second Five-Year Plan (1960-65) was made. It was so successful that
Pakistan led to an example for hunger nations of the world. But unfortunately Pakistan had to
fight war against India in 1965. Then there was a hue and cry against Ayub government and
another government got the power.
4. Period of decline of planning commission (1968 – 1977): This is the period of decline of
Planning Commission as an important decision-making body coincided with the fall of Ayub
Khan‘s government. During the Yahya Khan period (1969 – 1971), the serious planning on
national level was completely ignored. The Third Five-Year Plan (1965 – 1970) was virtually
abandoned by the Yahya Khan‘s government. In 1970, the Fourth Five-Year Plan (1970 –
1975) was made and it was also a big failure because of the worst political conditions and
instable government policies. In 1972, the newly elected government of Z. A. Bhutto decided
to run the economy through annual planning, rather than through a comprehensive five-year
plan. During the same year, the Planning Commission was placed directly under the control of
Ministry of Finance as a Division. During the period from 1972 to 1977, the Planning
Commission, with very less powers, have very few favourable economic decisions. In other
words, the Planning Commission was powerless and ineffective.
5. Period of revival of planning commission (1978 – 1988): After taking charge of the
government, the Zia-ul-Haq‘s regime emphasised on the needs of five-year plans. In early
1980s, the Zia government took steps to revive the Planning Commission as an effective and
authoritative economic decision-making body.
During this period, two Five-Year Plans were formulated, i.e., Fifth and Sixth. In 1978, the
Fifth Five-Year Plan to cover the period of 1978 – 1983 was published. But the Government
failed to pursue the plan mainly because of uncertain political as well as economic conditions
at that time. The Sixth Five-Year Plan was formulated in 1983 to cover the period 1983 –
1988. At that time, Dr. Mahbub-ul-Haq was the Finance Minister. He formulated the plan and
because of his great efforts, this plan was a success. During his tenure, the Planning
Commission has played a vital role in effectively formulating and implementing the economic
planning. Not only the Sixth Five-Year Plan, but also the annual plans were formulated by the
6. The period of (1988 – 1999): The period of 1988 to 1999 the period of political and economic
instability. During this period, four elected governments were dismissed by the President on
the charges of corruption. The role of Planning Commission was over-shadowed by political
decisions. Its role was just limited to the preparation and submission of reports. It has nothing
to do with the implementation of planning.
The Seventh Five-Year Plan was formulated during the Zia-ul-Haq period. But after his death,
in 1988, the newly elected government of Benazir Bhutto took over the charge and so the
Seventh Five-Year Plan has never been implemented. After the fall of Benazir‘s government
in 1990, Nawaz Sharif‘s government came into power. During his tenure, he introduced
privatisation, deregulation, and economic reform aimed at reducing structural impediments to
sound economic development. His top priority was to denationalise some 115 public industrial
enterprises, abolishing the government's monopoly in the financial sector, and selling utilities
to private interests. Although the Nawaz Sharif government made considerable progress in
liberalising the economy, but it failed to address the problem of a growing budget deficit, which
in turn led to a loss of confidence in the government on the part of foreign aid donors. In 1993,
the Nawaz Sharif government was dismissed by the President on the charges of corruption. In
the parliamentary elections of 1993, Benazir Bhutto, once again, became the Prime Minister of
Pakistan. Meanwhile, the so-called Seventh Five-Year Plan period came to an end. In 1994,
the Planning Commission publish the Eighth Five-Year Plan to cover the period 1993 – 1998.
In November 1996, once again, the PPP government was dismissed by the President on
corruption charges. The parliamentary election was held in 1997 and, once again, Mian
Nawaz Sharif elected as the Prime Minister of Pakistan. The targets of Eighth Five-Year Plan
were also not well achieved. For example, the target of wheat was set at 18.3 million tons
which could not be achieved by 1996-97 when its actual production was 16.6 million tons. It
was achieved in the last year of the plan but it again slipped down to 17.8 million tons in the
following year. Similarly the target of non-traditional oilseeds, grape and mustard was set at
0.4 million tons which was far below the national requirements. Likewise, the projected plan
period target of agricultural credit of Rs 80.5 billion could not be achieved as the maximum
credit given during the plan period was Rs 37.7 billion and most of which went to the influential
feudal lords and politicians rather than to the common farmers. The Ninth Five-Year Plan was
formulated by Nawaz Sharif government to cover the period 1998-2003. Following were the
priorities of Ninth Five-Year Plan:
(a) Maintenance of fiscal deficit at a sustainable level,
(b) Maintenance of GDP growth at 7% p.a.
(c) Investment in physical infrastructure,
(d) Export-led industrialisation,
(e) End of agriculture-water dichotomy,
(f) Developing a civil society, etc.
7. Period of restructuring of economy (1999 – to date): In October 1999, the Nawaz Sharif
government was dismissed with the military coup by the Chief of Army Staff, General Pervez
Musharraf. The entire country was in a state of jeopardy. Before that, the businessmen have
already lost their confidence due to economic instability with the Nuclear Test, freezing of
foreign currency accounts, devaluation of rupee, and the Kargil War in 1998. Therefore, the
targets of Ninth Five-Year Plan were never been well implemented.
The era of General Pervez Musharraf is known as the era of economic and political
restructuring. During this era, the economy grew at an average growth rate of 5.1% (started
from 2.6% in 2000-01 to 8.4% in 2004-05). President General Pervez Musharraf invited Mr.
Shaukat Aziz to take charge of the Ministry of Finance in November 1999. He very quickly
assembled a team of highly trained economists and extremely talented civil servants. To
address the issue of the severe macroeconomic crisis and place the economy on a path of
sustained higher growth, financial stability, and improved external balance of payments, the
economic team launched a comprehensive set of economic stabilization and structural reform
measures. The government believed that macroeconomic stability was vital for achieving
higher and sustained economic growth, creating employment opportunities and preventing
people from falling below the poverty line. It is with this view that a series of structural reform
measures were initiated in such areas as privatisation and deregulation, trade liberalization,
banking sector reform, capital market reform, tax system and tax administration reform,
agriculture sector reform etc. As a result, Pakistan‘s economy started showing signs of
improvement by 2000-01 well before 9/11. Manufacturing sector grew 11% in 2000-01 against
3.6% in 1998-99, revenue collection increased to Rs. 396 billion against Rs. 308 billion, debt
servicing declined from 64% to 57% of total revenue, export increased from $ 7.8 billion to $
9.2 billion. These are undeniable facts and well documented in official publications. These
improvements had taken place much before 9/11.
The present economic team under the stewardship of Shaukat Aziz has not only salvaged a
near bankrupt economy but has put it on a path of sustained high growth with financial stability
and considerably improved external balance of payments. Much has been done in the past
five years. The country has witnessed a decline in poverty and an improvement in social
indicators. The recent up-gradation of Pakistan in the Human Development Index of the UNDP
is a vindication of the policies pursued by the government in the last five years.
In 2005, the Government authorised the Planning Commission to issue the Tenth Five-Year
Plan namely ‘Medium Term Development Framework 2005-10’. The Medium Term
Development Framework (MTDF) 2005-10 has been conceived in the light of recent socio-
economic performance of the country, continuing supportive public policies and challenges
and opportunities emerging from the global economy. Wide-ranging economic and financial
reforms have made the economy open, liberalised and market friendly. As a result, private
sector has begun to play an active role in shaping structural changes in the economy. The
principal objective of the MTDF is to attain high growth of 8.2 percent by the terminal year
2009-10 with a sustained annual average growth of 7.6 percent during the five-year period
without compromising macroeconomic stability. The second key objective is to achieve higher
level of investment to meet the targeted growth and to effectively address the perennial issues
of poverty reduction, employment generation, better access to basic necessities of life
including quality education and skill development for up grading the human resources, better
health and environment for the common man. The third crucial objective is to attract foreign
investment to a level required to become a fast growing economy like Malaysia. Last but not
the least, the MTDF will focus on growth which is just and equitable.
The plan has also anticipated the share of manufacturing sector in GDP to increase from
18.3% in 2004-05 to 21.9% in 2009-10. It is also anticipated that the production base would
be expanded through the development of engineering goods, electronics, chemicals and other
hi-tech industries. The Government is also anticipating fastest growth of IT/Telecom sector.
Pakistan has seen an explosive growth in IT/Telecom sector in the last few years. The
number of mobile phones achieved their 2007 targets two years earlier, and the recent
deregulation of LDI, WLL and other sections have served to provide faster, better and wider
coverage, all at lower cost. Nearly 60,000 IT professionals are operating in the country with an
annual turnover of Rs. 12 billion of which 15% is exported. The plan has also estimated that
our major exports (gross) will increase from Rs. 14.05 billion in 2004-05 to Rs. 28.12 billion in
The MTDF projects a rising growth rate for the agriculture sector from 4.8% in 2005-06 to
5.6% in the last year of the plan, i.e., 2009-10. The production of meat (beef, mutton, poultry
meat) will increase from 2,275 thousand tonnes in 2004-05 to 3,124 thousand tonnes in 2009-
10, and milk production from 29,472 thousand tonnes in 2004-05 to 43,304 thousand tonnes in
The production of fisheries is projected at an average annual growth rate of 4.8 per cent. The
fish production will increase from 574 thousand tonnes in 2004-05 to 725 thousand tonnes in
Planning Machinery in Pakistan
Following are the planning agencies in Pakistan:
National Economic Council (NEC):
The planning machinery in Pakistan is headed by the NEC as the supreme policy making body in the
economic sphere. It has the President as the Chairman and all Federal Ministers, incharge of
development ministries and provincial governors as members. In addition, a number of other
persons are invited to attend the meetings of the NEC as and when the agenda relates to matters
Functions of NEC:
(a) To review the overall economic situation in the country
(b) To formulate plans with respect to financial, commercial and economic policies and economic
(c) To approve the Five-Year Plans (MTDF), the Annual Development Plans (ADP), provincial
development schemes in the public sector above a certain financial limit and all non-profit
It may appoint committees or bodies of experts as may be necessary to assist the council in the
performance of its functions. NEC discusses different cases and makes decisions. To ensure
implementation of the decisions, the secretary of each Ministry is expected to keep a record of all the
decisions conveyed to him and to watch the progress of action until it is completed. The Cabinet
Secretary is also expected to watch the implementation of the council decisions.
