Introduction: Pakistan's economic performance since 2001/02 has been impressive. Growth has accelerated, improvements in public spending and wide-ranging structural reforms have reduced the debt burden and increased efficiency, and pro-poor policies have helped lower poverty rates.
(Box 1). To maintain this momentum it is necessary to focus macroeconomic policies on containing domestic demand growth and reducing the possible associated vulnerabilities.
Over the medium term, the challenge remains to deepen structural reforms in areas critical for raising saving and investment, improving external competitiveness and sustaining high output growth.
2. The devastating earthquake of October 8, 2005 gave rise to additional demands for government spending. The earthquake left a heavy toll in terms of human lives and physical and social infrastructure, though it had relatively minor effects on macroeconomic indicators (other than government spending) owing to weak links between the affected areas and the rest of the economy. The bulk of government spending on relief and reconstruction during 2005/06 was financed by external grants and loans, but higher-than-budgeted fiscal resources also were allocated to this end. Reconstruction-related spending is expected to decline gradually over the next four years.
3. The political and security situation remains relatively calm. There has been some domestic unrest, however, especially near the border with Afghanistan and in the Balochistan province. Relations with India are progressing slowly, following the ratification of the South Asian Free Trade Area (SAFTA) in early 2006. Parliamentary and presidential elections are scheduled for October 2007.
4. The implementation of recent Fund advice on macroeconomic policy and structural reforms has been mixed. During 2005/06, large negative shocks, especially the earthquake, limited the scope for fiscal maneuver, and the overheating pressures that were identified during the last Article IV consultation continued.
Declines in inflation and, especially, domestic demand growth were relatively small, the external current account deficit widened by more than envisaged in mid-2005, and the rupee appreciated in real terms. The import coverage of reserves, however, remained stable. Against this background, the 2006 Article IV discussions focused on the macroeconomic policies needed to moderate demand pressures and contain the external current account deficit, appropriate policy responses to adverse external shocks, and structural reforms to help sustain rapid growth and reduce poverty.
BOX 1. POVERTY IN PAKISTAN-NEW ESTIMATES
Poverty declined during the last four years. Estimates based on the recent Household Integrated Economic Survey (HIES) show that the share of Pakistan's population living below the poverty line (poverty headcount ratio) declined by over 10 percentage points from 2000/01 to 2004/05. The decline was more than twice the size of the increase recorded in this indicator during 1996/97-2000/01. Despite this impressive outturn, nearly one quarter of Pakistan's population continues to live below the poverty line. Two other key measures of poverty incidence (the poverty gap and severity of poverty) also showed improvement during the last four years. Unlike the poverty headcount ratio, however, the improvement in these indicators was not sufficiently large to bring them below their 1996/97 levels.
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Pakistan: Poverty Indicators
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1996/97 2000/01 2004/05
(In units as indicated)
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Poverty headcount ratio 1/ 29.8 34.5 23.9
Poverty gap 2/ 4.1 7.0 4.8
Severity of poverty 2/ 1.1 2.1 1.5
Memorandum item:
Real GDP growth 3/ 4.4 3.4 6.0
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SOURCE: Pakistani authorities; and Fund staff estimates.
1/ Share of the population whose average spending falls below the poverty line.
2/ In percent. Both indicators measure the extent by which spending of poor households falls below the poverty line. The larger the value of these indicators, the larger the share of poor households that is "close" to (below) the poverty line.
3/ In percent. Average of previous four years.
The decline in poverty coincided with a strong pick up in economic growth. This is in line with cross-country studies that find evidence of a robust inverse relationship between growth and poverty. The large decline in the poverty headcount following the pick up in growth may also be related to the high concentration of households that had fallen just below the poverty line in 2000/01.1/
1/ See "Poverty, Risk and Vulnerability in Pakistan," Centre for Research on Poverty Reduction and Income Distribution, Karachi: Pakistan, March 2006.
II. RECENT ECONOMIC DEVELOPMENTS:
5. Economic developments during 2005/06 were broadly favourable, but the external current account deficit widened. Real GDP growth remained buoyant at 6.6 percent, and average inflation (12-month rate) declined from 9.3 percent to 7.9 percent. Domestic demand and import growth remained high, and the current account deficit increased to US $5 billion (3.9 percent of GDP), from US $1.5 billion (1.4 percent of GDP) a year earlier. Record-high net capital inflows (including from FDI and privatisation) more than covered the larger deficit and allowed an increase of nearly US $1 billion in gross official reserves. As of end-June 2006, gross international reserves stood at US $10.8 billion (3.6 months of next year's imports of goods and services), and the interbank market exchange rate was broadly unchanged from end-June 2005.
6. The fiscal deficit exceeded the original budget target for 2005/06 owing to earthquake-related spending. Excluding the latter (0.9 percent of GDP), revenues and expenditures both rose slightly (by roughly the same amounts) compared to the outturn in 2004/05. Strong corporate profits, higher petroleum taxes, and continued improvements in tax administration more than offset lower nontax revenue. The increase in total expenditure was mainly driven by development spending.
The government debt-to-GDP ratio fell to 56 percent by end-June 2006, below the 60 percent ceiling stipulated in the 2005 Fiscal Responsibility Law.1 The budget for 2006/07, approved in early June, targets a deficit of 4.2 percent of GDP (excluding grants), unchanged from the estimated outturn for 2005/06. The underlying fiscal deficit (defined as the overall deficit excluding grants and earthquake-related spending) is budgeted to increase by about 0.3 percent of GDP.
7. Domestic credit was, for the third year in a row, the main source of monetary expansion. The growth of broad money and bank credit to the private sector decelerated, but private sector credit still grew at the relatively high rate of 23 percent (Box 2). Bank lending rates became increasingly positive in real terms as inflation declined, but the real return on bank deposits remained negative. SBP claims on the government increased by more than total government borrowing from banks (as commercial banks continued reducing their holdings of government paper), and was the main factor behind the 10.2 percent increase in reserve money. Interest rates on 6-month treasury bills remained stable at 8.2 percent throughout 2005/06, and the discount rate was kept at its May 2005 level (9 percent) until end-June.
