World Bank lists factors exacerbating macroeconomic imbalances in Pakistan

ISLAMABAD: Further policy reform slippages and delays in adjustment measures are likely to exacerbate the already widening macroeconomic imbalances for Pakistan, as heightened domestic political uncertainty over the past few months has slowed the implementation of key reforms to improve overall fiscal and debt sustainability, says the World Bank.

The Bank, in its biannual report, “Pakistan Development Update”, noted that long-standing structural challenges pose risks to the country’s sustained growth. Domestic political uncertainty and policy reform slippages can lead to protracted macroeconomic imbalances, it added.

Tighter global financing conditions, potential further increases in world energy and food prices due to the Ukraine–Russia conflict, and slower global growth due to rising inflation, pose substantial risks for Pakistan’s economic outlook, it added.

A conducive external environment is particularly pertinent for narrowing the large current account deficit and meeting elevated external financing requirements, which requires continued access to international capital markets with manageable yields. The Bank recommended that given the current significant imbalances in the external sector and low external buffers, macroeconomic adjustment, specifically fiscal consolidation to complement ongoing monetary tightening, is urgently needed.

Historically low levels of capital accumulation and productivity growth limit Pakistan’s growth prospects and lead to frequent macroeconomic crises. As such, the current record high trade deficit due to elevated aggregate demand pressures is symptomatic of the long-standing structural issues associated with low potential growth.

To achieve higher and sustained growth, critical reforms needed include those aimed at sustaining macroeconomic stability, increasing domestic revenue mobilization, supporting private sector investment, raising export competitiveness, and improving the financial viability of the energy sector. In the absence of these measures, the fiscal deficit and external accounts could come under further pressure, exacerbating current imbalances. With low fiscal and external buffers, it is also important that Pakistan successfully complete the ongoing IMF–EFF program.

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The Bank stated that on the back of recent monetary tightening, high base effects, and stronger inflation, real GDP growth is expected to moderate to 4.3 percent in fiscal year 2022 and then further to 4 percent in fiscal year 2023 as the government undertakes fiscal tightening measures to manage growing demand pressures and contain external and fiscal imbalances. Economic growth is then projected to recover slightly to 4.2 percent in fiscal year 2024, supported by the implementation of structural reforms to support macroeconomic stability and fiscal sustainability.

After appreciating by 6.9 percent in fiscal year 2021, the Rupee depreciated by 14.3 percent against the U.S. dollar from July to end-March 2022, in part due to pressures from the rising import bill, policy normalization among advanced economies, safe-haven effects associated with the Ukraine war, and domestic political uncertainty. Pakistan’s Real Effective Exchange Rate (REER) depreciated by 3.0 percent between Jul-Feb fiscal year 2022.

Consumer price inflation is estimated to rise to an average of 10.7 percent in fiscal year 2022 on strong domestic demand, higher global commodity prices and a weaker exchange rate. Price pressures are then expected to gradually ease over the forecast horizon as energy prices moderate from recent highs and world inflation pressures dissipate.

Largely reflecting the surge in imports, the current account deficit (CAD) is expected to widen to 4.4 percent of GDP in fiscal year 2022. With monetary tightening to curtail macroeconomic risks emanating from the large external imbalance, imports are projected to decline next year before recovering again in 2024. As export competitiveness reforms gain traction, particularly those aimed at reducing import tariffs on relevant intermediates for the export sector, and increased allocations for export refinance schemes, exports are projected to begin recovering in 2024, the CAD is consequently expected to narrow to 3.0 percent of GDP. In addition, the growth of official remittance inflows is expected to moderate after benefiting from a COVID-19-induced transition to formal channels in fiscal year 2021.

Cumulatively, the CAD in Jul–Feb fiscal year 2022 was recorded at $12.1 billion, compared to a surplus of $1.0 billion in the same period in fiscal year 2021. In January-February 2022, Pakistan received inflows of $1.0 billion against an International Sukuk issuance and $1.1 billion from the IMF, taking net financial inflows in Jul–Feb 2022 to $12.1 billion. Despite these inflows, foreign exchange reserves fell to $12.9 billion at end-March 2022, the lowest since June 2020, and equivalent to 1.9 months of imports of goods and services.

The fiscal deficit (excluding grants) is projected to increase to 6.3 percent of GDP in fiscal year 2022, on the back of higher spending on COVID-19 vaccine procurement, settlement of energy sector arrears, development spending, and the recently announced food and fuel price reduction packages. As the government rolls back the relief measures and resumes fiscal consolidation efforts, the fiscal deficit is projected to narrow slightly to 6.1 percent of GDP in fiscal year 2023. With the implementation of structural reforms to increase domestic revenue mobilization, particularly harmonization of the GST regime and Personal Income Tax (PIT) reform, the fiscal deficit is projected to improve further to 5.3 percent of GDP in fiscal year 2024.

The consolidated fiscal deficit reached Rs1,372 billion in H1 fiscal year 2022 from Rs1,138 billion in H1 fiscal year 2021– an increase of 20.6 percent y-o-y. Higher taxes on imported items and sales tax on goods led to an 18.0-percent growth in revenues, but this was outweighed by higher government spending, which grew 18.7 percent. With most of the increase in spending coming from non-interest expenditures, the primary surplus shrank to Rs81 billion. In H1 fiscal year 2022, all provinces except for Khyber Pakhtunkhwa (KP) recorded a surplus leading to a consolidated provincial surplus of Rs481 billion, almost double of that a year ago. However, a sharp increase in federal current expenditure led to a 33.0-percent increase in the federal fiscal deficit – leading to the wider consolidated fiscal deficit.