Executive Committee of NEC (ECNEC):
The body directly below the NEC is the ECNEC. It is headed by the Federal Minister for Finance,
Planning and Development. Its members include all Federal Ministers incharge of development
ministries, provincial governors or their nominees and provincial ministers, incharge of planning and
(a) To set up development schemes (both in the public and private sectors) pending their
submission to the NEC.
(b) To allow moderate changes in the plan and sectoral adjustments within the overall plan
(c) To supervise the implementation of economic policies laid down by the Cabinet and the NEC.
Annual Plan Coordination Committee (APCC):
Another body concerned with economic policy is the APCC which is a purely advisory body
responsible for advising the Cabinet and the NEC regarding the coordination of policies. It is headed
by the Secretary General, Finance, Planning and Economic Coordination. All federal secretaries of
development ministries, heads of provincial planning and development departments and heads of the
State Bank, the Board of Industrial Management and PIDC are its members.
Central Development Working Party (CDWP):
Below ECNEC is the CDWP which is responsible for the scrutiny and sanction of development
projects. The Secretary, Planning Division, is the president of CDWP. Its members include federal
secretaries of the concerned departments, federal finance secretary and chairman of the provincial
planning and development departments.
The development schemes of federal ministers costing over Rs. 10 million and of the provincial
governments costing over Rs. 50 million are submitted to CDWP for approval.
The responsibility for the overall economic evaluation of Annual Plans remains with the Planning
Division which places a report each year before the NEC evaluating economic achievements and
failures. Mid-Plan reviews outlining the progress of the Five Year Plan are also published by the
A Critical Appraisal of Planning Machinery in Pakistan
Following are main hindrances in the way of effective planning in Pakistan:
(a) Administrative obstacles of planning: One major obstacle which has stood in the way of
establishing a sound, efficient and independent planning authority is the lack of an effective
administrative machinery as this has greatly limited the tasks of development policy and planning.
Some of the factors which still continue to be major hindrances and act as administrative
obstacles and bottlenecks to planning are discussed below:
(i) Lack of competent personnel: One of the major obstacles in the way of an effective
planning machinery is the lack of competent personnel. Good and highly qualified
economists, technicians, planners, etc. do not join government service because of lack
salaries and facilities.
(ii) Dilatory procedures: In Pakistan, documents and files must follow a prescribed series
of steps through administrative layers. It has been pointed out that often there seems to be
a disposition to shift the file and documents from one office to another, or from one ministry
to another. The resultant delays are sometimes unbelievably long.
(iii) Lack of coordination: In many cases, the coordination of development activities has
been extremely difficult because responsibility for different aspects of a project or
programme are divided among many ministries and agencies. So it becomes, sometimes,
very difficult to carry on programme according to policy.
(b) Inadequate preparatory work on projects: When a potentially desirable project has to be
identified, a feasibility study has to be made to determine whether it is practicable and justified. A
feasibility study involves a detailed examination of the economic, technical, financial, commercial
and organisational aspects of a project.
According to Planning Commission of Pakistan, preparatory work on public projects in the country
was frequently lacking. So due to inadequate preparatory work on projects, our plans have been
failed in achieving their targets.
(c) Lack of implementation of plans: A major reason for the lack of implementation of the
country‘s various five year plans has been the widespread failure of the governments of the day to
maintain discipline, implicit in their plan. What is planned and what is done in many cases bears
little relationship to each other. At times it almost appears that plans are prepared by a planning
agency in one corner of a government and policy is made by various bodies in other corners.
(d) Lack of evaluation of plan progress and project implementation: Flexibility is an essential
element of development planning because in many cases changes in economic conditions make
deviations from original plan unavoidable. A central planning agency must, therefore, constantly
review and assess progress in relation to events.
Unfortunately, whenever evaluation has been prepared by the country‘s planning authorities, they
have been issued long after the end of the period to which they refer. In many cases the mid-term
reviews of five year plans have been published almost near the end of the plan period and the
final reviews of the plan have come long after the new plan have been launched and, therefore,
been of little use to formulating targets and policies for the new plan. The need for a good
reporting system on plan and project implementation is, therefore, an essential prerequisite for a
good evaluation system.
An Operational Approach to Plan/Project Appraisal
A development plan is essentially a forward looking policy framework which envisages a concrete
and prioritised but somewhat flexible programme of action to be launched in a dynamic situation to
attain specified economic and social objectives. A plan or a programme / project is ultimately as
good as its implementation since it is the actual achievement of the results in line with the targets and
not merely the targets set or the resources allocated that determine the degree of success or failure
of the plan / programme as well as its impact on the socio-economic life of the people. Thus, it is
clear that only the technically, financially and economically sound and viable projects, if properly
executed in a coordinated manner, can provide a strong edifice for the successful implementation of
Most of the developing countries still need to further evolve their development planning processes by
redefining their national objectives and searching for alternative strategies, programmes and projects
because it has been realised by most of them by now that the development planning adopted so far
could not achieve the desired results especially in the areas of social development and income
distribution. Recent international experience also shows conclusively that the formulation of
technically sound, economically viable and administratively feasible programmes / projects, their
proper appraisal, implementation and management are amongst the palpably weaker areas of
development planning. In numerous instances, projects included in the development plans have
either not been optimally implemented or even if implemented, have failed to yield the expected
results on time. Similarly, such other factors like deliberate under-estimating of costs and over-
pitching of targets at the approval stage, coupled with recent increase in input prices, have adversely
affected the overall plan implementation in most of the LDCs.
In recent years, increasing attention is being devoted to more systematic processes of planning and
decision making as a means of addressing the concerns of developing countries about the pace and
pattern of economic growth, the failure to achieve planned objectives, and the continuing financial
and economic crises. This approach has reinforced the case for greater depth in and a more
systematic and inter-related approach to the monitoring, evaluation and follow-up of all public policy
actions. This renewed urge is shared both by national as well as international agencies in order to
up-grade the developing countries‘ status.
The United Nations International Development Strategy (UNIDS), therefore, emphasises that, to
provide increasing opportunities to all people for a better life, it is essential in the development
planning to bring about more equitable distribution of income and wealth for promoting both social
justice and efficiency of production, to raise substantially the level of employment, to achieve a
greater degree of income security, to expand and improve facilities for education, health, nutrition,
housing and social welfare, and to safeguard the environment. The International Development
Strategy emphasises the importance of national evaluation system. According to UNIDS, every
developing country is needed to establish a reliable and independent evaluation machinery or
strengthening the existing one, in order to ensure the implementation of development programmes.
Plan Preparation and Implementation Cycle:
The process of development appraisal and performance evaluation is an intrinsic component of
planning. The standard plan preparation and plan implementation cycle includes:
(a) Establishment of goals, objectives and targets;
(b) Formulation of strategies;
(c) Formulation of operating plans composed of policies and specific measures necessary to
achieve the real targets;
(d) Implementation of policies and measures to the plan;
(e) Monitoring and evaluation of performance (both financial and physical) against targets;
(f) Adjustment of targets and/or plans as may be indicated by actual accomplishments and
It can thus be summed up that the success of the whole process of planning, implementation,
monitoring and evaluation rests upon the very first step of „identifying and specifying clearly the real
objectives and targets‟.
There are two types of resource channels:
(a) Revenue Receipts: Revenue receipts can be bifurcated into:
(i) Tax Revenues, and
(ii) Non-Tax Revenues.
(b) Capital Receipts: Capital receipts can be classified into:
(i) External Borrowings, and
(ii) Internal Non-Bank Borrowings.
There are two ways through which resources can be mobilised. They are:
(a) Internal Resources: Resources can be mobilised internally by two methods. They are:
(i) Voluntary Savings: The task of voluntary savings is a crucial one. This can be done
through moral suasion and active government participation. The government should
provide necessary incentives to increase the savings through various policies
programmes. The government should develop its financial sector so that it can act as
an efficient instrument for mobilising resources.
(ii) Involuntary Savings: Involuntary savings refer to the system of mobilising resources
through tax revenues and non-tax revenues:
Tax Revenues: Taxation system occupies the most important place in the socio-
economic aspect of a country to mobilise the internal resources. The resources so
obtained are then channelised for development purposes by the government.
Pakistan has imposed various types of direct and indirect taxes for raising revenues.
These include custom duties, excise duties, estate duty, income tax, corporate tax,
taxes on sales and purchases, terminal taxes and surcharges, etc. Tax revenues
are ‗revenue receipts‘.