1 Among other requirements, the law stipulates that the government debt-to-GDP ratio should: (a) fall below 60 percent by 2012/13, (b) remain below 60 percent thereafter; and (c) decline by at least 21/2 percentage points of GDP every year. According to the authorities, requirement (c) ceases to be binding once requirement (a) has been met. Upward revisions to the nominal GDP series made in 2006 did not have a large influence on the recorded decline in the debt-to-GDP ratio.
BOX 2. BANKING SYSTEM UPDATE
Pakistan's banking system continued to strengthen since the last Article IV consultation. From December 2004 to June 2006 most financial soundness indicators (FSI) improved. The rise in earning and profitability indicators was particularly noteworthy, partly reflecting the high spread between deposit and lending rates (700 basis points). Pakistan's banks maintained their ranking among the top half in a group of 44 emerging market countries in terms of indicators of capital adequacy and asset quality, but moved to near the top of the ranking in terms of profitability-from a position near the bottom in 2001.
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Pakistan: Selected Financial Soundness Indicators,
Banking System, 1997-2006
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1997 2002 2004 2006 1/
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Capital adequacy ratio 4.5 8.8 10.5 11.9
Gross NPLs to gross loans 23.5 21.8 11.6 8.0
After tax return on average assets -1.2 0.1 1.2 2.1
After tax return on equity -36.2 3.2 20.3 26.5
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SOURCE: Pakistani authorities.
1/End-December for 1997-2004; end-June for 2006.
Banking Profitability in Selected Emerging Markets 1/
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Rank Value Rank Value
2005 2001
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Colombia 1 3.0 9 1.8
Venezuela 2 2.9 2 2.8
Pakistan 3 2.8 39 0.0
Costa Rica 4 2.5 8 1.9
Panama 5 2.4 13 1.3
Mexico 5 2.4 24 0.8
Peru 7 2.3 35 0.4
Brazil 7 2.3 40 -0.1
Estonia 9 2.2 3 2.7
Latvia 10 2.1 10 1.5
Bulgaria 11 2.0 1 2.9
Hungary 11 2.0 12 1.4
Ecuador 11 2.0 45 -6.6
Romania 14 1.9 4 2.5
Argentina 14 1.9 43 -0.2
Kazakhstan 16 1.8 21 0.9
Indonesia 17 1.7 31 0.6
Dominican Rep. 18 1.6 7 2.1
Thailand 19 1.5 10 1.5
Poland 19 1.5 17 1.0
Chile 21 1.4 13 1.3
Czech Rep. 21 1.4 28 0.7
Ukraine 23 1.3 15 1.2
Malaysia 23 1.3 17 1.0
El Salvador 23 1.3 21 0.9
Korea 23 1.3 24 0.8
Croatia 23 1.3 28 0.7
Lithuania 23 1.3 40 -0.1
South Africa 29 1.1 17 1.0
Philippines 29 1.1 35 0.4
Russia 31 1.0 5 2.4
Jordan 31 1.0 28 0.7
Slovenia 31 1.0 32 0.5
Jamaica 34 0.9 5 2.4
Slovak Rep. 34 0.9 17 1.0
India 34 0.9 32 0.5
Uruguay 34 0.9 40 -0.1
Lebanon 38 0.8 32 0.5
Israel 38 0.8 37 0.2
China 38 0.8 38 0.1
Bosnia & Herzeg. 38 0.8 44 -0.6
Tunisia 42 0.6 16 1.1
Egypt 42 0.6 24 0.8
Morocco 44 0.5 21 0.9
Algeria 45 0.4 24 0.8
Average 1.5 0.9
Median 1.3 0.9
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SOURCE: Fund staff estimates.
1/ Banking profitability is defined as the percentage return on assets after tax.
Banks' FSIs have improved, though this could be partly due to continued rapid credit growth. The expansion in bank credit to the private sector slowed to 23 percent in 2005/06 (from an average of 31 percent in the previous two years) but remained on the high side. The slowdown in credit during 2005/06 was broad-based, affecting all types of borrowers-including households. The growing deposit base remained the primary source for credit expansion; banks' foreign borrowing, other than for trade credit, remained negligible.
Concentration of the banking system remains high. As of March 2006, Pakistan's five largest banks held 53 percent of the system's assets and 51 percent of its loans-somewhat less than at end-2004. Public banks still account for about 20 percent of total assets of the banking system (excluding the SBP). Mergers and acquisitions are on the rise, partly as a result of mandated increases in minimum required capital (from PRs 1.5 billion at end-2004, to PRs 3 billion at end-2006, and further to PRs 6 billion in 2009). Foreign banks' interest in Pakistani banks is also on the rise, partly in response to the government's plans to divest most of its shares in several domestic banks.
Monetary policy was tightened in July 2006; reserve requirements on bank deposits were raised for the first time since end-2000 and, two weeks later, the discount rate was increased to 9.5 percent.2
8. Foreign investors' interest in Pakistan increased significantly in 2005/06. The sale of the Karachi Electric Supply Company (KESC) and the partial sale and transfer of management control of Pakistan Telecommunication Company Limited (PTCL) generated large foreign exchange inflows and revitalised the privatisation process.3 Foreign direct investment inflows, excluding privatisation, rose by 70 percent. The successful March 2006 placement of US $800 million of 10-year and 30-year government bonds at very favourable terms was also indicative of strong foreign demand for Pakistani paper.
2 Cash reserve requirements on demand deposits (CRR) were raised from 5 to 7 percent, and the Statutory Liquidity Requirement on demand and time deposits (excluding CRR) was raised from 15 to 18 percent.
3 In mid-June, the Supreme Court annulled the March 2006 sale of Pakistan Steel Mills (for US $362 million) to a group of foreign investors due to procedural irregularities.
9. Progress on structural reforms was mixed. Reforms to broaden the income tax base and reduce rates continued, and the legal framework for investor protection was strengthened. However, reform of the power sector has stalled, and the schedule of higher regional electricity tariffs has not yet been implemented. Progress on trade liberalisation slowed.
III. REPORT ON THE DISCUSSIONS:
10. Discussions on the near-term macroeconomic outlook focused on steps to strengthen the balance of payments and lower inflation, and on policy responses to possible adverse external shocks. On structural reforms, discussions focused on key areas to sustain high growth and reduce poverty over the medium term.