Public debt as a share of GDP is projected to remain high, but gradually decline over the medium term, supported by higher GDP growth and declining primary deficits. However, Pakistan’s vulnerability to debt-related shocks will remain elevated as will the country’s external financing requirements. To meet these, Pakistan will need the continued support of its multilateral and bilateral partners and access to international capital markets. The macroeconomic outlook is predicated on the IMF–EFF program remaining on track.

Public and publicly guaranteed debt stood at Rs45.3 trillion at end-December 2021, an increase of Rs3.1 trillion since end-June 2021. Of the total public debt at end-H1 fiscal year 2022, the share of external debt was 37.5 percent, whereas short-term debt was 13.0 percent. Pakistan’s total debt level is in breach of the Fiscal Responsibility and Debt Limitation Act (FRDLA) 2005 (amended in 2017) that stipulated a reduction of total public debt to 60 percent of GDP by end-fiscal year 2018. Moreover, the growing arrears of the power sector and liabilities emanating from commodity operations pose further risks to debt sustainability

In H1 fiscal year 2022, tax revenues grew 19.2 percent y-o-y, up from a growth of 12.0 percent in H1 fiscal year 2021. The higher taxes collected on imported items were due to a combination of higher global prices, and a larger volume of imports. The three largest contributors to growth in revenues in H1 FY22 were sales tax on goods, direct taxes, and taxes on international trade/customs duties. Of the revenues collected by the Federal Board of Revenue (FBR), 52.1 percent are related to imports. More specifically, 70 percent of the sales tax on goods, 13.7 percent of direct taxes and 8.5 percent of the federal excise duty collected were based on imports

The report noted that high demand pressures and rising global commodity prices led to double-digit inflation and a sharp rise in the import bill. These developments have had an adverse impact on the rupee.

The report highlighted that with economic recovery and improved labor market conditions, poverty—measured at the lower middle-income class poverty line of $3.20 Purchasing Power Parity 2011 per day—declined from 37 percent in fiscal year 2020 to 34 percent in fiscal year 2021. However, rising food and energy prices are expected to decrease the real purchasing power of households, disproportionally affecting poor and vulnerable households that spend a larger share of their budget on these items.

The report further noted that Pakistan’s financial sector remains underdeveloped and is failing to effectively deliver on its role as an intermediary of capital. Credit to the private sector as a percent of GDP is low in comparison to peers and has also trended downward over the past decade and a half.

Credit is also concentrated in the corporate segment, leaving other critical segments and sectors such as SMEs underserved. While there are bright spots, such as the microfinance sector, these sub-sectors remain smaller than the dominant banking sector, despite significant potential for growth and financing the real economy in the immediate term. There are several structural impediments preventing the greater flow of financing to the real economy, in particular to the underserved segments. These include: 1) extensive government borrowing from the financial sector; 2) growing but still limited financial inclusion and low domestic saving that limits the resources available to be intermediated to the private sector; 3) market failures in the form of inadequate financial infrastructure leading to informational asymmetries; 4) a weak insolvency and creditor-rights regime; 5) underdeveloped capital markets; 6) high informality and low financial literacy; and 7) high cost of finance and an emphasis on traditional forms of collateral. Enhancing the flow of financing to the real economy requires both the resolution of structural problems and leveraging emerging growth areas, which comprise: a) microfinance; b) digital finance; c) risk capital; d) development finance; and e) capital markets.

The importance of investment for growth is highlighted by the fact that the current levels of private investment and productivity limit Pakistan’s growth potential to 2.5–3 percent per year. Despite the importance of investment for growth, both public and private investment remain low in Pakistan. Private investment stood at 11.3 percent of GDP in 2020, half of the South Asian average of 21.2 percent, and lower than all peer comparators except Egypt.

Credit to the SME sector accounted for only approximately 6.3 percent of total private sector financing in June 2021, catering to the financing needs of only 172,893 SMEs, slightly lower than a decade earlier. According to the SME finance forum, the current quantum of financing amounts to less than 10 percent of the financing requirements of the SME sector. At less than 1 percent of GDP, SME financing also pales in comparison to Pakistan’s peer comparators.

Credit to the government, which includes investments in government securities, direct lending for commodity operations, and lending to SOEs, has increased drastically in recent years, both in levels and as a percentage of total credit extended by the banking sector.

The government is the dominant borrower in the system. Compared to the 131- percent increase in credit to the private sector over the period fiscal year 2011–21, credit extended by the banking sector to the government surged by 442 percent over the same period. This has led to credit to the public sector accounting for 66.8 percent of all the credit extended by the banking sector at end-December 2021. These trends are not limited to the Banking sector but permeate across the financial sector. Pakistan also stands out among peer comparators. As of 2019, credit by domestic money banks to the government and SOEs as a share of GDP in Pakistan was the 11th highest among the 156 countries for which data is available.

“Pakistan’s economic recovery after the Covid-19 crisis indicates that the country has enormous potential to overcome challenging economic situations,” said Najy Benhassine World Bank Country Director for Pakistan. “However, sustaining the economic recovery requires addressing long-standing structural weaknesses of the economy and boosting private sector investment, exports and productivity.”

“To mitigate immediate macroeconomic risks, the government should focus on containing the fiscal deficit at a level which ensures debt sustainability, closely coordinate fiscal and monetary policy, and retain exchange rate flexibility,” said Zehra Aslam, the lead author of the report.

Copyright Business Recorder, 2022