Non-Tax Revenues: Non-tax sources of revenues for the Federal Government
are state trading profits, earnings of commercial departments like post office,
telegraph and telephone, interest charges on loans to provincial governments, local
bodies, etc., whereas for the provincial governments, they include irrigation charges
and forests, etc.
(b) External Resources: The external resources include grants, loans and foreign aid of various
types. Since the internal resources are inadequate to meet the government expenditures, we
have to rely heavily on foreign assistance. For this purpose, we have been taking loans from
IMF, IBRD, ADB and various developed countries.
How to Increase the Rate of Capital Formation:
A country can increase its capital formation through its own domestic saving and by inflows of capital
from abroad. Following are the ways to increase net capital formation as a percentage of national
(a) Capital Imports: We can increase the capital formation with the pain of reducing current
consumption, by capital inflows from abroad or exploitation of idle resources.
(b) Moral Suasion: The government should convince the people to save more. Sound national
economic management, coupled with a social security system, might make people less
insecure about economic emergencies, so that they may invest more in productive activity.
(c) Improvement to the Tax System: Saving is unconsumed current production. Taxation is one
form of saving. Improving the tax system increases saving. There should be emphasis on
direct taxes, taxes on luxuries and sales taxes.
(d) Increasing Investment Opportunities: Government subsidies, tariffs, loans, training
facilities, technical and managerial help and construction of infrastructure may increase saving
because prospective entrepreneurs perceive higher investment returns.
(e) Redistribution of Income: The government can encourage particular sectors and economic
groups by its tax, subsidy and industrial policies. It can redistribute income to persons with a
high propensity to save or stimulate output in sectors with the most growth potential and in
which saving and taxation are high.
(f) Local Financing of Social Investment: Local government can levy taxes, that Federal
Government cannot if the funds are used to finance schools, roads or other social overhead
projects that clearly benefit local residents.
(g) Inflationary Financing: The banking system can provide credit and the treasury can print
money to loan to those with high rates of saving and productive investment. Creating new
money, although inflationary, increases the proportion of resources available to high savers,
so that real capital formation rises.
(h) Foreign Inflow of Capital: The foreign investors from developed countries are also invited to
invest in the country. Moreover, the foreign aid and assistance are also obtained from
developed countries and international financial institutions such as IMF, World Bank, ADB,
Islamic Bank, Paris Club, EU, etc.
Foreign Aid and Its Role in Economic Development
Definition of Foreign Aid:
Foreign Aid occurs when the recipient country receives additional resources in foreign currency over
and above the capacity to import generated by exports. In simple words, foreign aid means those
additional resources which are used to raise the performance of the recipient country above the
existing level. It can be defined as the debt which is given by a country to another country on the
concessional rates. The concessional elements may be:
(a) Lower rates of interest than the prevailing rate of interest in the international commercial
(b) Longer period for repayments.
(c) Grants which does not entail the payment of other principal or interest, i.e., a free gift.
A country which gives loan is called donor and the country which receives the loan is called recipient
Types of Foreign Aid:
There are two types of foreign aid, according to their source:
(a) Bilateral Aid: Bilateral aid is the aid which is given from the government of the donor country
to the recipient country. It depends upon political and economic relationships of various
countries and it also depends on the will of donor country.
(b) Multilateral Aid: Multilateral aid is the aid given by certain financial institutions, agencies or
organisations to the government of developing country. It is distributed in a fair manner in
order to raise the pace of economic development. So it is better than bilateral aid which is
given on the basis of political considerations and the fear of the domination of a donor country
is also removed in the case of multilateral aid which may be helpful in raising the pace of
Forms of Foreign Aid:
Following are the forms of foreign aid:
(a) Financial Aid: The simplest form of capital inflow is the provision of convertible foreign
exchange, but very little foreign capital indeed comes to the underdeveloped world so
conveniently. Financial aid is further divided into various sub-forms, i.e.:
(i) Tied Aid: Tied aid is of two types:
Nation Tied Aid: is given to the recipient country on the condition that she
will spend it in the donor country to solve the BOP problems of that country and
to stimulate exports, i.e., if Pakistan is given aid by US and is asked to import
raw materials or machinery from US only then it is ‗nation tied aid‘ or ‗resource
Project Tied Aid: is given only for specific projects and the recipient country
cannot shift it to other projects.
(ii) Untied Aid: Untied aid is the aid which is not tied to any project or nation. It is, in all
respects, better than the tied aid because it offers more efficient use of foreign resources. It
is much desired because in the case of untied aid the recipient country is not bound to
spend the foreign resources on specific projects or in the donor country which may charge
higher prices than international market.
(iii) Grants: A grant is that form of foreign aid which does not entail either the payment of
principal or interest. It is a free gift from one government to another or from an institution to
a government. It is much desired because it increases the internal expenditures and
generates income. It is given on the basis of humanitarianism, especially in days of
emergencies, earth quakes, floods, wars, etc.
(iv) Loans: It is the borrowing of foreign exchange by the poor country from the rich country to
finance short-term or long-term projects. They are further sub-divided into two types:
Hard Loans: Hard loans are also called short-term loans. In order to finance
industrial imports they are given usually for a period less than five years, and they
are paid in the currency borrowed. It contains no concessional element but interest
rate is usually lower than the prevailing rate of interest in the international market.
Soft Loans: Soft loans are also known as long-term loans. Soft loans are
made for 10-20 years and it is repaid in the currency of recipient country. Interest
on these loans is lesser than hard loans and often these loans invoice grace period.
Concessional elements are comparatively greater.
(b) Commodity Aid: Commodity aid, in fact, is another type of tied aid, which relates to
agriculture products, raw materials and consumer goods. Under commodity aid, the donor
country has much political influence on the recipient country, for example, in 1960s, US gave
wheat to Pakistan under PL-480 and had much influence on the development policy of
Pakistan. Commodity aid may be received in cash form or in the form of food grains:
(i) In Cash Form: If it is received in cash form it may be more helpful because then a
country may buy more commodities from cheaper sources.
(ii) In Food Grain Form: It is a special type of commodity aid, which is given in the form of
food grains only, for example, US gives food grains to the poor country under Public
Law (PL-480) and funds obtained from it are used on American companies and
agencies operating in the recipient countries. The rest of the aid is granted.
(c) Food Aid: There is more than enough food produced each year to feed adequately everyone
on earth. However, food is so unevenly distributed that malnutrition and hunger exist in the
same country or region where food is abundant.
During 1960s, the United States sold a sizable fraction of its agricultural exports under a
concessionary Public Law 480, where LDC recipients could pay for the exports in inconvertible
currency over a long period. During late 1970s, about three-quarters of the food aid went to
low-income countries. It was about one-third of their cereal imports. Projections indicate that
food deficits are likely to increase in the 1980s and 1990s. In the early 1980s, the United
States, which provides the bulk of total food aid, reduced its food assistance.
Critics of food aid argue that it increases dependence, promotes waste, does not reach the
most needy and dampens local food production. Nevertheless, the food aid has frequently
been highly effective. It plays a vital role in saving human lives during famine or crisis, and if
distributed selectively, reduces malnutrition. Unfortunately, poor transport, storage,
administrative services, distribution networks and overall economic complex hinder the
success of food aid programmes, but the concept itself is not at fault.
(d) Technical Aid: Technical aid is another form of tied aid and is much useful for the recipient
country to increase the pace of economic development by using the modern technology or skill
in some specific sectors of the economy. Under this aid programme, training facilities are
provided by the donor country‘s government and it bears all the expenditures involved in the
training of advisory technocrats. Technical assistance from the donor‘s point of view takes two
(i) Through Recruitment: Technical assistance may be given through recruitment.
Selected people of recipient country are recruited in the donor country for service
overseas, partly, often largely, at the expense of the donor government.
(ii) Through Scholarships & Training Facilities: The second form of technical assistance
is scholarship and training facilities in donor country for foreign students (from recipient
(e) Foreign Direct Investment (FDI): It is also included in the category of foreign aid. In
Pakistan, the examples of FDI are Lever Brothers, Reckitt and Colman, Bata, Philips, etc. It is
often argued that FDI should be run under strict control, like licensing, annual auditing,
compulsory treatment of foreign capital as domestic capital, etc.
(f) Double Tied Aid: It is also known as ‗procurement tied aid‘. It is the aid which is tied both for
projects as well as for resources.
Types of Foreign Aid to Pakistan:
The foreign aid received by Pakistan can be categorised as follows:
(a) Project Assistance: The large bulk of foreign aid received by Pakistan has been in the form
of project assistance which is tied in most cases, to both source and utilisation. Project aid is
a type of aid allocated for particular development ventures like irrigation projects or large
industrial and communication networks which require a substantial imported component.
Besides the imported component, there is also a local finance component of a particular
project which has to be covered by raising the necessary resources domestically. Once the
domestic component of the project has been raised, the government has to open a special
account for the project and withdrawals from the account are possible only after the approval
of Aid Mission of the donor countries or agencies.
(b) Commodity Assistance: Commodity assistance, the second largest component amongst the
different types of aid received by Pakistan, has allowed some degree of flexibility to the
country by not being tied to utilisation although in most cases it is tied to sources. It is for this
reason that Pakistan has preferred commodity over project assistance. However, commodity
assistance as a ratio of total aid decreased from 34% in 1960-65 to 23% in 1979-80.