A. ECONOMIC OUTLOOK AND KEY CHALLENGES:
11. The outlook for sustained growth is favourable, provided inflation falls further. In addition, there is a need to strengthen the balance of payments to reduce external vulnerabilities by:
a. containing the external current account deficit;
b. obtaining foreign financing consistent with external debt sustainability; and
c. achieving a higher stock of international reserves.
Discussions on these issues were illustrated by quantitative scenarios. The focus was mainly on: (i) the level and trajectory of the external current account deficit; (ii) the prospects for external financing (particularly for non-debt-creating capital flows); and (iii) the role of macroeconomic policies in reducing external risks.
12. The authorities and staff had broadly similar views on the medium-term path for the external current account deficit, the prospects for external financing, and the targets for international reserves. The external current account deficit has reached relatively high levels-by both historical and cross-country standards-and a further widening could, at some point, compromise external sustainability. However, Pakistan's increased attractiveness to foreign investors (including from oil-exporting countries in the Gulf region) has led to a notable rise in the supply of non-debt-creating capital flows (in search of both profitable new projects and purchase of entities slated for privatisation). At the same time, the country's ability to borrow from international and regional capital markets at relatively low spreads and long maturities has also improved. With this change in the supply of capital flows, external financing prospects can remain favourable for several years. During this period, Pakistan could sustain external current account deficits in the range of US $5-6 billion (consistent with a steady decline in the current account deficit-to-GDP ratio), and strengthen gradually its international reserves position (chart).
13. There were, however, differences of views on the policies needed to achieve those outcomes. In the authorities' view, the macroeconomic policy stance envisaged for 2006/07 will keep the external current account deficit at levels broadly similar to last year's outturn, and reduce headline CPI inflation to about 61/2 percent. The current policy stance was also seen by the authorities as consistent with the government's target of real GDP growth of at least 7 percent in 2006/07. The authorities expected import growth to decelerate sharply during the year as the effects of transitory, nonrecurrent factors that pushed up imports in 2005/06 (eg, oil price spike, unforeseen imports of sugar) unwind.
They were also confident that the July 2006 tightening of monetary conditions, supported by continued exchange rate stability, would accelerate the pace of disinflation. The authorities thought that the recent tightening of monetary policy would not have adverse effects on bank lending to the private sector.4 Moreover, they indicated that they were prepared to tighten monetary policy further if inflation continued above the government's 61/2 percent target. On the fiscal side, the authorities saw some scope for overperforming on their budget deficit target for 2006/07, including by saving higher-than-projected revenue.
14. The authorities' policy stance for 2006/07 may not suffice, however, to contain domestic demand growth and stabilise the external current account deficit. In particular, a further tightening of monetary policy, including by allowing higher cut-off rates at treasury bill auctions (to increase commercial banks' demand for government paper and reduce SBP's direct lending to the government), would help slow the growth of private sector credit and non-oil imports, and avoid an increase in the external current account deficit-to-GDP ratio. To be effective, this tightening would have to be supported by greater exchange rate flexibility and by fiscal restraint to keep the underlying budget deficit (the overall deficit excluding grants and earthquake-related expenditures) at the level of 2005/06-ie, some 0.3 percent of GDP lower than the outcome envisaged in the budget.
4 At the time of the discussions the SBP had not finalised revising its monetary projections for 2006/07.
However, staff was informed that the revised projections would include an increase in bank lending to the private sector of about 18 percent (year-on-year) during 2006/07.
15. During the discussions, staff prepared a macroeconomic scenario encompassing monetary and fiscal tightening (Tables 2-6). In the staff's scenario, higher real interest rates starting in 2006/07 are assumed to rein in domestic demand growth, significantly reduce non-oil imports growth, and lower inflation to 61/2 percent. Over the medium term, fiscal consolidation bringing the overall fiscal deficit (excluding grants) below 21/2 percent of GDP, a stable real exchange rate, and the maintenance of real interest rates at positive levels would help keep domestic demand growth in check and narrow the aggregate saving- investment imbalance. Under these policy assumptions, output growth would remain in the 61/2-7 percent range (compared to growth in the 7-8 percent range expected by the government), headline and core inflation would fall further to 5 percent, and the reserve import coverage would rise moderately. The downward trend in public debt and external debt ratios would continue, even under less favourable assumptions for growth and interest rates (Tables 7-8, Figures 1-2). By 2010/11, the external current account deficit as a share of GDP (2.3 percent) would be close to Pakistan's current account "norm" (Box 3).
16. The authorities were in broad agreement with the inflation and international reserves objectives contained in the staff's scenario, as well as with the balance of payments outlook, but took the view that achieving those objectives did not require major changes in the policies currently in place. They also believe that growth would be somewhat higher than assumed by staff. The authorities anticipate that higher growth would result from rapid increases in investment as a result of the large inflows of foreign direct investment, continued support from credit policy, and higher capital expenditure- especially in infrastructure. In addition, they envisage that growth in national savings would outpace the increase in domestic investment, driven by a gradual rise of real interest rates (as a result of the lower inflation), a decline in the fiscal deficit below 3 percent of GDP over the medium term, growth-induced increases in personal disposable income, and favourable demographic trends.
17. The authorities viewed the current level of the real exchange rate as broadly appropriate. They indicated that the real exchange rate was significantly more depreciated than its level during the 1990s, and that export growth had not been affected by the recent, small, real appreciation. Staff noted that while domestic demand pressures, rather than losses in external competitiveness, had been a major factor behind the increase in the trade and current account deficits since 2003/04, future policies should be consistent with avoiding a steady appreciation of the real exchange rate over the medium term. The authorities recognised that a continued strengthening of the rupee would be inconsistent with the required decline in the current account deficit-to-GDP ratio.
BOX 3. PAKISTAN'S REAL EXCHANGE RATE:
Relative to its trading partners, the (CPI-based) real value of the rupee rose by almost 10 percent from December 2004 to June 2006, a period when strong domestic demand put pressure on prices and the external current account, and the external terms-of-trade deteriorated. As of mid-2006, Pakistan's real effective exchange rate (REER) was at about the same level as in early 2002, but well below its average during the 1990s.
