IMF's tenth review

The IMF's tenth review has ended on a positive note. Pakistan has met all the quantitative performance criteria for the quarter ended December 2015. In particular, the strong tax revenue collection by FBR in the second quarter has been commended. However, the end-December target for Net Domestic Assets of the SBP was raised by Rs 250 billion to increase the likelihood of meeting this performance criterion. How has the process of achieving targets been implemented?
Net international reserves were expected to increase by $2345 million during the quarter. This represented a big jump of 34 per cent. Gross international reserves increased during the quarter by only $638 million or 4 per cent. Therefore, reserve-related liabilities must have decreased by as much as $1707 million. It is not clear how this has been achieved.
The fiscal deficit target was exceeded by Rs 23 billion in the first quarter of 2015-16. It has been restricted to below Rs 296 billion in the second quarter as compared to Rs 329 billion in the first quarter. This is partly due to extra revenues of Rs 35 billion by FBR in the second quarter.
Also, the four Provincial Governments combined have generated a very large cash surplus of over Rs 200 billion as of the 31st of December 2015. This is almost 150 per cent above the level achieved on the same date last year. The fundamental question is whether the large surplus will continue for the rest of the year. The target is ambitious at a cash surplus of Rs 297 billion as of 30th June 2015. Will the Provinces continue to demonstrate restraint when they would like higher expenditure benchmarks for the 9th NFC Award?
Other mechanisms which have been used to restrict the fiscal deficit are a reduction of 21 per cent in releases for the Federal PSDP in the second quarter as compared to the first quarter. Probably, there will be a cut of Rs 100 billion in the federal PSDP for 2015-16, in relation to the originally budgeted level. It is significant that bank borrowings during the month of January 2016 have risen by as much as Rs 180 billion in relation to the end-December level. Clearly, there is an issue of timing of payments. Towards the end of a quarter, these appear to be deferred by post-dated transactions.
FBR revenues have increased by 24 per cent in the second quarter. This is even in excess of the annual growth target of 20 per cent. Indirect taxes like sales tax and customs duty have shown extraordinary increases of 32 per cent and 41 per cent respectively. Over 72 per cent of the increase of Rs 120 billion in revenues in the second quarter is in indirect taxes. Income tax has shown a modest increase of less than 12 per cent.
A large part of the jump in indirect tax revenues has come from petroleum products. The fall in prices has been used as an opportunity for raising tax rates drastically. During the last quarter, the sales tax rate on HSD was enhanced to 51 per cent, three times the standard rate. This has yielded additional revenues of Rs 30 billion during the quarter. In addition, import duties have been introduced on petroleum products, which were exempt earlier. Further, minimum duties have been raised on all other exempt products. These measures yielded higher revenues of Rs 50 billion. The mini budget announced at the end of November, mostly included enhancement in tax rates. It generated an extra Rs 15 billion in December.
A number of concerns can be raised about the strategy of mobilising additional resources through escalation in indirect tax rates. First, the incremental burden falls more on the lower income groups. Second, the sustainability of such a strategy remains doubtful in the event prices start rising once again. It appears that one of the key reforms in the Fund Program of broad-basing the tax system and raising the share of direct taxes remains elusive.
The Press Note issued by the IMF emphasises that a strong buffer has been created by the increase in foreign exchange reserves to a level equivalent to four months of imports. But these reserves increased by only $638 million in the quarter under review. This is the smallest increase in the last five quarters. There would have actually been a decrease if short-term debt of $727 million had not been contracted in the quarter.
Also, there are no grounds for complacency on the balance of payments front. No doubt the precipitous fall in oil import prices has reduced the pressure on the current account. But exports have also fallen and non-oil imports have risen. Home remittances have begun to flatten out, with little growth in the last two months. The consequence in that, contrary to expectations, the current account deficit has actually increased by 10 per cent in the second quarter, as compared to an improvement of 77 per cent in the first quarter.
Developments on the capital account are also worrying. Total foreign investment has fallen by 49 per cent in the first six months. Almost, $250 million of portfolio money has left the country. Foreign direct investment from China has increased by $180 million, but it has fallen from all other countries combined by $206 million. Overall external borrowings have aggregated to $1784 million in the second quarter. But reserves have increased by $638 million only. Over $1billion has been used to finance current and other transactions. This does not auger well for the sustainability of external debt.
The IMF also believes that 'economic activity remains robust. Although a weak cotton crop, declining exports and a more challenging external environment are weighing on growth prospects, real GDP growth is expected to reach 4.5 per cent in 2015-16, helped by lower oil prices, planned improvements in the energy supply, investment related to the CPEC, buoyant construction activity and acceleration of credit growth'.
Positive factors behind the likelihood of achievement of the higher GDP growth rate of 4.5 per cent are perhaps exaggerated. According to the IMF in Eighth Review Report, any economic expansion as a result of CPEC project implementation is expected to be limited as increased investment may initially be offset by a significant increase in imports. Moreover, CPEC projects in the Federal PSDP are being implemented slowly. On average, only about 20 per cent of the annual allocation to these projects has been utilised in the first seven months of 2015-16.
There is an increase of 9 per cent in the stock of borrowing by the private sector from the banking system. Imports of machinery have increased by 14 per cent, almost 52 per cent of which are for the power sector. However, 31 per cent of private investment is in agriculture compared to 13 per cent in manufacturing. Given the state of agriculture, investment in the sector is likely to fall sharply in 2015-16.
The rate of increase in electricity generation, in the first five months, is only 2 per cent. This is despite the big fall in fuel costs. The build-up of circular debt is constraining generation once again. Construction activity was more buoyant in the first quarter than in the second quarter. As cuts are applied on the Federal and Provincial PSDPs, the buoyancy will come down further in the second half of the year.
Overall, it is unlikely that the GDP growth rate will reach 4.5 per cent in 2015-16. A more likely outcome is a growth rate close to 3 per cent, significantly less than last year. There is need to also factor in the fall in rural purchasing power due to lower output and prices on demand for consumer goods and durables. Already, for example, production of tractors is down by 40 per cent. As of November, half the industries have shown either negative growth or low growth (below 2 per cent).
There is also a need to recognise that the massive privatisation program agreed with the IMF has not gone well. Ten entities have been identified for capital market transactions, 25 for strategic private sector participation and three for restructuring followed by privatisation. Up till now, the only significant transactions are the sale of shares of HBL and UBL, which have yielded over one billion dollars of foreign exchange receipts from buyers.
The opposition by workers of PIA and the tragic deaths during the strike have clearly led to a postponement of the process. The Fund Program comes to an end in September 2016. It is unlikely that much progress will be made in implementing the privatisation program by this time. Fortunately, the balance of payments projections by the IMF do not assume any privatisation receipts from foreign buyers up to 2019-20.
Finally, there is need for greater transparency. Up till now, every review has led to agreement on some prior actions, implementation of which is necessary before a tranche release. In the last four reviews three prior actions have been required on average. What are the prior actions that the Ministry of Finance has committed to in the latest review? Does this include further enhancement in energy prices/ tax rates or more expenditure cutbacks?
(The writer is Professor Emeritus and former Federal Minister)