(c) Food Aid under PL 480: The third largest component of aid received by Pakistan is
commodity assistance under PL 480 provided by USA through the sale of surplus agricultural
commodities. These commodities, ranging from wheat to edible oil, have been purchased by
Pakistan Government from US Government and were paid for Pakistani rupee till 1967 and in
rupee and dollars after 1967. The funds generated by the sale of these surplus agricultural
commodities are then deposited in a special counterpart fund controlled by US Government
through its Aid Mission to Pakistan. The allocation of these funds, termed as aid, between
different activities has been prerogative of the US Government.
(d) Technical Assistance: This type of foreign aid is of great significance to Pakistan, because in
Pakistan, there is a shortage of technical knowledge, entrepreneurial skill and skilled labour.
This type of foreign aid helps in increasing the intangible value of our skill and semi-skill labour
in particular projects, for example, construction of sea ports, dams and other water projects,
fly-overs, highways, motorways, underground railway system, high rise buildings, etc.
However, as these foreign experts are paid much higher salaries than what a local person of
the same qualification can expect to receive, the real value of technical assistance can be
reduced with obvious resentment amongst local experts.
Need of Foreign Aid:
The principal economic arguments advanced in support of foreign aid are as follows:
(a) Foreign Exchange Constraints: External finance (both loans and grants) can play a critical
role in supplementing domestic resources in order to relieve savings or foreign-exchange
bottlenecks. This is the familiar ‗two-gap‘ analysis of foreign assistance, which will be briefly
discussed later in this chapter.
(b) Growth and Savings: External assistance also is assumed to facilitate and accelerate the
process of development by generating additional domestic savings as a result of the higher
growth rates that it is presumed to induce. Eventually, it is hoped, the need for concessional
aid will disappear as local resources become sufficient to give the development process a self-
(c) Technical Assistance: Financial assistance needs to be supplemented by ‗technical
assistance‘ in the form of high-level manpower transfers to assure that aid funds are most
efficiently utilised to generate economic growth. This manpower gap filling process is thus
analogous to the financial gap filling process.
(d) Absorptive Capacity: Finally, the amount of aid is determined by the recipient country‘s
absorptive capacity. Typically, the donor countries decide which LDCs are to receive aid, how
much, in what form (i.e. loans or grants, financial or technical assistance), for what purpose
and what conditions on the basis of their assessment of LDCs absorptive capacity.
Criticism on Foreign Aid:
The following criticism has been forwarded on foreign aid:
(a) According to critics, foreign aid does not promote faster growth but may in fact retard it by
substituting for, rather than supplementing, domestic savings and investment and by
exacerbating LDCs balance of payments deficits as a result of rising debt repayment
obligations and the linking of aid to donor country exports.
(b) The foreign aid is generally focused on and stimulates the growth of modern sector,
thereby increasing the gap in living standards between the rich and the poor in Third World
countries. Rather then relieving economic bottlenecks and filling gaps, aid, and for that matter
private foreign investment, not only widens existing savings and foreign exchange resource
gaps but may even create new ones (e.g. urban rural or modern traditional sectors gaps).
(c) If the aid given is concerned with unproductive fields or obsolete technology, it will have the
effect of increasing the inflation in the country.
(d) The biggest objection which is imposed on foreign aid is that donor countries make
interference in the economic and political activities of the recipient country. The recipient
country has to devise its economic policies in accordance with the wishes of donor countries
or international financial institutions.
The two-gap model was presented by Hollis Chenery and A. Strout as an approach to economic
development. According to them, most of the developing countries faced either:
a shortage of domestic savings to match investment opportunities (i.e. the saving gap
or constraint), or
a shortage of foreign exchange to finance needed imports of capital and intermediate
goods (i.e. foreign exchange gap or constraint).
They also further assume that the savings and foreign exchange gaps are „unequal‟ in magnitude and
that they are mutually „independent‟. In other words, there is no substitutability between savings and
foreign exchange, which is an unreal assumption.
In an economy where the demand of investment cannot be met entirely by domestically generated
savings nor through imports financed by the country‘s own export earnings, resources are transferred
from abroad in the form of either loans, credits, grants, remittances, or direct private foreign
investment. This is the traditional ‗two-gap‘ or dual approach to the analysis of the role of foreign aid
in economic development where foreign resources are assumed to fill both a saving-investment gap
as well as a foreign exchange gap in the recipient country. According to the assumptions of the two
gap model, foreign aid, given an MPS, raises the level of domestic savings by raising the level of
income and exports with the result that at some terminal date, foreign inflows are reduced to zero.
According to this model, a country passes through three stages on its way to self-sustained growth:
(a) In the first stage, the dominant constraint is that of absorptive capacity, i.e. the economy is
so primitive and backward that it cannot invest beneficially the minimum amount, i.e. 15% or
so, necessary to achieve the required rate of growth let say 5 to 6%. The purpose of foreign
aid at this stage is to increase the absorptive capacity of the country by providing technical
assistance, training, education, managerial ability, entrepreneurial talent and so on. Once the
absorptive capacity of the economy has increase sufficiently, the constraint on growth is that of
(b) The second stage is the stage where there is a saving constraint on the economy. A
country, like Pakistan, with a low level of income and a large proportion of its population at
subsistence level can hardly be expected to save 15-20% of its national income. The
suggested way out is that foreign aid may be used to supplement domestic savings and fill the
gap between domestic savings and the investment required for a reasonable level of growth.
During this stage, the saving gap will be greater than trade gap, and there may be some deficit
BOP and high inflation as well.
(c) The third stage is the stage of trade constraint. As the economy grows, more and more
inputs are required in the form of capital goods, industrial raw materials, etc. Exports cannot
keep pace with increasing imports and the resultant difference between the two becomes
larger and larger until it exceeds the difference between domestic savings and the required
savings. Therefore, at this stage, the trade gap is said to be dominant and the foreign aid is
now required to bridge this gap. However, at this stage, there is less need of foreign aid and
assistance, because as the economy develops further rising levels of income result in an
increase in savings as a proportion of national income until the required level is attained and
the saving gap is closed. Also as development proceeds, first import substitution of consumer
goods, then their export and import substitution of capital goods takes place with the result that
exports grow faster than the imports and ultimately catch up with them and hence the trade
gap is also filled. With the filling of this gap, the need for foreign aid and assistance is now
Foreign Aid to Pakistan:
Before discussing the foreign capital inflow in Pakistan, it is important to distinguish between pledges,
commitments, disbursement and utilisation of aid. These terms are frequently used to describe the
various stages through which foreign aid passes before being utilised in the recipient country. A
pledge is a promise by the donor country to advance a specified amount of foreign aid, commitment
implies the allocation of foreign aid by the donor for specific projects or programmes, disbursement of
aid means the transfer of resources from donor to the recipient, and utilisation implies the actual
implementation of foreign aid financed projects.
Pakistan, like many other developing countries, has been relying on foreign assistance to supplement
national saving to finance investment. In order to bridge the resource gap, it started foreign
borrowing as early as 1950s.
Over the years, there has been a continuous decline in the aid inflows to Pakistan. Net transfer
which constituted about 90% of the gross disbursements in 1964-65 dropped to 56% in 1977-78 and
50% in 1979-80.
In the early periods greater proportion of aid was received as grant or grant like aid or assistance.
This type of assistance was gradually reduced and its place was taken by hard terms foreign loans
and credits repayable in foreign exchange with strict terms and conditions such as tied aid and other
The share of grants and grants like assistance in total commitments was 80% during the first plan
which was reduced to 46% during the second plan, 31% during third plan and came to as low as 12%
during non-plan period. Moreover, its share increased slightly to above 20% during the fifth and sixth
five year plan periods mainly due to relief assistance for Afghan refugees.
Pakistan’s Debt Servicing:
By subtracting the annual debt servicing (repayment of principal and interest) from gross aid, we
deduce the net foreign aid which is available to the recipient country for financing its imports and
The annual debt servicing charges shown in official statistics are net of relief provided in the form of a
moratorium. A moratorium on debt means the postponement of the annual debt servicing obligations
till some later time which no doubt provides temporary relief to a foreign exchange crisis-ridden
country. But since the debt has to eventually be repaid, a moratorium only delays, by increasing its
foreign exchange earnings, would at some later stage be in a position to fulfil its debt servicing
Pakistan's debt situation reached unsustainable level by 1999 because of persistence of large fiscal
and current account deficits during the last two decades. The ‗twin deficits‘ resulted in an explosive
accumulation of both domestic and external debt. Domestic debt grew at an average annual rate of
almost 28 % during the first half of the 80's; 22 % during the second half and 16 % during the first
nine years of the 90's. In other words; Pakistan's total external debt and foreign exchange liabilities
which stood at $ 9 billion in 1980-81, reached almost $ 22 billion by the end of the 80's and by 97-98
touched a high figure of $ 42.7 billion.
The stock of public debt stood at Rs 155 billion by end of the 1970's and by end of the 80's another
Rs 646 billion was added which caused public debt to rise at Rs 801 billion. But by end of the 90's,
another Rs 2430 billion was added to the public debt, which stood at Rs 3231 billion. The absolute
number of public debt is not much of interest. What is more damaging is the burden of the public
debt, which means as percentage of GDP or total revenue. At the end of 70's, the public debt was 56
% of GDP or 317 % of total revenue. It rose to 92 % of GDP or 505 % of the revenue by the end of
the 80's. It was over 100 % of GDP and 630 % of the revenues by the end of the 90's. By any
standard, this was horrifying number for any country. It was horrifying because almost two-third of the
revenues were consumed for debt servicing alone which forced the government to cut Public Sector
Development Programme (PSDP).