Estimates based on two methodologies to evaluate misalignment suggest that the rupee may be slightly overvalued as of mid-2006.1/ Estimates from the equilibrium real exchange rate approach suggest that the rupee is 10 percent more appreciated than the (equilibrium) level that results from applying to Pakistani data the coefficients obtained from a cross-country panel regression of "fundamental" REER determinants. Estimates from the external sustainability approach also suggest the need for a real depreciation of a broadly similar magnitude in order for the current account deficit to decline to the level that stabilises Pakistan's net foreign assets-to-GDP ratio at its 2004 level.
In contrast, estimates from a third methodology, the macroeconomic balance approach (MBA), do not point to an overvaluation of the rupee. According to this methodology, the macroeconomic policies in the staff's scenario (see paragraph 15) would be consistent with a five-year ahead current account deficit-to-GDP ratio (2.3 percent) that is broadly in line with the equilibrium current account ("current account norm") implied by the medium-term levels of the "fundamentals" that determine Pakistan's saving and investment. If the five year-ahead current account deficit-to-GDP ratio were higher than in the projections in Table 3, however, the MBA would also find evidence of overvaluation.
1/ For details on the methodologies see "Methodology for CGER Exchange Rate Assessments"
IMF Research Department, November 2006 (http://www.imf.org/external/pp/longres.aspx?id=3957).
B. RISKS TO THE OUTLOOK AND POLICY RESPONSES:
18. The favourable outlook for capital flows and the balance of payments is subject to downside risks. Even if the external current account-to-GDP ratio is placed on a downward trajectory, macroeconomic stability throughout the projection period will be dependent on the timely receipt of large flows of foreign direct investment (FDI). FDI flows typically consist of a few "lumpy" transactions that are subject to delays of uncertain duration, and are intrinsically difficult to predict.
It is thus possible that in some periods (which may last weeks, or even months) the external financing available to Pakistan could fall short of the amounts assumed in the scenario.5 If policies remain unchanged, official international reserves during those periods would fall below the (rising) path shown in Tables 2-3. Shocks to the current account are also possible. Higher oil prices or lower private transfers could cause deviations from the path for the external current account deficit shown in Tables 2-3, which would also call for a policy response.6
19. The authorities indicated that their response to adverse balance of payments developments would take into account the nature and severity of the shock. They believed that temporary shocks involving external financing shortfalls could be accommodated by using international reserves or increasing foreign borrowing. In cases where the shortfalls were sizeable, or more permanent, however, the authorities noted that their response would take into consideration the full range of policy instruments.
20. Using international reserves to cover external financing shortfalls stemming from balance of payments shocks would carry some risks. This would especially be the case for shortfalls caused by the postponement of new FDI projects (or large-scale privatizations).
The time required to recover the reserves used to finance shortfalls caused by this type of shock is uncertain, and often beyond the authorities' control. Until the flows from that particular FDI transaction materialise, the balance of payments position would be weaker, and external vulnerabilities higher than in the baseline scenario. Continued reliance on this policy response may result in significantly lower levels of reserves which, if sustained for a prolonged period, could reduce Pakistan's attractiveness for foreign investors, and jeopardise external sustainability.
21. Monetary policy should respond quickly to shortfalls of external financing. Because foreign borrowing may not be readily available to cover all external financing shortfalls,7 the task of preventing significant losses of international reserves following shocks to the current or financial account has to fall primarily on monetary policy. In cases where external shocks are very large, fiscal measures conducive to higher fiscal savings also should be part of the policy response. In this regard, discussions centered on the authorities' preparedness to tighten monetary policy in a timely manner in response to balance of payments shocks. To this effect, staff recommended to pay close attention to the level of official reserves when formulating interest rate and exchange rate policy, and to signal to market participants tolerance for greater flexibility in the nominal exchange rate.
5 Net flows of FDI (including privatisation receipts) average US $5.2 billion per annum in the baseline "policy" scenario of Tables 2-6. This implies that delays in finalising one large transaction (either a new project or a privatisation) representing, for example, 20-25 percent of the inflows expected for any given year would create an ex-ante shortfall of financing, relative to the baseline projections, of over US $1 billion.
6 Figure 2 (second row, second column) illustrates the effect of a negative shock to the non-interest current account balance on the external-debt-to-GDP ratio. In this exercise, the new foreign borrowing (which is assumed to be fully available in the same year of the shock) represents the "policy response" to the higher current account deficit.
7 Figure 2 (second row, first column) shows the effects on the external-debt-to-GDP ratio of a shock to the level of FDI flows that is fully offset, within the same year, by additional foreign borrowing.
C. Key Structural Reforms:
22. Structural reforms will be essential for sustaining high growth and poverty reduction through higher rates of saving and investment. Discussions focused on four areas critical to attain this goal.
23. Deepening domestic financial markets. Efficient financial intermediation is a key element in the strategy to maintain Pakistan on a high-growth trajectory. The authorities pointed to the ongoing modernisation of the National Savings Schemes (NSS), recent initiatives to foster microfinance, and the phased reform of the system of broker-financing of stock trading ("Badla") as evidence of their continued efforts to develop domestic financial markets. Discussions centered on the need to subject the NSS to market discipline so as to integrate it more fully with local financial markets, and on the advisability of moving speedily with plans to replace Badla with the regular margin financing used in modern stock exchanges. The staff stressed that new issues of long-term government securities-eg, Pakistani Investment Bonds (PIBs)-were essential for the development of a local bond market, and encouraged the authorities to substantially increase reliance on this means of deficit financing during 2006/07.8 Although banking system soundness indicators have continued to improve, and recent stress tests by the SBP do not reveal vulnerabilities, the authorities agreed with staff that it was prudent to remain vigilant of banking system developments in light of the rapid credit expansion of the last three years.
