The bullish case for Pakistan’s economy by Fortune Editors @FortuneMagazine January 9, 2012, 3:42 PM EDT E-mail Tweet Facebook Google Plus Linkedin Share icons By Ken Stier, contributor Shaukat Aziz FORTUNE — Despite the regular eruptions of bad news from Pakistan, Shaukat Aziz, a former finance and prime minister there, remains cautiously bullish about his country’s prospects, including the peace dividend that could come with the orderly exit of U.S. troops from Afghanistan. But that depends, he says, on a Marshall Plan-like reconstruction of Afghanistan — and the U.S. delivering on tribal economic development plans. That might seem overly ambitious for distracted Western capitals with tapped out coffers. But the ‘mostly-sunny’ technocratic vision is not unusual for Aziz, a former Citibank C executive who presided over strong growth as finance minister after General Pervez Musharraf staged a coup in 1999. (Musharraf just announced he would shortly be returning to Pakistan — and risking arrest — from Dubai where he has been since leaving office.) Aziz, 64, was elected prime minister in 2004 (surviving an assassination attempt while campaigning) and was the first of 23 predecessors to serve out a full term, until 2007. He took up residence in London soon after and now serves on the board of the British hotel chain Millennium and Copthorne Hotels, and as an advisor to the Blackstone Group BX . Aziz recently spoke with Fortune about the state of Pakistan’s economy, how to rebuild Afghanistan, and why Pakistan deserves a free trade agreement with the U.S. Below is an edited transcript of that discussion. It’s been more than six years since Goldman Sachs GS recognized Pakistan among the Next Eleven newly industrialized countries — inflation is up, investment is at a 40-year low, and infrastructure is deteriorating, particularly in the power sector. By just about any measure things are not particularly good, so what is the source of your optimism about the Pakistani economy? The problems of the world economy have obviously leaked to Pakistan. Yes, investment is down, trade also, but in Pakistan’s case a lot of this is due to the security situation, the war on terror. We have to pay a huge price in terms of damaging our investor confidence — both domestic and foreign. On the other hand, we should bear in mind that more than two-thirds of the population lives in rural areas and agriculture has done well, especially in cotton — prices and exports are up and the farmer is relatively more comfortable. The country’s human capital is a strong suit, the Pakistani people are very talented, their skills levels are impressive and they are hard-working. There’s a huge number of Pakistanis working overseas and we can export a few more million and there won’t be an iota of difference because there is a whole pipeline of trained – and untrained – people coming. You mentioned the need for good management. How would you assess the current management of the economy? I ask that in light of the lapsing of the stabilization plan with the IMF. Being out of the IMF — obviously this reflects the desire of the government to have more flexibility to pursue its reforms. The IMF program does bring with it certain macroeconomic discipline and that’s beneficial, but I also believe in economic sovereignty. You need good governance and good management, but abdicating the economy to the IMF is not the way to succeed. What we need is growth and job creation, like every other country in the world. The disagreement with the IMF is at least in part related to tax collection, which has been notoriously weak in Pakistan. There is a lot of concern whether Pakistan can muster the political will to make tough reforms, partly because of self-serving elites among the political class that have brought the country to the point of being nearly a failed state. No, I think that’s not true. The country is large — roughly 180 million people — and it’s functioning. It has many challenges — governance issues, transparency and management issues — on top of the security issues that have cost us dearly. But the country is functioning. Obviously it could function better, but it’s not come to a grinding halt. Life is going on. Don’t expect an Iranian oil crisis Clearly, the country is facing a challenging situation financially, and tax reform has been an issue. It’s true there is low tax compliance, but you have to look at the political impact — not just the economic impact — of taxes. The tax system has been around for a long time. Trade-offs have to be made; indirect taxes — sales tax and customs duties — have grown because of that, quite handsomely. Income tax is also up, but that is mostly out of big corporations’ profits. The key question is: How do we get growth? The pie has to get bigger for you to collect more taxes. You can’t squeeze the lemon if there’s no juice in it. Moving on to Afghanistan, the U.S. is being more realistic about its transformative agenda and the Obama administration seems to be determined to wind things down. How do you see this playing out? I think this is the right way to go. The presence of foreign troops generates ill effects and the sooner they are gone, the better. But the exit strategy has to be very carefully choreographed. We need a Marshall Plan-like approach, a massive program for reconstruction. The World Bank, the Asian Development Bank, the sovereign banks, and many individual countries, have to be involved. There was a very successful meeting recently of Turkey, Pakistan, Afghanistan and others in Istanbul. People need to see a future, that tomorrow will be better than yesterday. The people of Afghanistan will have to work hard themselves to leverage this opportunity. It’s a good thing that the U.S. and the Taliban are talking — all stakeholders have to be included. I’m cautiously optimistic that adversity can be changed into an opportunity if it is funded well. U.S.-Pakistan relations are generally refracted through the prism of Afghanistan but also through the fact that Pakistan is a nuclear power. I think certainly the relationship is opportunistic on both sides. But I think the U.S. is pursuing a policy of both engagement and containment of Pakistan at the same time. We are both a friend and an adversary. Therein lies the conflict in the relationship. There is a trust deficit and when it comes to the nuclear issue there is a fundamental problem. Investing after the Arab Spring: Unfinished business When India was drawn into the Nuclear Suppliers Group (a multilateral anti-proliferation organization) Pakistan should have been included too. The United States has to decide: are we in the tent or outside? That was a major missed opportunity. Inclusion in the NSG comes with a lot of responsibility and obligations. Engagement becomes more formalized, providing a forum for all key players to be around the table to discuss and solve issues. We are a nuclear power – there is no such thing as a halfway house here – and to deny it doesn’t help anybody. It’s not too late to rectify this. It would help the whole atmosphere in South Asia. If you keep people out of the tent, things can suddenly move the other way. You’ve said that Pakistan would be better off with a free trade agreement with the U.S., instead of aid, but given the state of US-Pakistan relations that seems very unlikely. I’m not optimistic about a free trade agreement because even when Congress was very friendly, they couldn’t get things through, even things which were promised like the Reconstruction Opportunity Zones in the border area of Afghanistan and Pakistan, which was important for all three countries. The idea was to give duty-free access to the U.S. market for any goods produced in the tribal areas. Obviously when you put up a factory there the cost of production will be high, initially at least, because there is no infrastructure. This was a well-conceived and well-designed way of creating jobs. Otherwise they will have no incentive to put down their guns. Congress has approved other special market access programs like this for Haiti and Jordan, and maybe others. It was promised by the U.S. five or six years ago but nothing happened. We really need to re-focus on these things so that when peace returns in the area, especially in the border areas, people will have alternatives for making a living. Security is not a big issue. It can be done by local people. You don’t need expatriates; there are already plenty of entrepreneurs in that area. You’re talking about very small numbers for the textile market, but symbolically it’s very important because it will give people hope. This would be a good way for the U.S. government and Congress to send a message to people in the border areas: we want you to have a better, peaceful future.