Executive Summary: Real Sector - Agriculture: Initial estimates suggest that the performance of FY10 kharif crops has been significantly weaker than in the corresponding period last year. This was due to water shortages at sowing times and, more importantly, farmers' disappointment with prices received in the previous kharif season.
The latter is particularly evident in the decline in area under rice and sugarcane cultivation. Conversely, the impact of favourable prices is reflected in the higher acreage under cotton during kharif FY10; cotton prices are currently at an all time high.
On the other hand, the announced support price for wheat may help the rabi crop; however, it is less likely that wheat could add significantly to growth given the high base set by the record FY09 crop. Early signals of poor kharif output, saturation in rabi and uncertain livestock due to decline in non-farm agri-credit, raise the risk of an overall weak performance of agriculture during the current fiscal year.
Large Scale Manufacturing: A modest improvement in aggregate demand was seen in July-October FY10 as manufacturing index increased by 0.7 percent compared with a decline of 5.0 percent in July-October FY09. This could be attributed to gradual easing in monetary policy and fiscal support as well as the impact of increase in farm incomes in FY09.
However, plagued by a multitude of structural issues, the recovery remained weak and patchy: a) although ginning numbers were strong, high lint and yarn exports resulted in raw material shortages for high-value added industries, bringing overall textile growth in the negative, b) automobile sales showed promising growth following a decline in both vehicle and fuel prices; but despite this, refinery production declined owing to the unsettled circular debt, c) domestic cement sales are expected to be impressive as modest recovery was seen in construction activities evident in high YoY growth in production of building material items (eg, billets) as well as import of steel in October 2009.
Nonetheless, export prospects are uncertain given capacity augmentations in importing countries as well as slowdown in construction industry in Afghanistan and Gulf. With such unbalanced patterns of domestic recovery, expected upturn in global prices that will push up domestic energy costs, and lower sugarcane harvest coupled with fears of late crushing (which could impede growth in sugar industry), the outlook for industry in FY10 remains uncertain.
Prices: Domestic inflationary pressures eased significantly during the first five months of FY10 compared with the corresponding period of FY09. Inflation measured by consumer price index (CPI) and the sensitive price indicator (SPI) declined, with CPI inflation YoY dropping to 10.5 percent YoY in November 2009, after reaching single digits (8.9 percent) during October 2009, for the first time in the preceding 21 months.
While an uptick in November is largely attributed to higher food prices on account of Eid-ul-Azha, the recent disinflationary process is a result of: a) improvement in supply of most of the key staples (except sugar), b) constraints on the government's magnetisation of the fiscal deficit, c) lagged impact of tight monetary stance, and d) a decline in imported inflation.
However, variability in monthly inflation rates in WPI inflation (YoY) raises concern over the sustainability of the downtrend, particularly in the second half of the fiscal year. The risk of resurgence in inflationary pressures is also evident from strong core inflation. Both indicators, the non-food non-energy (NFNE) and 20 percent trimmed mean, though declining since H2-FY09, remained high.
One of the main reasons for the persistence in both measures of core inflation, is the double-digit increase in house rent index (HRI) despite an easing since June 2009. HRI has around 46 percent weight in NFNE and 29 percent weight in trimmed mean, hence, the pace of decline in core inflation is slow relative to headline inflation.
Moreover, the rising trend in international commodity prices, particularly crude oil, metals and some food items (eg, rice and sugar) is likely to fuel inflationary pressures in the economy. The risk of higher inflation in food commodities also stems from weak monsoons in India, which would likely have negative spillovers on domestic prices.
Money and Banking: SBP continued to gradually ease monetary policy in FY10, reducing the policy rate by 150 bps in two rounds. On cumulative basis, this means a reduction of 250 bps in the policy discount rate since the beginning of current easing cycle in April 2009. These policy measures were supported by substantial moderation in demand pressures.
For instance, a very sharp drop in headline inflation, ie, from 24.7 percent in November 2008 to 10.5 percent in November 2009; persistent YoY fall in import growth (particularly the negative growth in import volumes during July-November FY10) and the low growth in private sector credit expansion.
The scale and speed of the decline in inflation suggest that the tight monetary policy and sharply constrained magnetisation of the fiscal deficit have eased excess demand pressures that had plagued the economy in the previous three years. This disinflationary impact received further support from lower imported inflation1 and improved domestic production of key staples. However, the expansionary fiscal stance in Q1-FY10 (the deficit increased by Rs 223.7 billion compared with a rise of Rs 137.7 billion in the same quarter last year) has had some repercussions.