24. Increasing government revenues. The authorities concur that raising the tax revenue-to-GDP ratio will be necessary to realise their fiscal strategy and create space for pro-poor spending. Key measures to broaden the tax base (such as expanding taxation of the agricultural and service sectors and eliminating non-standard exemptions) could have large revenue potential, but the authorities indicated that there was not enough political support for undertaking them at present. Efforts to increase the efficiency of tax collection by streamlining of income tax rates, however, have continued. On tax administration, there has been recent progress on rolling out large- and medium-taxpayer offices, and discussions covered reform priorities going forward-including improvement of audit strategies, and advancing the functional integration of income and sales tax administration.
8 In May 2006, the authorities raised PRs 10 billion through the placement of 10-year PIBs that carried an average yield of 9.8 percent. This was the first placement of PIBs since May 2004 and represented less than 15 percent of net domestic government borrowing in 2005/06. On September 30, the authorities re-allowed nonbank institutional investors to access the NSS. The scope for large issuances of PIBs in 2006/07 is likely to be substantially smaller as a result of this decision.
25. Improving public service delivery. Steps are being taken to improve the efficiency and composition of government spending and strengthen public financial management, including through technical assistance from FAD. Work conducive to the doubling of spending on education and health as a share of GDP within 10 years (as mandated by the 2005 Fiscal Responsibility Law) is underway, including through the rolling out of medium-term budget frameworks in several key ministries and the preparation of a new Poverty Reduction Strategy Paper. Discussions highlighted the importance of reallocating spending from untargeted subsidies to pro-poor and pro-growth spending in order to reduce inefficiencies and facilitate faster progress towards the attainment of the Millennium Development Goals.
26. Trade liberalisation. Pakistan remains committed to a liberal trade regime, but the authorities indicated that progress in trade liberalisation has been affected by the inconclusive Doha round. Pakistan's textile exports performed reasonably well following the January 2005 expiration of the Multi-Fiber Agreement (Box 4). The authorities noted, however, that they had since felt compelled to adopt schemes to support Pakistani exporters in order to offset the increased subsidies provided by other textile-exporting countries. They also argued that Pakistan's increased efforts to sign preferential trade agreements with several countries was part of a global trend. Staff stressed the advantages of persevering with trade liberalisation despite difficulties in the global trading environment.
D. OTHER ISSUES:
27. Statistics. Pakistan's data are broadly adequate for effective surveillance, but further improvements in the availability and timeliness of key economic statistics would help policy analysis and formulation (Appendix III). On fiscal data, the authorities plan to make interim arrangements (pending full implementation of system upgrades under a World Bank- supported project) for economic classification reporting, and to work on avoiding the recurrence of the large statistical discrepancies between above- and below-the-line fiscal outturns of the last two years. Staff encouraged the authorities to expedite the process of subscribing to the Special Data Dissemination Standard, including by compiling quarterly national accounts and wage data and appointing a national co-ordinator.
28. AML/CFT framework. Pakistan continues to strengthen its anti-money laundering/ combating the financing of terrorism (AML/CFT) framework. In July 2006, the SBP issued prudential regulations recommended by the Financial Action Task Force. In addition, a bill creating a national executive committee on AML is under parliamentary consideration.
BOX 4. TEXTILE AND CLOTHING EXPORTS FOLLOWING THE EXPIRATION OF THE MULTI-FIBER AGREEMENT (MFA)
Textile and Clothing (T&C) is Pakistan's main export industry. Its share in total exports has been around 60 percent for the last 10 years, up from 50 percent in the early 1990s. Only Bangladesh and Cambodia have a larger share of T&C in total exports.
Pakistan performed relatively well in the wake of the removal (in January 2005) of the quotas restricting T&C exports to developed countries under the MFA. T&C export growth started to rise in 2002 (up to a sample-peak of 23 percent in mid-2003) reflecting both expanding production capacity and an improving trade regime. T&C export growth fell below 10 percent in the first quarter of 2005, but ratcheted up to nearly 20 percent by the end of the year.
The scope for sustained market share gains in a post-MFA environment has become more uncertain. Pakistan's T&C export base is relatively concentrated in low value-added products: yarn and bedwear/towels account for 45 percent of T&C exports, while exports of ready-made garments account for only 15 percent. Increases in input costs (ie, minimum wages, interest rates and energy) during 2005/06 may have reduced Pakistan's T&C competitiveness.
Pakistani exporters argue that their foreign competitors benefit from export subsidies and protection from similar cost increases. To allay these concerns, the government has recently granted T&C exporters a research and development subsidy of 5 percent as well as loan-refinancing schemes at below market terms.
Prospects for strong growth in Pakistan's T&C exports remain favourable if productivity gains are sustained and the value-added content of export increases.
Pakistan's textile industry has up-to-date technology, and easy access to home-grown premium-quality cotton. Policies should help enhance the industry's responsiveness to market signals through improvements in the overall business climate, increases in the efficiency of the production process and enhancements in product quality. Across-the-board export subsidy schemes run counter to this objective, as they tend to delay the allocation of resources toward the most competitive sub-sectors in the T&C industry.
IV. STAFF APPRAISAL:
29. Economic performance during 2005/06 was strong. The economy withstood well the impact of large negative shocks, including the tragic earthquake of October 2005, a large rise in international oil prices, and unfavourable weather conditions. Growth remained buoyant, inflation started to decline, and debt ratios fell further.
30. Pakistan continued to attract large inflows of foreign investment. The surplus in the financial account of the balance of payments in 2005/06 reached a historical peak, reflecting a marked rise in FDI flows-destined to both new projects and entities slated for privatisation. Strong foreign demand for Pakistani assets (including from oil-exporting countries in the Gulf region) was also reflected in the favourable terms for new bond placements in international capital markets. Global and regional conditions, together with Pakistan's strong record on the macroeconomic and structural reform fronts in recent years, bodes well for continued sizeable FDI flows.
31. Domestic demand pressures, however, have not subsided. The trade and current account deficits have increased, driven by rapid import growth, and the pace of disinflation remains slow. Credit growth continued at a strong pace in 2005/06, the fiscal deficit (excluding earthquake-related expenditures) increased slightly, and policy interest rates and the exchange rate remained stable. Monetary conditions were tightened somewhat in July 2006, but the authorities do not envisage that further changes in the stance of macroeconomic policies will be necessary in the remainder of 2006/07.