The various composition of expenditure also continued to change over the years. The share of
defence in total expenditure was 24 % in 1980-81 while interest payment accounted for only 9 % and
development budget was 41 % of total expenditure. By the end of 1980's, defence spending
increased marginally to 26 % from 24 % in beginning of 80's. The share of interest payments more
than doubled during this period from 9 % to 21 %. Development spending continued to shrink from 41
% to 25 %. In other words, interest payment was taking over development expenditure in the country.
As Pakistan entered the decade of the 90's the composition of expenditure continued to deteriorate.
Interest payments increased further to 33 % of total expenditure by the end of the 90's, while
development spending decline to 13 % and defence spending also shrank to 20 % .The onslaught of
rising interest payments continued to crowd out not only development spending but defence spending
With President‘s Musharraf‘s policies, Pakistan has rescued the worst economic situation, but still
there are lot of improvements needed in the economy, especially in manufacturing sector and energy
sector. The economy is now more stable. Interest payment has started declining, it was as high as
Rs 240 billion in 1999-2000 and declined to Rs 210 billion in 2003-04. Interest payments were
drastically reduced to 22.4 % from 33 % in the past. Most importantly public debt as percentage of
GDP, which was over 100 % a few years back, has declined to 91 %. Similarly public debt has
percentage of total revenue which was as high as 633 % has come down to 516 %. Most importantly,
the external debt and foreign exchange liabilities have declined from $38 billion to $35 billion.
Pakistan's external debt and liabilities to foreign exchange reserves ratio was 22 times in 1998-99 but
with the decline in debts and increase in foreign exchange reserves, the ratio declined sharply to 2.8
times in six years.
(All figures in billion rupees)
Particulars 2000-01 2001- 2002-03
External Debt 2059.5 2005.6 1927.7
Total Debt Servicing 340.3 431.2 304.7
Total Debt as % of GDP 113.5 104.3 95.1
External Debt as % of GDP 60.2 55.3 48.0
Ratio of External Debt Servicing to:
Export Earnings 38.0 44.8 28.8
Foreign Exchange Earnings 23.7 26.5 16.0
Ratio of Total Debt Servicing to:
Tax Revenues 77.1 90.2 55.1
Total Revenues 61.5 69.1 43.2
Total Expenditure 47.4 52.2 34.1
Current Expenditure 52.7 61.6 41.8
Pakistan’s Earthquake Disaster and the Role of Foreign Aid
An earthquake of 7.6 magnitude struck Pakistan, India, and Afghanistan, on October 8, 2005. The
epicentre of the earthquake was located near Muzaffarabad in Pakistani-administered Kashmir, and
approximately 60 miles north-northeast of Islamabad. The most affected areas are the NWFP and
Azad Kashmir. More than 80,000 were killed, thousands of people injured and more than 3 million
people were homeless in Pakistan. According to United Nations, the loss and damages in October
8‘s South Asia Earthquake are more than that of Tsunami struck Sri Lanka, Indonesia and India in
On call for aid on humanitarian basis from Pakistan, several countries come forward and generously
announced aid and assistance for earthquake victims. Initially US and Turkey announced $256
million and $250 million respectively. On 19th November the World Donor Conference 2005 was held
in Islamabad, in order to collect donations for the reconstruction and rehabilitation of earthquake
affected victims and areas. Among bilateral aid pledges United States was again on top. USA
promises to provide $510 million in the Conference. About $5.9 billion were pledged on the same
day and about $7 billion have been pledged so far. Most of these pledges include interest-free soft-
loans repayable within 40 years.
The USAID initially pledged $156 million to Pakistan for earthquake disaster relief, which includes
$100 million for humanitarian relief and reconstruction, and $56 million to support the Defence
Department‘s relief operations. The aid was further increased to $510 million pledged in the Donor
Conference 2005. Around 1000 American emergency management personnel are working in
Pakistan to assist with relief efforts and 140 US military and civilian cargo airlifts have delivered
thousands of tons of medical supplies, food, shelter material, blankets and rescue equipment to the
people of affected areas. Six US military ships have delivered 115 pieces of heavy equipment and
158 tons of humanitarian assistance supplies through the port of Karachi.
In addition, American charitable organizations have raised $21.6 million for the relief effort and US
companies have committed $47.9 million in cash and in-kind contributions.
Turkey pledged aid worth $150 million to Pakistan out of which $100 million would be extended as
financial assistance and $50 million in the shape of relief goods and technical assistance. Apart from
the contributions of US$150 million the Turkish Government has also committed another US $ 3
million at the Geneva Donors Conference. Moreover, the Turkish Prime Minister Tayyip Erdogan
became the first foreign leader to visit Pakistan after the earthquake, and assured his country‘s aid
and assistance for relief efforts to Pakistan on long-term basis. Turkey has also sent her medical and
rescue teams to Pakistan. Turkey is also providing 1 million blankets and tents, 50000 tonnes of flour
and 25000 tonnes of sugar and cooking oil.
Star TV of Turkey organized a live telethon for donations. Turkish Prime Minister, Cabinet members
and members of business community participated with a target of is US$ 15 million. Turk Samanyolu
TV, another channel collected US$ 3.7 million.
Several other countries and international organisations announced aid packages and assistance for
Pakistan (before Donor Conference 2005):
Saudi Arabia is on third rank with its financial support of US $133 for the quake victims.
Saudi 1 TV Channel has also organised a live telethon for donations and collected millions of
dollars for earthquake victims in Pakistan.
UAE announced $100 million aid package for Pakistan.
Kuwait pledged $100 million to help the victims of the earthquake, half in immediate relief and
half to finance infrastructure repairs under the supervision of the Kuwait Fund for Arab
Economic Development (a government organisation).
Italy converts debts of US $70 million into relief, while another of 15 million US dollars will also
be converted to be used for the reconstruction and rehabilitation of the earthquake affected
people. The Italian government has also offered training for Pakistani officials in Disaster
Management and preparedness.
United Kingdom (UK) sent three Chinook Helicopters to Pakistan to take part in relief
operations in Azad Kashmir and NWFP. UK has also announced additional ₤20 million in aid.
India announced Rs. 1 billion aid.
China announced US $6.2 million aid for quake victims and also sent an emergency-response
team. The Chinese government sent a 49-member international rescue team.
Australia announced Australian $5.5 million (US $4.18 million) in aid, which include Australian
$500,000 for immediate medical and relief assistance. The funds will be channelled through
Red Cross and Red Crescent.
Ireland will provide one million euros to the relief effort in Pakistan.
Afghanistan has announced US $500,000 financial help, four helicopters, 30 tonnes of dry
fruit and 35-member rescue and relief team. Afghanistan also observed a three-day mourning
on the loss of lives due to the earthquake.
Japan had sent a 50-strong emergency relief team. The team, formed by disaster rescue
experts from fire fighting, police and coast guard organizations, included police, disaster
management and coast guard specialists. They are engaged in search and rescue operations
as well as information gathering.
A military plane has been sent from Spain with emergency doctors, fire-fighters and medical
supplies to help deal with the aftermath of the South-Asian earthquake.
The Swedish Rescue Services Agency was sending tents and blankets and the Czech
government said it was ready to send rescue teams with dogs.
France sent sniffer dogs and cutting gear.
Malaysian Red Crescent Society sent a 12-member team including four doctors and eight
relief workers to Pakistan.
Red Cross and Crescent workers from other Southeast Asian nations, including Indonesia,
the Philippines and Singapore will also join the relief efforts in Pakistan.
European Union (EU) has proposed giving at least €80 million (US $96 million) in aid for
reconstruction and relief activities for the survivors of earthquake in Pakistan. This is in
addition to the 13.6 million euros emergency humanitarian aid already released, bringing the
total proposed aid for 2005-06 to 93.6 million euros (US $111.7 million).
World Bank offered US $20 million to Pakistan to help deal with the tragedy unleashed by the
South Asia earthquake.
Asian Development Bank (ADB) announced reallocation of $10 million for immediate
emergency assistance in the worst-affected areas of Pakistan.
World Health Organization (WHO) has provided Pakistan with two emergency health kits,
which will provide essential medical supplies to care for a total of 20,000 people for three
months. It has also announced five more kits as well as packages to cover 1000 surgical
operations in coming days.
United Nations (UN) has sent its emergency coordination team to join relief efforts after the
NATO is planning to send engineers teams to open blocked roads and setting up hospitals in
the quake ravaged areas.
According to the Government of Pakistan, Rs. 5.15 billion donations have been received in
President‘s Earthquake Relief Fund, while Rs. 5.35 billion donations have been pledged. And some
US $ 2.05 billion foreign aid has been announced including US $1.93 billion aid pledges from 15-20
countries. It has been estimated that the time for reconstruction of earthquake devastated areas will
take atleast three to five years. The Government will need billions of dollars in the reconstruction and
rehabilitation process, which could only be provided through foreign aid.
