The World Bank (WB) has revised GDP growth projection for Pakistan down to 4.8 percent and raised the projection for inflation to eight percent, predicting a slow-down in poverty reduction efforts in fiscal year 2019. The WB latest report titled "South Asia Economic Focus Fall 2018, Budget Crunch", states macroeconomic stabilization policies will take a toll on growth this fiscal year.
Immediate macroeconomic adjustments are required to correct the large twin deficits. Rising global interest rates and tighter liquidity situation will pose challenges to Pakistan given the high gross external financing requirements. With declining reserves and elevated debt ratios, Pakistan''s ability to withstand external shocks is diminished and risks will remain predominantly on the downside.
The report estimates GDP growth at 4.8 percent in fiscal year 2018-19, reflecting a tighter fiscal and monetary policy. However, with improved macroeconomic conditions, growth could reach 5.2 percent in fiscal year 2019-20. This recovery is conditional upon the restoration of macroeconomic stability, a supportive external environment, including relatively stable international oil prices, and a strong recovery in exports.
Pakistan''s macroeconomic situation remains fragile. Consumption-led growth is expected to slow down due to fiscal and possibly monetary tightening. However, short term measures for fiscal consolidation and export growth need to be complemented with implementation of medium term structural reforms to uplift the economy out of frequent boom-and-bust cycles.
Appropriate policy responses to correct these imbalances and increased buffers to absorb future shocks will reduce these risks and support a positive growth outlook. Such responses would entail increased flexibility of the exchange rate, strengthening the fiscal position through renewed efforts to improve revenue collection and better coordination between federal and provincial governments to reduce public spending.
Inflation is expected to rise to eight percent (average) in fiscal year 2019 and remain high in fiscal year 2020, driven by exchange rate pass-through to domestic prices and a moderate increase in international oil prices. The presence of safety net programs will mitigate the negative impact of inflation on poverty.
FDI, multilateral, bilateral, and private debt-creating flows are expected to be the main financing sources in the near to medium term. The fiscal deficit is projected to narrow in fiscal year 2019 due to post-election adjustments and some fiscal measures. It is expected that there will be some scaling down of public investment spending at the federal and provincial levels, and increase in revenue collection through tax base expansion and other administrative measures.
Fiscal consolidation would improve debt dynamics, but the public debt to GDP ratio is expected to stay around 70 percent of GDP during fiscal 2019 and 2020 - the debt burden benchmark for high-risk in case of Emerging Markets (as per the IMF Market-Access Countries public debt sustainability analysis).
The recent economic history of Pakistan is one of slow growth punctuated by recurrent macroeconomic adjustments, often supported by International Monetary Fund programs. Adjustment programs brought in macroeconomic stability, but often at the cost of a temporary (and often substantial) deceleration in economic activity. And once the economy was back on track, fiscal pressures mounted again, triggering the next boom-and-bust cycle. Fiscal policy has thus amplified macroeconomic fluctuations.
Pakistan''s macroeconomic imbalances are increasing. Economic growth reached 5.8 percent in fiscal year 2018, 0.4 percentage points higher than in fiscal year 2017. On the demand side, growth was driven by consumption which contributed seven percentage points towards GDP growth. On the supply side, recovery in the agricultural and industrial sectors and consistent acceleration in the services sector contributed to the GDP growth.
Although headline inflation remained benign and was recorded at 3.9 percent in fiscal year 2018, core inflation was raised indicating underlying inflationary pressures. Therefore, the State Bank of Pakistan increased the policy interest rate by 175 bps to 7.5 percent between January 2018 and July 2018. The current account deficit increased to 5.8 percent of GDP in 2018, up from 4.1 percent in 2017.
The State Bank of Pakistan intervened heavily in the foreign exchange market in the first half of 2018 to maintain the value of the Pakistani Rupee, resulting in a large decline in international reserves from 16.1 USD billion (2.9 months of imports) at end-June 2017 to 10.2 USD billion (or 1.7 months of imports) by August 24th, 2018.
Under intense market pressure, the currency depreciated by almost 18 percent between 1st December 2017 and 25th of July 2018. Post-election, with emerging political certainty, the Pakistani Rupee recovered three percentage points against the USD and was trading at 124.3 Pakistani Rupees per USD on 7th September 2018.