32. Macroeconomic policies in 2006/07 should be more effectively geared at slowing domestic demand growth in order to contain the external current account deficit and accelerate the pace of disinflation. A further tightening of monetary policy resulting in higher cut-off rates at treasury bill auctions and significantly lower central bank lending to the government would help reduce credit and import growth, stabilise the external current account deficit, and attain the government's 61/2 percent inflation target. To be effective, the monetary tightening should be supported by greater exchange rate flexibility and fiscal restraint to keep the underlying budget deficit (the overall deficit excluding grants and earthquake-related expenditures) at the level of 2005/06.
33. Beyond 2006/07, macroeconomic policies should ensure that the current account deficit-to-GDP ratio remains on a declining path. Fiscal consolidation that brings the overall fiscal deficit (excluding grants) to about 21/2 percent of GDP over the medium term, a tight monetary policy stance that keeps real interest rates at positive levels (and credit growth more closely aligned with nominal GDP growth), and the continuation of a policy allowing for greater exchange rate flexibility are necessary to keep domestic demand growth in check, avoid a sustained real appreciation of the currency and gradually bring the external current account deficit to a more sustainable level-in the range of 2-21/2 percent of GDP.
34. The favourable prospects for foreign direct investment bode well for future gains in productivity, but large non-debt-creating capital inflows also present challenges for macroeconomic policy. Continued reliance on inflows of foreign direct investment of uncertain size and timing to finance large current account deficits would require a high degree of flexibility in economic policymaking. In this regard, an improved capacity to generate timely policy responses to shortfalls of external financing arising from negative balance of payments shocks would help safeguard macroeconomic stability in the years ahead. When designing those policy responses, staff recommends that priority be given to a significant strengthening of the international reserves position. The option of resorting to official international reserves to cover shortfalls of external financing carries risks, and should be used sparingly.
35. Structural reforms conducive to sustained increases in saving and investment need to be prioritised. Completing the reform of the regulatory and tariff framework for the power sector will improve productivity, increase public sector savings, and enhance the prospects for privatisation of power companies. Creating space for increases in public investment and pro-poor spending, and for faster fiscal consolidation, requires stepped-up efforts to garner the political support required for broadening the tax base and further curtailing non-standard exemptions.
Improvements in the debt management strategy to shift the sources of fiscal deficit financing away from short-term treasury bills and NSS funds into long-term government securities (PIBs) are essential to jump-start the local bond market. Initiatives underway to modernise the NSS and reform the system of broker-financing of stock trading are welcome, but should be followed quickly with measures that enable the integration of the NSS with local financial markets and with the adoption of the regular margin financing used in modern stock exchanges. Ongoing efforts to improve the investment climate are also important for sustaining rapid growth and reducing poverty.
36. Staff welcomes Pakistan's commitment to maintaining a liberal trade regime, and its determination to contribute to the success of the Doha round of trade talks. To further raise the economy's outward-orientation, staff advises the authorities to resist pressures to reinstate ad-hoc tariff and nontariff measures, and to adopt special support schemes for some exports. It is also important to evaluate carefully the administrative costs and trade diversion effects of the preferential trade agreements currently under consideration.
37. Pakistan maintains an exchange restriction on payments for current international transactions that should be lifted. Under this restriction, advance payments for certain imports are limited to 50 percent. Staff is not proposing approval given the lack of a timetable for lifting this restriction.
38. It is proposed that the next Article IV consultation take place within the standard 12 month cycle.
======================================================================================================================================================================Table 1. Pakistan: Selected Economic Indicators, 2001/02-2006/07 1/
(Population: 151 million (2004))
(Per capita GDP: US$724 (2005))
(Poverty rate: 23.9 percent (2004/05))
======================================================================================================================================================================
Est. Proj. 2/
2001/02 2002/03 2003/04 2004/05 2005/06 2006/07
(Annual changes; in percent)
======================================================================================================================================================================
Output and prices
Real GDP at factor cost 3.1 4.7 7.5 8.6 6.6 6.5
Partner country demand (WEO definition) 2.4 3.6 4.5 4.6 4.6 4.4
Consumer prices (period average) 2.5 3.1 4.6 9.3 7.9 6.5
Consumer prices (end of period) 3.4 1.9 8.5 8.7 7.6 6.2
Pakistani rupees per U.S. dollar (period average) 5.2 -4.7 -1.5 3.1 0.8 ...
(In percent of GDP)
Saving and investment
Gross national saving 20.7 21.9 18.4 16.7 16.1 16.5
Government -0.8 1.3 1.1 0.5 1.1 1.6
Nongovernment (including public sector enterprises) 21.5 20.5 17.3 16.3 15.1 14.9
Gross capital formation 3/ 16.8 16.9 16.6 18.1 20.0 20.5
Government 2.9 2.7 2.8 3.5 4.7 5.2
Nongovernment (including public sector enterprises) 13.9 14.2 13.7 14.7 15.3 15.3
Public finances
Revenue (including grants) 16.1 17.4 14.6 14.0 14.5 14.6
Expenditure (including statistical discrepancy) 19.7 18.7 16.4 17.0 18.2 18.1
Budget balance (excluding grants) -5.5 -3.8 -2.3 -3.3 -4.2 -3.9
Budget balance (including grants) -3.6 -1.4 -1.8 -3.0 -3.6 -3.5
Primary balance (including grants) 2.0 2.9 1.7 0.2 -0.6 -0.4
Total government debt 81.4 75.3 67.8 61.8 56.1 53.0
External government debt 41.0 36.0 32.1 29.0 26.2 24.9
Domestic government debt 40.4 39.3 35.7 32.8 29.9 28.1
Implicit interest rate on government debt (in percent) 4/ 6.9 5.8 5.4 5.5 5.8 6.4
(Annual changes in percent of initial stock of broad money; unless otherwise indicated)
Monetary sector
Net foreign assets 13.4 17.5 2.1 2.2 1.7 3.9
Net domestic assets 2.0 0.5 17.5 17.1 13.4 8.6
Broad money 15.4 18.0 19.6 19.3 15.2 12.5
Private credit (annual change; in percent) 4.8 18.9 29.8 33.2 23.2 10.4
Six-month treasury bill rate (period average; in percent) 8.2 4.1 1.7 4.7 8.2 ...