World Donor Conference 2005
On 19th November, 2005, the World Donor Conference was held in Islamabad. The purpose of this
Conference was to collect the fund necessary for the reconstruction and rehabilitation of earthquake
affected victims and areas. More than 56 countries attend the Conference, including the countries
like India, Cuba, Russia, etc. President Musharraf and Prime Minister Shaukat Aziz outlined the
earthquake relief plan and the strategy to cope with the aftermath of earthquake, and the
rehabilitation programme necessary for the affected victims to survive such a mental and physical
trauma. The Conference was a success. Government of Pakistan had requested the initial pledge of
$5.2 billion from the world community and received the pledge of $5.9 billion on the same day. About
$7 billion have been pledged so far by the world community including the big contributors World Bank
and ADB with the pledges of $1 billion each. Most of these pledges included interest-free soft-loans
repayable in 40 years. A break-up of the aid pledges is given as below:
(all the figures in US$ million)
Countries and Multilateral Agencies Pledges
Saudi Arabia 233
World Bank 1000
Islamic Bank 250
Pak-Turkish Education Foundation 36
Ireland € 1 million
India Rs. 1
Besides above Canada, Russia, Singapore, Philippines, Spain, Cuba and many others have also
promised to contribute in the relief efforts.
Importance of Foreign Private Investment:
There is no doubt that the inflow of foreign capital accelerates the economic growth of under-
developed countries in number of ways:
(a) Foreign investment supplement domestic savings and harnesses them to secure a rapid
rate of growth. It serves as a stimulant to additional domestic investment in the recipient
country. By increasing the rate of capital formation in the country, it goes a long way in
removing the capital deficiency which is the main hurdle in the economic growth.
(b) Foreign investment generally brings along with it technical know how. By providing technical
expertise it helps in building modern industrial structure in the receiving countries. In this
way, it adds to their aggregate national product and per capita income which not only works
towards removing their poverty but increases the rate of savings which in turn accelerates the
process of their growth. In course of time, the vicious circle of poverty is broken and the
beneficial circle of prosperity is set in motion.
(c) Foreign investment provides valuable foreign exchange which is the desperate need of the
developing economies. It is generally observed that, in the early years of development, the
import bill of such countries goes on mounting because they have to import food grains,
machinery and capital and essential industrial raw materials but their exports lag woefully
behind. This creates balance of payment difficulties in the solution of which foreign capital
proves a god send.
(d) Benefits also accrue from foreign investment to domestic labour in the form of higher real
wages, to consumers in the form of greater supply of consumer goods, larger in quantity,
better in quality and greater in variety and to the government in the form of higher tax
revenues. The economy benefits through the realisation of external economies. Since
foreign capital helps in building up economic infra-structure in the form of means of transport
and communications, railways, roads, hydro-electric projects supplying irrigation and power, it
undoubtedly results in acceleration of the rate of growth.
Determinants of Private Investment:
The private investment rates in developing countries have varied significantly over time. In Pakistan,
the private investment rate fall sharply during 1990s. Instead of rapid economic growth, Pakistan
witnessed slowing down of economic growth during 1990s. Investment rate decelerate from an
average of over 19% of GDP to 15.6% by 1999. There are number of factors that help explain these
(a) Real Per Capita Growth Rate: There is general agreement among economists that a
country‘s growth rate would have a positive impact on private investment. A higher growth
rate would increase private investment activity if the relationship between the level of real
output and the desired capital stock is relatively fixed.
(b) Real Interest Rate: There are competing views about the effect of real interest rates on
private investment. A high level of real interest rates raises the real cost of capital, and
therefore dampens the level of private investment. But there is another side. Poorly
developed financial markets in these countries and inadequate access to foreign financing for
most private projects implies that private investment is constrained largely by domestic
(c) Level of Per Capita Income: Economists have argued that per capita income levels should
be positively related to private investment activity, because higher income countries are better
able to devote resources to saving.
(d) Public Investment Rate: As with the real interest rate, the impact of the public investment
rate (i.e., the ratio of public investment expenditure to GDP) on private investment activity is
(e) Domestic Inflation Rate: High rates of inflation adversely affect private investment activity by
increasing the riskiness of longer-term investment projects, reducing the average maturity of
commercial loans, and distorting the information conveyed by prices in the economy. In
addition, high inflation rates are often considered a sign of macroeconomic instability and the
inability of government to control macro-economic policy, both of which contribute to an
adverse investment climate.
(f) External Debt Burden: Measured by its debt-service payments ratio and the ratio of external
debt to GDP, the external debt burden can have a powerful negative effect on a country‘s
private investment rate. A higher debt-service payments ratio means that fewer resources are
available for domestic use, including private investment, and hence should have a direct
adverse impact on private investment rates. A high ratio of external debt to GDP, which
indicates that the country has a large debt ‗overhang‘, may also discourage private investment.
(g) Non Economic Factors: Besides the above economic variables, there are also other non-
economic factors, such as political stability and investor confidence, that play an important role
in investment behaviour. Another factor is a country‘s tax and regulatory environment which
also plays a vital role in establishing investor‘s confidence in the administrative structure of the
Investment Policy and the Current Situation in Pakistan:
According to Pakistan‘s Board of Investment, our country‘s investment policy is based on
liberalisation policy. The main features of Pakistan‘s investment policy are outlined as below:
(a) All economic sectors open to Foreign Direct Investment.
(b) Equal treatment to local and foreign investors.
(c) 100 % foreign equity allowed.
(d) No Government sanction required.
(e) Attractive tax / tariff incentives package.
(f) Remittance of Royalty, Technical & Franchise Fee, Capital, Profits, Dividends allowed.
By October 2004, total foreign direct investment (FDI) stood at $950 million as against $472 million in
October 1999. During the year 2004-05, total investment provisionally estimated at 16.9%, slightly
lower than last year 17.3%. Fixed investment as percentage of GDP is estimated at 15.3% for the
year 2004-05 as against 15.6% last year. Public Sector investment declined from 4.8% in 2003-04 to
4.4% in 2004-05. During the year 2004-05 private sector investment rose marginally to 10.9%.
Net Inflow of Foreign Private Investment
(Direct + Portfolio)
(All figures in US$ million)
Country 2001-02 2002-03 2003-04 2004-05
USA 324.7 226.6 259.8 373.0
UK -2.1 184.8 41.9 199.1
UAE 17.3 120.4 146.5 417.3
Germany 11.2 3.8 4.0 15.2
France -6.6 2.6 -5.6 -3.5
Hong Kong 23.4 5.2 5.0 61.2
Italy 0.1 0.4 - 0.4
Japan 6.6 14.1 11.6 41.7
Saudi Arabia 1.4 43.6 5.3 18.2
Canada 6.2 0.5 0.5 2.0
Others 92.4 218.1 452.7 552.0
Total 474.6 820.1 921.7 1676.6
Source: State Bank of Pakistan
Importance of Foreign Trade
Theory of Gains from Foreign Trade:
The gains from foreign trade can be broadly classified into:
(a) Static Gains: Static gains arise from optimum use of the country‘s factor endowments or
resources in men, money and material, so that the national output is maximised resulting in increase
in social welfare. Static gains result from the operation of the theory of comparative cost in the field
of foreign trade. Acting on this principle, the participating countries are able to make optimum use of
their resources or factor endowments so that the national output is greater than it otherwise would be.
This raises the level of social welfare in the country. Utility or welfare can be measured by
indifference curves. Utility or welfare can be measured by indifference curve. As a result of
introduction or extension of foreign trade, the people can move to a higher indifference curve. This
has been shown in the following figure. Take two countries A and B both producing wheat and
cotton. Production possibility curve and indifference curves are shown as below:
In the above figure, it can be seen that, before the commencement of foreign trade, country A would
be in equilibrium at the point E where the price line PP‘ is tangent to both production possibility curve
AB and indifference curve IC1. The slope of the price line shows the price ratio or cost ratio of the
two commodities in the country A; TT‘ is the terms of trade line showing the price ratio at which goods
can be exchanged between these two countries, TT‘ line is tangent to A‘s production possibility curve
AB. At point F, country A will produce more of cotton in which it has comparative advantage and less
of wheat at F than at E. Taking the pattern of demand in the country A, we have the indifference
curves IC1 and IC2 representing the demand for the two commodities. Now TT‘ is tangent to IC2 at
G which shows the quantities of wheat and cotton consumed by the country A. It can be seen that as
a result of introduction of foreign trade, the country A has moved from E on the indifference curve IC1
to G on the difference IC2, which represents a higher level of social welfare in terms of larger
consumption of the two trade goods. This is called „static gain‟ resulting from specialisation brought
about by the introduction of foreign trade. It can also be seen that the quantities of the two goods
consumed and different from the quantities produced. The quantities produced are shown at F and
quantities consumed at G. The difference is accounted for by exports and imports. The country A
will be exporting KF quantity of cotton importing KG quantity of wheat.