For example:
1. A part of the growing deficit was financed through an IMF bridge finance loan, the inflationary impact of which is similar to that of deficit magnetisation.
2. The large jump in deficit, and lower recourse to SBP finance, meant that despite higher non-bank financing, government borrowings from commercial banks increased substantially. Net budgetary borrowing from scheduled banks was Rs 166.0 billion during July-5th December FY10 compared with a net retirement of Rs 67.0 billion in the corresponding period last year.
3. Strong government demand for financing, and low deposit growth is now constraining banks' ability and willingness to take additional exposure; this means an element of crowding out of private investment. These problems are compounded by a significant increase in quasi-fiscal activities, such as financing of the circular debt, and borrowings by various public sector enterprises (PSEs), and government borrowing for commodity operation.
In terms of monetary aggregates, the YoY growth in M2 after witnessing the lowest level of 8.0 percent in April 2009 during the last eight years, reached 13.4 percent by December 05, 2009. This improvement came entirely from YoY rise in net foreign assets (NFA) of the banking system, as net domestic assets (NDA) of the banking system decelerated markedly by end-November 2009. Deposit mobilisation by banks shows some recovery; on a cumulative basis, deposits recorded a growth of 0.1 percent during July-November FY10 in sharp contrast to previous year, when deposits contracted by 3.8 percent.
Fiscal Developments: The Q1-FY10 fiscal deficit came in at 1.5 percent of projected annual GDP, raising concerns over the government's ability to meet the annual target of 4.9 percent of GDP. A significant part of the slippage owed to an unexpected rise in spending (eg, increase in government wages, anti-militancy operations, etc) and delays in some revenue receipts.
If these factors are excluded, the quarterly fiscal deficit should be below 1.2 percent target for the first quarter of FY10. One concern, however, is the heavier contribution of non-tax revenues within overall revenues during Q1-FY10. This is because jumps in non-tax revenues are unpredictable, and are often not sustainable.
For example, non-tax revenues would have fallen by Rs 47.8 billion, had there not been a Rs 70 billion transfer from SBP profits to the government in Q1-FY10. Despite sharp increase in fiscal deficit, financing from domestic sources has grown only moderately, because of the significant rise in net external financing. Also, quite encouragingly, the government has reduced its reliance on inflationary borrowing from the central bank.
The government faces very difficult choices, with considerable pressure to increase social sector spending and build infrastructure, even as the cost of the anti-militancy campaign continues to mount. At the same time, the weak economy constrains its ability to raise revenues from an unchanged tax base.
This suggests the need to urgently work towards broadening the tax base to provide needed essential services and public goods. A major success in fiscal policy, however, is the recent agreement between the federal and provincial governments on the 7th National Finance Commission (NFC) Award.
External Sector:
Balance of Payments: Pakistan's external accounts improved significantly during Q1-FY10 compared to the same period last year. This improvement owed to both, a marked contraction in the current account deficit and an increase in the financial account surplus.
The major impetus came from a contraction in the trade account deficit, but the services and income account deficits also contracted significantly, reflecting lower economic activity. Current transfers were particularly robust recording 43.9 percent rise on account of increase in both, workers' remittances as well as other transfers.
The financing side also recorded marked improvement with the financial account surplus rising by 34.9 percent during July-November FY10. This improvement was primarily driven by increased inflows from the IFIs. Although net foreign investment contracted by 22.4 percent, net portfolio investment returned to positive territory, contributing US $301 million during July-November, against a decline of US $182 million in the corresponding period last year. Foreign direct investment, on the other hand, did not show any signs of recovery and declined by 52.3 percent during the period under review.
As a result of the improvement in the overall external account, Pakistan was able to rebuild its foreign exchange reserves, which reached US $14.5 billion by end November 2009. The foreign exchange market also exhibited relative stability, and exchange rate depreciated by only 2.6 percent during July-November 2009 compared to 13.3 percent in the corresponding period last year.
Trade Account: Pakistan's trade deficit declined significantly by 37.6 percent YoY during July-November FY10, in contrast to a 20.8 percent rise in the same period last year. The decline in the trade deficit was entirely due to 23.0 percent YoY fall in the import bill as exports continued to decline, recording 7.4 percent YoY fall.
The contraction in imports was a result of restrained demand, better domestic production of some commodities (wheat and cotton), as well as fall in international commodity prices. Of these, however, the impact of the fall in the international commodity prices was strongest. Like imports, the fall in exports was also broad-based. Growth in all the main categories, including food, textile, petroleum as well as other manufacturers groups, either extended their decline from the previous year or turned negative.
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