External sector
Merchandise exports, U.S. dollars (growth rate; in percent) 2.3 20.1 13.5 16.2 14.0 13.0
Merchandise imports, U.S. dollars (growth rate; in percent) -7.5 20.1 21.2 38.3 31.3 10.1
Current account including official current transfers (in percent of GD 3.9 4.9 1.8 -1.4 -3.9 -4.0
(In percent of exports of goods and nonfactor services; unless otherwise indicated)
External public and publicly guaranteed debt 282.0 229.0 209.5 183.7 168.3 156.9
Debt service 35.8 26.6 17.3 16.1 14.1 12.8
Implicit interest rate (in percent) 4/ 4.3 3.4 2.8 2.5 2.4 2.6
Gross reserves (in millions of U.S. dollars) 5/ 4,337 9,529 10,564 9,805 10,760 12,060
In months of next year's imports of goods and services 3.7 6.5 5.0 3.6 3.6 3.6
Memorandum items:
Real effective exchange rate (annual average; percentage change) 6/ -2.6 -0.1 -1.8 0.3 5.3 ...
Terms of trade (percentage change) -0.5 -0.9 1.8 -8.3 -4.4 0.5
Real per-capita GDP (percentage change) 1.1 2.2 5.4 6.5 4.6 4.6
GDP at market prices (in billions of Pakistani rupees) 4,402 4,823 5,641 6,581 7,713 8,748
GDP at market prices (in billions of U.S. dollars) 71.9 82.6 98.1 111.0 129.0 141.4
======================================================================================================================================================================
Sources: Pakistani authorities; and Fund staff estimates and projections.
1/ Fiscal year ends June 30.
2/ Staff projections; assume monetary and fiscal tightening during 2006/07.
3/ Including changes in inventories. Investment data recorded by the Federal Bureau of Statistics are said to underreport true activity.
4/ Calculated as interest payments in percent of the end-of-period debt stock of the previous year.
5/ Excluding gold, foreign deposits held with the State Bank of Pakistan, and net of outstanding short-term foreign currency swap and forward contracts.
6/ An increase is a real appreciation.
===============================================================================================================================================
Table 2. Pakistan: Medium-Term Macroeconomic Framework, 2003/04-2010/11
Est. Proj. Proj. Proj. Proj. Proj.
2003/04 2004/05 2005/06 2006/07 2007/08 2008/09 2009/10 2010/11
(in percent of GDP)
===============================================================================================================================================
Saving and investment
Current account balance 1.8 -1.4 -3.9 -4.0 -3.6 -3.1 -2.8 -2.3
Gross national saving 18.4 16.7 16.1 16.5 17.4 18.4 19.1 20.2
Gross capital formation 16.6 18.1 20.0 20.5 21.0 21.5 22.0 22.5
(In billions of U.S. dollars, unless otherwise indicated)
Balance of Payments
Current account balance 1.8 -1.5 -5.0 -5.6 -5.6 -5.2 -5.2 -4.6
Net capital flows 1/ -1.0 1.1 6.3 7.0 7.7 7.4 7.7 7.8
of which : Foreign direct investment 2/ 1.0 1.5 3.5 4.5 5.0 5.3 5.5 5.5
Gross official reserves 10.6 9.8 10.8 12.1 14.0 15.9 18.1 21.0
In months of imports 3/ 5.0 3.6 3.6 3.6 3.8 3.9 3.9 4.1
External debt (in percent of GDP) 34.0 30.7 27.7 26.0 24.8 23.4 22.0 20.7
(In percent of GDP)
Public Finances
Primary balance 4/ 1.7 0.2 -0.6 -0.4 0.2 0.4 0.4 0.5
Overall fiscal balance 4/ -1.8 -3.0 -3.6 -3.5 -3.1 -2.7 -2.5 -2.2
Underlying fiscal balance 5/ -2.3 -3.3 -3.4 -3.4 -3.2 -2.9 -2.6 -2.4
Total government debt 67.8 61.8 56.1 53.0 50.4 47.9 45.4 43.1
(Annual changes in percent)
Output and prices
Real GDP at factor cost 7.5 8.6 6.6 6.5 6.5 6.5 7.0 7.0
Consumer prices (period average) 4.6 9.3 7.9 6.5 6.0 5.5 5.0 5.0
===============================================================================================================================================
Sources: Pakistani authorities and IMF staff estimates for historical data. Projections based on a staff scenario of monetary
and fiscal tightening.
1/ Difference between the overall balance and the current account balance.
2/ Including privatisation.
3/ Ratio of gross official reserves to next year's imports of goods and services (divided by twelve).
4/ Including grants and earthquake-related expenditures.
5/ Excluding grants and earthquake-related expenditures.
