KARACHI: The State Bank of Pakistan on Monday urged the government for desirable revenue generating measures like broadening of the tax base, improving documentation of the economic system, elimination of un-targeted subsidies and curtailment of quasi-fiscal operations as these are necessary to contain the fiscal deficit in FY12.
According to State Bank of Pakistan's third quarterly report on the State of Pakistan's Economy for FY11, these measures will also help in reducing inflation and the crowding out of private sector credit, thereby facilitating investment, growth and employment opportunities. The government is facing difficulties in containing the fiscal deficit and upto March 2011 the budget deficit was 4.5 percent of GDP, slightly higher than the deficit of 4.3 percent in the corresponding period of the previous year, the report revealed.
"Fiscal discipline and restrictions on government borrowing from SBP are necessary to contain inflationary expectations, which we believe have become ingrained in recent months," the report said and added that in overall terms, although the post-flood hike in CPI inflation has largely dissipated, inflation is stubborn, in excess of 13 percent. Possible reasons could include: (a) the lagged impact of government borrowings from SBP during July-September 2010; (b) frequent upward adjustments in utility and POL prices (c) increase in commodity prices; and (d) the rising trend in the house rent index (HRI), the report said.
The SBP report further said that the impact of the widening fiscal deficit is clearly visible in the sharply rising domestic debt. Outstanding government domestic debt reached Rs 5,594 billion (31.8 percent of estimated GDP) which is more than double the stock at end-June 2007, the Report said and added that this sharp growth in debt stock is fuelling concerns about macro stability and monetary management.
The report has also pointed out four challenges comprising energy shortages, high fiscal deficit, build-up of domestic debt and inflationary pressures and urged the government to develop the policies for these challenges. "Although, Federal Board of Revenue (FBR) is making efforts to improve tax compliance, the implementation of fiscal reforms still poses political challenges and structural problems that require difficult policy decisions for fiscal consolidation are pending resolution and awaiting multi-partisan consensus," the report said and added these decisions include expansion of base of GST through the withdrawal of exemptions, tax on agri-income, and restructuring and privatisation of Public Sector Enterprises. Agricultural and services experiencing growth still remain either outside the tax net or are lightly taxed, it said.
The report observed that the government has had little option but to rely on domestic sources to finance a growing fiscal gap. More specifically, while borrowing from SBP was largely contained at end-September 2010 levels, the abrupt change from April 2011 onwards, as the government borrowed over Rs 350 billion from the central bank during 31st March - 3rd May 2011, were largely meant to internalise the growing quasi-fiscal expense (eg the circular debt in energy) into the budget. In other words, this borrowing is actually financing the carry-over of quasi-fiscal deficits from previous years, according to the report.
It said the provisional estimates show GDP growth at 2.4 percent for FY11, lower than the growth of 3.8 percent in the previous year. In the context of the prevailing security concerns, the exogenous shock from rising oil prices and the impact of the unprecedented floods, this decline is broadly in line with SBP's expectations.
Pointing out the challenging, the report said that the growth outlook will be shaped by policy responses to several key domestic challenges comprising (1) energy shortages, which are restricting growth, the high fiscal deficit- partly owing to the backlog arising from the non-recognition of power sector subsidies of earlier years as reflected in the circular debt; (3) build-up of domestic debt, raising concerns for macro stability; and (4) inflationary pressures which are not receding readily.
On a positive note, the post flood recovery in wheat, sugarcane and minor crops helped agricultural growth surpass previous year's level. However, rural incomes may not rise proportionately due to lower market prices of wheat and rising input costs of diesel and fertiliser, the report noted. On other side the government has also managed to contain spending, showing its commitment to pursue prudent macroeconomic policies, although much of the burden has been borne by development expenditures.
As far as financing is concerned, the report observed that the government has had little option but to rely on domestic sources to finance a growing fiscal gap. More specifically, while borrowing from SBP was largely contained at end-September 2010 levels, the abrupt change from April 2011 onwards (the Government borrowed over Rs 350 billion from the central bank during 31st March - 3rd May 2011) were largely meant to internalise the growing quasi-fiscal expense (eg the circular debt in energy) into the budget. In other words, this borrowing is actually financing the carry-over of quasi-fiscal deficits from previous years, according to the Report.