The gain to country B can be similarly explained. Production possibility curve of B between wheat
and cotton is shown by the curve CD in the following diagram. It is clear that given the factor
endowments, it is more profitable for B to produce wheat. The country B fixes her production and
consumption at point E before the introduction of foreign trade. At this point, price ratio line PP‘ and
indifference curve IC1 are tangent to production possibility curve CD. The country B would gain from
trade if it can sell at a price ratio different from PP‘. Given the terms of trade line TT‘, the country B
will produce at F on the production possibility curve CD:
From the above diagram, it would be evident that the country B will produce more of wheat in which it
has comparative advantage and less of cotton in which it has comparative disadvantage. But given
the price ratio as represented by terms of trade line TT‘, B will consume the quantities of two goods
as shown by the point G where the terms of trade line TT‘ is tangent to the indifference curve IC2. It
is clear that specialisation resulting from the introduction of foreign trade has enabled the country B to
move to the higher indifference curve IC2 and thus consume more of the two goods. This is her gain
from international trade. The country will now export KF amount of wheat and import KG amount of
cotton. It may be borne in mind that in the case of constant opportunity cost, each country resorts to
complete specialisation i.e. producing only one of the two goods. On the other hand, in case of
increasing opportunity cost, specialisation is not complete so that a country produces relatively larger
quantity of the commodity in which it has comparative advantage.
(b) Dynamic Gains: Dynamic gains, on the other hand, refer to those benefits which promote
economic growth of the participating countries. International trade also brings to the participating
countries that are known as dynamic gains. They relate to economic growth and development which
results from the introduction of international trade. According to the theory of comparative cost,
specialisation by different countries in producing commodities for which they are best fitted, results in
a larger volume of production and improves productivity. This obviously promotes economic
development. There is no doubt that extension of international trade has accelerated economic
growth in the participating countries, like China, Malaysia, Indonesia, Turkey, India, Pakistan, Sri
Role of Foreign Trade in Economic Development:
International trade increases national income and facilitates saving and opens out new channels of
investment. Increase in saving and investment is bound to promote economic growth. Exports earn
foreign exchange which can be utilised in buying capital and equipment and know-how from abroad
which can serve as instruments of economic growth. The larger the national income and output, the
higher will be rate of growth. The higher level of output enables a country to avoid the vicious circle
of poverty and put the country in the ‗take-off‘ or self-sustaining growth. Production possibilities and
cost of production in different countries differ so widely that foreign trade brings to the participating
countries tremendous gains in terms of national output and income.
Foreign trade promotes economic development in the following different ways:
(a) Acquisition of Capital Goods from Developed Countries: The under-developed countries
(UDCs) are enabled by foreign trade to obtain in exchange for their goods capital equipment
and heavy engineering machines to foster their countries‘ economic development. For
example, Pakistan exports rice, cotton and cotton textiles, leather and leather goods, and
sports goods and in exchange she imports heavy engineering machines and tools, trucks, and
other capital equipment from the developed countries.
(b) Import of Technical Know-how or Skills: An under-developed country (UDC) is short of all
kinds of professionals like engineers, architects, doctors, managers, accountants, economists,
and other technical personnel. To cover this shortage and to learn more, a UDC can allow the
inflow of technical brains from developed countries.
(c) International Market: The foreign trade can extend the scope of the business to the
international market. The domestic market is limited, the foreign trade sector opens new
vistas, new marketing channels and new markets. When the markets are extended, the
economies of scale are reaped, the efficiency and productivity will increase. Accordingly, the
forces of development will set themselves in motion.
(d) Foreign Investment: The foreign trade is also helpful in attracting foreign investment. The
foreign investors are attracted towards active trading countries and invest in the form of capital
goods and technical expertise. In this way, the assembling plants, the manufacturing plants
and the latest technology will come into the country. As our recent investment agreements
with China, USA, UK, South Korea, Sweden, Hong Kong, Saudi Arabia and UAE will be
helpful in promoting trade and industries in the country.
(e) Source of Public Revenue: When there is imports and exports of goods and services, the
government can earn the revenue in form of tariffs, custom duty, import licence fees, etc.
(f) Foreign Exchange Earnings: Moreover, the external sector also opens the employment
opportunities for the country-men in the foreign countries. Hundreds of thousands of
Pakistanis are working abroad. Pakistan is earning billions of dollars through foreign
exchange remittances. Pakistan has earned $ 2.4 billion on account of workers‘ remittances
working abroad during the year 2001-02, which increased to $ 4.2 billion during 2002-03.
Therefore, such remittances are proved to be a major source of foreign exchange earnings.
Import Substitution vs. Export Promotion:
There are two types of economic strategies – import substitution and export promotion, which are
helpful in removing the deficit in BOP and accelerating the process of industrialisation and economic
(a) Import Substitution: The import substitution strategy or „import-led‟ or „inward-looking strategy‟
aims at producing the import substitutes in the country. The import substitution (IS) strategy will
reduce the dependence of a country on foreign goods. It will enable a country to produce the plants,
machinery, electronic goods, consumer durables and a variety of goods. In this way, not only the
domestic production will increase, but the domestic employment will also be boosted up. This
strategy provides self-sufficiency in the economy. But at the same time the country has to rely on
heavy foreign loans and assistance in order to complete expensive projects.
The import substitution strategy fosters the process of industrialisation and economic development. It
helps in protecting and developing small and medium sized industries. It protects the local
manufacturers and labour by protecting them from foreign competitors.
During 1950s and 1960s, the major stress was laid upon initiating the IS strategy in Pakistan. As a
result of such strategy the manufacturing sector has had its foundations. The growth rate of
manufacturing sector, during this period is estimated at 16% p.a. Some economists accorded that
Pakistan, on the basis of such IS strategy, has entered in the stage of „take-off‟. The import
substitution strategy pursued in Pakistan was given the name of „Easy-Import Substitution Strategy‟,
which was mostly confined to the establishment of consumer goods like textile and sugar industry.
But inspite of import-substitution in the country, we remained depending upon imports of capital
goods, machinery, automobiles, chemicals, petro-chemicals and medicines, thus increasing BOP
deficits. Moreover, the industrial sector, which was came into being as a result of IS strategy, was
extremely inefficient. There was a misallocation of resources. The goods were produced at the
prices higher than the international prices. The investors engaged in import-substitution not only
reaped abnormal profits, but they were also exempted from direct taxes. They did not have to face
competitors, trade-unions and even the anti-monopoly authority. Moreover, during this period,
„multiple exchange rate system‟ was prevailed in the country. Due to this system, the price of rupee
had fallen to a greater degree, which led to income disparity and unemployment. Moreover, during
this era, Government‘s major focus was on industrial policies and she ignored altogether the
development of agriculture sector.
(b) Export Promotion: Export promotion strategy is also known as „export-led‟ or „forward-looking
strategy‟. Export promotion strategy is aimed at boosting the exports of semi-manufactured and
manufactured goods in place of traditional commodities and improving the standard of exports.
Export growth is equivalent to the economic growth. Because of comparative advantage when a
country specialises in a product, the export-led strategy enables her to make the product available to
the world community at cheaper prices. Thus, the international markets are extended for an
exporting country. The income and employment levels are expanded. Consequently, the process of
economic development is facilitated.
The export promotion strategy will also attract the foreign capital. The countries which are well
endowed with natural resources like oil, gas, iron, rubber, tin and other mineral deposits and which
are having potential and prospective comparative advantage in these products would be able to
attract the foreign investors. The foreign capital, foreign technology and foreign skill will open new
vistas. The output and employment will increase, and finally the export will go up.
In export promotion strategy, the subsidies and incentives are given to all the sectors of the economy,
rather to a particular sector of the economy (as in the case of import substitution strategy). When
exports are boosted enough foreign exchange could be earned which would be utilised in respect of
importation. With the help of industrial imports, purchased with the foreign exchange earned through
exports, a country may also launch the process of industrial development.
The emphasis of Pakistan‘s industrial policy has been more on import substitution than on export
promotion. The position of domestic industries results in higher prices for the consumer. Industries
are become inefficient because of absence of foreign competition, there is no incentive to reduce
their production costs. The export industries of Pakistan have to be very efficient in order to compete
in the global market.
Pakistan’s Foreign Trade Sector:
Pakistan‘s foreign trade balance has always been negative throughout its economic history except for
the years 1947-48, 1950-51 and 1972-73. In the first year after independence the country faced
huge economic problems and as a result no attention could be paid to industrial sector development.
Import bill was less than one hundred million dollars and the trade balance, even will small magnitude
of exports, was positive. In the second year of independence, i.e. 1949-50, the trade balance was
negative. In 1950-51, because of Korean War boom, our exports increased by 140% as compared to
the preceding year. This huge increase in exports resulted in second ever positive trade balance. In
1972-73, Pakistan, once again, had a surplus balance of trade after 21 successive yearly deficits.
The success achieved in 1972-73was the result of deliberate policy actions including devaluation and
export promotion measures. This surplus partly as a result of a sharp increase in the volume and
value of exports and partly due to slower increase in imports. Besides the said financial years of
surplus, Pakistan has never achieved positive trade balance.
Pakistan’s Exports, Imports and Trade Balance
(All figures in US$ million)
Years Exports Imports Balance
1947-48 138 96 42
1950-51 406 353 53
1960-61 114 457 -343
1972-73 817 797 20
1980-81 2958 5409 -2451
1990-91 6131 7619 -1488
1998-99 7779 9432 -1653
1999-00 8569 10309 -1740
2000-01 9202 10729 -1527
2001-02 9135 10340 -1205
2002-03 11160 12220 -1060
2003-04 12313 15592 -3279
2004-05 14391 20592 -6201
(a) Composition of Exports and Imports: Structure and composition of Pakistan exports and
imports have changed over time:
Composition of Pakistan’s Exports and Imports
Year Primary Manufactured Capital Material Consumer
Goods Goods Goods Capital Consumer Goods
1969-70 33 23 44 50 11 29 10
1979-80 42 15 43 36 6 42 16
1989-90 20 24 56 33 7 41 19
1993-94 10 24 66 38 6 43 13
2000-01 13 15 72 25 6 55 14
2001-02 11 14 75 28 6 55 11
2002-03 11 11 78 31 6 53 10
2003-04 10 12 78 35 7 49 9
2004-05 11 10 79 36 8 46 10
In 1969-70 the primary commodities comprised a huge share of 33% of total exports, while of the
shares of semi-manufactured and manufactured goods were limited to 23% and 44% respectively.