=================================================================================================================================================================================================
Table 3. Pakistan: Balance of Payments, 2001/02-2010/11
Est. Projections 1/
2001/02 2002/03 2003/04 2004/05 2005/06 2006/07 2007/08 2008/09 2009/10 2010/11
(In millions of U.S. dollars; unless otherwise indicated)
=================================================================================================================================================================================================
Current account 2,833 4,061 1,811 -1,534 -4,996 -5,617 -5,608 -5,195 -5,225 -4,602
Balance on goods -294 -359 -1,279 -4,514 -8,442 -8,819 -8,713 -8,599 -8,220 -7,460
Exports, f.o.b. 9,140 10,974 12,459 14,482 16,506 18,648 21,445 24,876 29,105 34,344
Imports, f.o.b. -9,434 -11,333 -13,738 -18,996 -24,948 -27,46 7 -30,158 -33,476 -37,326 -41,805
Services (net) -298 -11 -1,316 -3,293 -4,402 -4,990 -5,577 -5,637 -6,135 -6,549
Services: credit 1,916 2,703 2,644 3,319 3,748 3,724 4,395 5,239 5,969 7,105
Services: debit -2,214 -2,714 -3,960 -6,612 -8,150 -8,715 -9,973 -10,876 -12,104 -13,654
Income (net) -2,319 -2,211 -2,207 -2,386 -2,676 -2,804 -3,144 -3,409 -3,684 -3,903
Income: credit 111 170 187 437 761 825 841 894 928 974
Income: debit, of which: -2,430 -2,381 -2,394 -2,823 -3,437 -3,628 -3,985 -4,303 -4,612 -4,877
interest payments -1,584 -1,277 -1,056 -1,036 -1,232 -1,355 -1,485 -1,553 -1,598 -1,588
income on direct investment -851 -990 -1,228 -1,640 -2,115 -2,273 -2,499 -2,749 -3,014 -3,289
Current transfers (net) 5,744 6,642 6,613 8,659 10,524 10,995 11,826 12,450 12,814 13,309
Current transfers: credit, of which: 5,789 6,714 6,713 8,768 10,632 11,075 11,930 12,555 12,920 13,417
official 1,500 918 549 266 714 447 464 390 292 295
workers' remittances 2,390 4,237 3,871 4,168 4,600 5,000 5,500 5,900 5,925 5,950
other private transfers 1,899 1,559 2,293 4,334 5,310 5,629 5,966 6,265 6,703 7,172
Current transfers: debit -45 -72 -100 -109 -108 -80 -104 -105 -106 -108
Capital account 0 1,133 82 685 183 158 422 261 366 273
Capital transfers: credit 0 1,133 85 693 192 169 434 275 381 288
Of which: official capital grants 2/ 0 1,133 70 657 144 118 384 225 202 179
Capital transfers: debit 0 0 -3 -8 -9 -11 -12 -14 -15 -15
Financial account -1,107 -1,104 -1,673 -12 5,897 6,887 7,251 7,130 7,381 7,577
Direct investment abroad -2 -27 -45 -66 -70 -90 -99 -109 -120 -132
Direct investment in Pakistan 485 798 951 1,525 3,521 4,517 5,000 5,300 5,500 5,500
Of which: privatisation receipts 117 186 199 363 1,540 1,517 1,500 1,500 1,500 1,500
Portfolio investment (net), of which: -491 -206 -25 162 985 1,765 1,405 912 818 1,423
Eurobond/GDR 0 0 500 600 800 1,500 1,000 1,000 1,000 1,000
amortisation -483 -261 -163 -142 -187 -165 -25 -523 -622 -22
Other investment assets 236 -216 -669 -1,352 196 -445 -115 -110 -215 -140
General government 127 -18 3 -2 3 0 0 0 0 0
Banks -53 -25 -220 -986 380 -195 100 100 100 100
Other sectors 162 -173 -452 -364 -187 -250 -215 -210 -315 -240
Other investment liabilities -1,335 -1,453 -1,885 -281 1,265 1,140 1,060 1,138 1,397 926
Monetary authorities -155 -51 2 -5 -1 0 0 0 0 0
General government, of which: -452 -1,419 -1,792 574 761 808 794 768 1,033 590
disbursements (medium and long term) 1,416 1,202 970 1,892 2,036 1,888 1,853 1,855 2,101 1,993
amortisation (medium and long term) 3/ -1,513 -2,421 -2,419 -1,434 -1,059 -1,044 -1,109 -1,137 -1,118 -1,093
Banks -90 36 75 -55 15 87 87 87 87 87
Other sectors -638 -19 -170 -795 490 244 180 282 278 248
Net errors and omissions 927 534 221 -7 244 0 0 0 0 0
Reserves and related items -2,653 -4,591 -781 410 -1,328 -1,427 -2,066 -2,197 -2,522 -3,247
Reserve assets, of which: -3,081 -5,261 -299 610 -1,130 -1,400 -2,000 -2,000 -2,300 -3,000
foreign exchange (State Bank of Pakistan) -2,713 -5,678 -442 493 -774 -1,300 -1,900 -1,900 -2,200 -2,900
foreign exchange (deposit money banks) -365 650 123 117 -356 -100 -100 -100 -100 -100
Use of Fund credit and loans 290 50 -427 -145 -143 -127 -166 -197 -222 -247
Exceptional financing 138 620 -55 -55 -55 100 100 0 0 0
Memorandum items:
Current account (in percent of GDP; including official transfers) 1.8 0.0 0.0 0.0 -3.9 -4.0 -3.6 -3.1 -2.8 -2.3
Exports f.o.b. (growth rate; in percent) 2.3 20.1 13.5 16.2 14.0 13.0 15.0 16.0 17.0 18.0
Imports f.o.b. (growth rate; in percent) -7.5 20.1 21.2 38.3 31.3 10.1 9.8 11.0 11.5 12.0
Terms of trade (growth rate; in percent) -0.5 -0.9 1.8 -8.3 -4.4 0.5 0.3 0.5 0.5 0.4
Workers' remittances and other private transfers (growth rate; in percent) 38.6 35.1 6.3 37.9 16.6 7.3 7.9 6.1 3.8 3.9
External debt (in millions of U.S. dollars) 4/ 33,400 33,352 33,307 34,037 35,679 36,784 38,405 39,299 40,381 41,616
Gross financing needs (in millions of U.S. dollars) 5/ -837 -1,379 771 3,110 6,242 6,825 6,742 6,855 6,965 5,717
End-period gross official reserves (millions of U.S. dollars) 6/ 4,337 9,529 10,564 9,805 10,760 12,060 13,960 15,860 18,060 20,960
(In months of next year's imports of goods and services) 3.7 6.5 5.0 3.6 3.6 3.6 3.8 3.9 3.9 4.1
=================================================================================================================================================================================================
Sources: Pakistani authorities; and Fund staff estimates and projections.
1/ Projections are based on a staff scenario of monetary and fiscal tightening.
2/ Includes U.S. capital grants to finance accelerated repayment of U.S. debt in 2002/03 ($1 billion) and in 2004/05 ($495 million).
3/ Includes accelerated repayments to the U.S. ($1 billion in 2002/03 and $495 million in 2004/05) and to the AsDB ($1.1 billion in 2003/04).
4/ Including IMF, military debt, commercial loans, and short-term debt.
5/ Defined as current account balance plus amortization of medium- and long-term debt.
6/ Excluding foreign currency deposits held with the State Bank of Pakistan (cash reserve requirements), gold, and net of outstanding short-term swap and forward contracts.
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