Contours of a new IMF programme-II

This is the second article on the contours of a new IMF Programme. The first article was published last week. It focused on the projected external balance of payments from 2024-25 to 2026-27. The targets identified are such that based on a strong process of adjustment Pakistan’s foreign exchange reserves will rise sufficiently by 2026-27 to a ‘safe’ level, equivalent to import cover of three months.

The methodology adopted for setting targets is three-fold. The first approach is to look at the three-year Extended Fund Facility of Pakistan within the IMF from 2019 to 2023 and determine the magnitude of changes that were expected during the tenure of the Programme. This Programme was a failure and Pakistan received only a small fraction of the committed loan size.

The second approach is to look at the five-year macroeconomic projections and targets in the PML-N (Pakistan Muslim League-Nawaz) election manifesto. There will be need to identify if these targets have to be made even more challenging.

The third approach is to look at the targets embodied in IMF Programmes of countries like Sri Lanka, Egypt and Bangladesh. These countries face similar problems like Pakistan in varying degrees in building up their foreign exchange reserves and reducing the extent of their external vulnerability.

The first set of targets in this article relates to the budgetary position over the next three years. A fundamental improvement in the state of public finances of the country is essential if the economy is to be stabilized and the pressure reduced on the external balance of payments.

The first key target relates to the required level of fiscal effort. The last few years have actually witnessed a significant decline in the tax-to-GDP ratio. It was 11.3% in 2017-18 and has fallen to 10%, even after the inclusion of petroleum levy as a source of tax revenue.

The previous EFF of Pakistan had included a very ambitious target of an increase in the tax-to-GDP ratio by 5 percentage points over the three-year period. The PML-N manifesto envisages a rise in the tax-to-GDP ratio by 3 percentage points over the five-year period.

A demanding target will be an annual increase of 1% of the GDP over the three-year period of the EFF. This will require the implementation of taxation proposals by the federal and the provincial governments combined yielding over Rs 1500 billion annually. Hitherto favored sectors like agriculture, wholesale and retail trade, private services and real estate will have to be brought strongly into the tax net. Simultaneously, the process of greater documentation and reduction in tax evasion will have to be achieved.

Turning to the expenditure side, the expectation is that as the rate of inflation moves downwards, interest rates will accordingly come down. The likelihood is that the debt servicing burden will fall by 1% of the GDP by 2026-27. Also, the expectation is that there will be greater economy in expenditure on the current side, especially in costs of civil and defence administration, subsidies and grants. This should enable another 0.5% of the GDP reduction in current expenditure.

The big jump in tax-to-GDP ratio and containment of the current expenditure-to-GDP ratio should provide some ‘fiscal space’ for enhancement in the level of development spending by 1% of the GDP and rise in pro-poor spending by 0.5% of the GDP.

Overall, the budget deficit should be brought down to 5% of the GDP in 2026-27 from close to 8% of the GDP in 2023-24, with an annual reduction of 1% of the GDP. Correspondingly, the primary surplus will rise to almost 2.5% of the GDP. This improvement will facilitate the process of decline in the government debt-to-GDP ratio and constitute a ‘market test’ of the performance of the incumbent government.

Based on the process of stabilization during the tenure of the IMF EFF, the economy of Pakistan should see some recovery over the next three years in the GDP growth rate. It is likely to remain low at close to 2.5% in 2023-24. The expectation is that it will show a further increase of 0.5 percentage points in 2025-26 and rise to 4% by 2026-27. This will, of course, hinge on the level of gross fixed capital formation. The projection is that as the economy stabilizes and interest rates fall, the overall level of investment in the economy will rise by 2.5 percentage points by 2026-27, from the likely low level of 13.5% of the GDP in 2023-24.

A very critical projection relates to the rate of inflation. Despite the recent decline, the average rate of inflation is likely to be close to 25% in 2023-24. The maintenance of a low current account deficit in 2024-25 will have to be achieved by a market-determined exchange rate policy, as per the likely conditionalities of the IMF. This will imply a significant depreciation in the value of rupee. Further, big increases in electricity and gas tariffs are already under consideration. There is also the likelihood that the IMF may ask for restoration of the sales tax on POL products, which was reduced following the big enhancement in the petroleum levy.

The result is that the rate of inflation is likely to remain relatively high in 2024-25. The likely magnitude is close to 18%. Thereafter, as conditions improve on the external front and the rupee depreciates less, while interest rates come down, the rate of inflation should come down close to a single-digit rate by 2026-27.

There is need to emphasize that the PML-N manifesto targets for a bigger reduction in the rate of inflation to only 4% to 6% by 2028-29, if not even earlier. This will hinge crucially on improved performance of the power and gas sectors, whereby containment of the circular debt is achieved more by efficiency improvements, containment of losses and a transition to renewable energy.

Overall, the next three years are crucial for Pakistan. There is need to appreciate that given the large external financing needs the reform agenda in the impending EFF with the IMF will have to be fully implemented. Pakistan will need to show a much better performance than in the last EFF if the risk of a default in external payments is to be avoided and a rise gradually in the level of foreign exchange reserves is achieved.

Copyright Business Recorder, 2024