"In addition, the maturity profile of domestic debt reveals that the government has to rollover the entire stock of Rs 2,854 billion of short term debt at least once a year. Any surge in credit demand from other sectors of the economy could elevate rollover risk, and could also expose the government to interest rate risk," the Report added.
"In terms of fiscal management, going forward, desirable revenue generating measures, like broadening of the tax base, improving documentation of the economic system, gradual elimination of un-targeted subsidies and curtailment of quasi-fiscal operations, are necessary to contain the fiscal deficit to below 4.5 percent of GDP in FY12," the report said, adding that these efforts need to be accompanied with better debt management to increase the tenor of domestic debt and lower risks associated with debt re-pricing and rollover. While ensuring fiscal sustainability, these initiatives will also protect the external account position and rebuild confidence of the private sector and the country's international development partners.
"In the context of a sustainable energy policy, we believe that feasible alternatives to furnace oil, for power generation, need to be developed urgently. Furthermore, the potential role of imported gas is unquestionable in the medium-term, and policy emphasis must be directed towards developing the necessary infrastructure to use imported gas," the report said, adding that more importantly, a better policy option going forward is to rationalise tariffs for different users of this scarce resource and improve the gas pricing structure to incentives further exploration and extraction.
The final budget deficit will depend upon the realisation of the targets of FBR revenues and provincial surpluses. Secondly, SBP is already shifting a portion of this borrowing to the market through outright OMOs, and we expect that government borrowing from SBP will converge to the end-September 2010 level by the end of the current fiscal year as committed by the government.
Despite these major challenges, the external sector showed significant improvement. Specifically, rising prices of value added textiles and strong growth in remittances pushed the current account into a surplus of US $748 million (Jul-Apr 2011) from a deficit of US $3.5 billion in the corresponding period of the preceding year. Textile exports managed to post strong growth despite efforts by competitor countries to hinder concessionary access of Pakistani products in developed markets. The steady growth in remittances is a welcome development - for the first time in the history of the country, monthly remittances crossed the US $1 billion mark for two consecutive months (March and April 2011).
This comfort from the external account together with broadly contained government borrowings from the central bank, allowed SBP to hold the policy rate at 14 percent in the last three policy announcements (January, March and May 2011). These decisions reveal a shift when compared to the cumulative increase of 150 bps implemented during H1-FY11. For effective monetary management, maintaining government borrowings from SBP at end-September 2010 levels will be critical.
"For agriculture, we are optimistic about the next cotton crop for several reasons: (a) higher cotton prices during FY10 encouraged farmers to increase acreage for the next crop; (b) there is a shift towards more productive (and disease resistive) BT cotton seeds; and (c) water availability is expected to improve over last year. On the other side rising fertiliser prices are the key downside risk at the moment", the report noted.
The government has set the wheat procurement target at 6.57 million tones, which is lower than the target for the previous year, the report said. However, the report said, the central bank feels the government may come under pressure to exceed this target since the market price of wheat is considerably lower than its support price while banks appear to be willing to finance the additional procurement. This could feed the circular debt problem and also crowd out the private sector at the margin.
While energy shortages continue to impact a number of industries, some sectors could face new challenges. For example, the disruption in the global supply of auto parts from Japan may impact some manufacturers in Pakistan. In addition, auto manufacturers will face stiff competition from imported cars as the government has increased the age limit for used imported vehicles from 3 to 5 years.
Imports may come under pressure given the sharp increase in crude oil prices in recent days, while the recovery in global demand appears fragile, and could hit Pakistan's textile exports. Furthermore, the price gain in textiles, which helped create a surplus in the current account during FY11, may not be available going forward following a sharp drop in cotton prices even during the off-peak season.
However, there are two reasons for comfort: first, the relative stability in financial markets is an indication that Pakistan has the ability to handle exogenous shocks; and second, net International Financial Institution (IFI) inflows in the past two years have been low, which means a further curtailment is not likely to change the overall position in the external sector.
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