During the fiscal year 2004-05, the shares of primary, semi-manufactured and manufactured
commodities are 11%, 10% and 79%. The significant rise in manufactured commodities, i.e. from
33% in 1969-70 to 79% in 2004-05, is a positive sign, but still Pakistan is lack of semi-manufactured
goods. Pakistan has to reduce the export of her primary commodities and increase that of semi-
manufactured goods. This is due to the fact that our primary commodities are short of international
standards. Moreover, the prices of primary commodities are prone to severe price shocks. Whereas,
the market for manufactured goods is huge and stable.
The change in composition of imports has not been very conducive to long-term growth
requirements. In the above table and graph, it is indicated that the percentage share of ‗industrial
raw materials for consumer goods industries‘ has a significant rise from 29% in 1969-70 to 46% in
2004-05. Whereas the percentage share of industrial raw material imports for capital good industries
has declined from 11% to 8%. The percentage share of imports of manufactured capital goods has
decreased from 50% to 36%. This situation indicates that our consumer good imports (including
industrial raw materials) have increased at a rapid pace as compared with capital good imports which
are prerequisite for long-term self-sustained economic growth. It is very import to note that we are
talking in terms of percentage share and not in terms of absolute values.
(b) Terms of Trade: The TOT of the country has been deteriorating since long, which states that
the prices of our exports are decreasing while those of our imports are increasing. This is also one of
the major shocks to our exports. Pakistan‘s annual terms of trade, and unit value indices of exports
and imports are tabulated below:
Pakistan’s Annual Terms of Trade
Unit Value Indices of Exports & Imports
(Base Year: 1990-91)
Unit Value Unit Value
Year Indices Indices
of Exports of Imports
2000-01 90.96 271.47 298.44
2001-02 90.83 271.18 298.56
2002-03 82.07 254.02 309.52
2003-04 78.68 279.65 355.43
2004-05* 73.60 288.84 392.45
* The figures of FY 2004-05 include the provisional figures of 4th Quarter (Apr-Jun).
(c) Workers’ Remittances: Workers‘ Remittances are a major source of foreign exchange
earnings and occupy a significant place in financing the import bill of the country. Pakistan has
shown a remarkable progress in workers‘ remittances from abroad. In 1972-73 the workers‘
remittances stood at $136 million. In the year 1999-00, the workers remittances stood at $983.73
million. It increases four-fold to $4236.85 million in 2002-03 within the period of two years. Such
amount of workers‘ remittances from abroad has never been achieved before in the economic history
of Pakistan. This sharp increase shows the confidence of expatriate Pakistanis in the transparency
of economic and foreign policies:
Workers Remittances from Abroad
(All figures in $US Million)
(d) Foreign Exchange Reserves: On November 12, 1998, the foreign exchange reserves of
Pakistan were at a ridiculous level of $415 million, hardly sufficient to finance two weeks of imports.
The main reasons for such a low foreign exchange reserves were huge budgetary deficit,
uncontrollable debt servicing, low foreign investment, heavy government expenditures, poor
governance, and worst political conditions. Musharraf‘s Government‘s recent economic policies have
survived the shortage of foreign exchange reserves. With vigorous and transparent policies of the
Government, Pakistan‘s FOREX reserves stood at $12.6 billion on June 30, 2005:
Pakistan’s FOREX Reserves
(All figures in US$ Billion)
Year End (June Total Liquid
(e) Exchange Rate: During the decade of 1990s, Pakistan has suffered a lot from huge
fluctuations in foreign exchange rates. During the year 1990-91, the rupee-dollar exchange rates
averaged at Rs. 22.42 per dollar. With further devaluation of rupee, the exchange rate climbed up to
the level of Rs. 30 during the FY 1993-94 and Rs. 43 during the FY 1997-98. After the nuclear test in
May 1998 all the transactions through foreign currency accounts operating in Pakistani banks were
frozen. Different exchange rates prevail in the economy. The official exchange rate was around Rs.
46, whereas the commercial banks announced their own exchange rates. During September 1998,
the exchange rate in the open market was averaged at Rs. 65. In June 2000, State Bank of Pakistan
finally made adjustment in the exchange rate and as a result it managed to pull down to Rs. 55.30 in
the open market.
During the past four years, with the massive inflow of remittances, the foreign exchange reserves
have been built up which, in turn, has provided stability in the exchange rate.
Strategy to Promote Exports:
Pakistan is in emergent need to promote and foster her exports. During the past 50 years, Pakistan
has shown a poor performance in her export growth when compared to other Asian countries, like
South Korea, India, Malaysia, etc. During 1980s, it took 10 years to add an amount of just $ 2 billion
in our exports, and during 1990s, it took 9 years to add an amount of just $ 1.5 billion. However,
Pakistan has shown a considerable achievement during the past 5 years adding $5 billion in total
exports. But still we need more than 100% increase in our exports. Pakistan‘s exports to GDP ratio
stands at a very low percentage of just 13% when comparing to Sri Lanka with 27%, Indonesia 32%,
Philippines 44%, Thailand 56%, Korea 39% and Malaysia 96%. This simply suggests that Pakistan
has to catch up with others. Following are few suggestions to promote our exports in international
(a) Role of Private Sector: The following things needed to be done in enhancing the role of private
The first thing that the private sector must do is to improve their competitiveness by employing
state of the art machinery; through better management; through cost effectiveness; and by
improving their working environment. They have a comparative advantage in terms of
relatively cheap labour, relatively low cost of capital, a strong macroeconomic environment
represented by a stable exchange rate, relatively low inflation and strong growth.
The second most important task that private sector must undertake is to look for new markets
and new products. Today our exports are highly concentrated in few items and into few
markets. More than 75% of our exports originate from four items, namely cotton, rice, leather
and sports goods. Similarly more than one-half of our exports go to 7 countries. This state of
affairs will not take us at higher export path. Diversification of exports, both in terms of
commodity and regions will be needed. For new markets we need to look at China, Japan,
Latin America and ASEAN Region.
(b) Role of the Government:
The first and foremost duty of the government is to provide a strong macroeconomic
environment – an environment where exchange rate is stable; a comfortable foreign exchange
reserves; low cost of capital; low inflation, low budget deficit and no debt crisis and consistent
and transparent macroeconomic policies.
The second most important duty of the government is to provide strong infrastructure –
transport and communication, roads and highways, power, well-functioning ports etc.
The third most important duty of the government is to enter into active Trade Diplomacy. We
have to explore the possibilities in joining various Preferential Trading Arrangements (PTAs),
and have to enter into bilateral negotiation at all levels for Free Trade Arrangements (FTA).
(c) Value Addition: Pursue enhancement of manufacturing and marketing capabilities and
efficiencies with a view to achieve value addition and increased competitive strength for our core
(d) Women Entrepreneurship: To energize the women entrepreneurship in support of developing
and realizing Pakistan's export capabilities and potential, and enhance overall economic value
(e) Marketing Support: Majority of our exporters are presently weak in the marketing management
abilities and the financial /human resources required for aggressive market share enhancement and
product and geographical diversification. Due need of upfront investment of funds, SME exporters are
shy to invest. It is essential that professional and financial help be provided by the government in
partnership with the exporters, for aggressive international promotions, distributors and gaining
access to new customers and markets.
(f) Pakistan's Business Image: It is recognized that all countries have their strengths and
weaknesses. Success depends upon efficient capitalization of Strengths and management of
Weaknesses to provide an honest and positive business image. It is also recognized that image
management has to be professionally achieved for best results.
(g) Human Resources and Skill/Technology Support: In alignment with the strategic product,
geographic needs and international trading regulations, the skills, training /technical facilities be
enhanced amongst all stakeholders especially the exporters, Pakistan's Missions and the Export
Promotion Bureau, financial institutions and SMEDA.
(h) Quality, Social and Environment Management: Culture of 'TQM' (Total Quality Management)
and 'CI' (Continuous Improvement) needs to be inculcated and embedded in support of Quality,
Social progressively and meet international standards and specifications as a minimum. Appropriate
regulatory framework, quality and social management processes such as ISO/SA certifications and a
transparent efficient judicial process needs to be in support.
(i) Foreign Direct Investment and Finance: Foreign Direct Investment needs to be strongly
encouraged to strengthen our exporters management expertise, technological and infrastructural
support, competitive edge and market access.
Transparent access to finance will be vital for the desired significant increase in exports. Sufficient
access at internationally competitive mark ups would need to be ensured, especially for the value
adding and Developmental Product Categories.
(j) Small & Medium Enterprise Development: On a medium term basis, the success of Pakistan's
exports must heavily rely on the strength of our Small and Medium size exporters. EPB in alignment
with the supply chain management efforts of SMEDA, must help enhance the exporting and
marketing capacity of the SME's inclusive of adequate finance through the relevant financial
institution i.e. State Bank, SBFC, RDFC and other DFI's.