The fiscal deficit has widened over the past two years - reversing fiscal consolidation efforts in previous years and raising public debt levels. The fiscal year 2018 fiscal deficit (including grants) reached 6.5 percent of GDP-a slippage of 2.5 percentage points compared to the budget target. This was due to limited revenue growth and large increases in recurrent spending at both the federal and provincial levels. Consequently, Pakistan''s public debt reached 73.5 percent of GDP by end-June 2018, significantly raising debt-related risks.
The widening current account deficit reflects the growing trade deficit as exports are not growing as fast as imports. Imports are growing fast due to high domestic demand and import-intensive investments related to the China Pakistan Economic Corridor (CPEC).
The pressure on the current account is expected to persist and the trade deficit is projected to remain elevated during fiscal year 2019 and 2020. Remittances will continue to partly finance the current account deficit, although slower growth in the Gulf Cooperation Council (GCC) countries will affect remittances.
In Pakistan the current account deficit worsened from USD 220 million in the first quarter of 2016 to USD 5.80 billion in the second quarter of 2018. The growth of imports is partly the result of capital goods imports for the China Pakistan Economic Corridor (CPEC), but it is also the consequence of growing macroeconomic imbalances.
In Pakistan, external financing needs reached USD 21.5 billion in fiscal year 2016-17, or 7.1 percent of GDP. They are expected to increase further over the next few years, partly due to loan repayments and profit repatriation related to projects in the China-Pakistan Economic Corridor (CPEC).
The newly elected government recognizes the need for macroeconomic adjustments to overcome these challenges and has already announced its plans to cut expenditures, improve the management of State Owned Enterprises, and undertake revenue mobilization reforms.
After a period of strong foreign exchange intervention, Pakistan has allowed its currency to depreciate substantially. The lowest value was reached by end-July, at 129 Rupees per USD. Despite a modest rebound subsequently, there was a 10 percent depreciation compared to the beginning of the year and a 14 percent depreciation compared to one year before. In India and Pakistan recent nominal exchange rate depreciations have led to a depreciation of the real effective exchange rates. And indeed, in Pakistan import growth came down quite dramatically from its peak of over 30 percent in the first quarter of last year. But at 9.1 percent it is only marginally lower than the 10.4 percent growth in exports
A weaker macroeconomic situation in Pakistan and a delayed adjustment of the exchange rate led to considerable loss of reserves, bringing coverage down to 1.5 months of imports by end-September 2018.
The Bank also released another report, "Pakistan Development Update", which acknowledges that the mini budget is a step in the right direction, but for the gains to continue, additional and urgent reforms are required. These include strengthening taxation, improving public finance and increasing spending efficiency. It also makes a case for investing in people.
As of end-June 2018, total public debt stood at 73.5 percent of GDP, 5.6 percentage points higher than the previous year. This is the highest level since fiscal year 2003. Almost one-third of the increase in fiscal year 2018 came from the depreciation of the Pakistani rupee against the US dollar.
Had this depreciation stayed in line with historical trends, Pakistan''s public debt would have hovered at around 70 to 71 percent of GDP. These levels are still significantly higher than the limit set in the Fiscal Responsibility and Debt Limitation Act (FRDLA) 2005 (amended in 2017), which stipulates a reduction of total public debt to 60 percent of GDP by fiscal year 2018. The country has been in breach of the Act since fiscal year 2010. If the current trajectory persists, Pakistan is unlikely to be able to comply with this law over the next decade.
During the first two months of fiscal year 2019, the current account deficit stood at $2.7 billion (or 0.9 percent of GDP) compared with $2.9 billion (or 0.8 percent of GDP) in the same period in fiscal year 2018.
Pakistan''s ability to raise financing from global markets could be impacted by further interest rate increases by the US Federal Reserve, and by contagion from recent challenges faced by some large developing economies such as Turkey and Argentina which, taken together, could squeeze liquidity away from emerging markets, the report adds.
In addition, the recent recovery in exports may be thwarted by the likelihood of a no-deal ''Brexit'' - the UK being one of Pakistan''s largest trading partners-and by the increased uncertainty that the United States-China trade tensions are bringing to the markets.
However, these tensions could also provide an opportunity for Pakistan, if multinationals opt to relocate production facilities away from China to avoid the adverse effects of tariffs. It is unclear to what degree Pakistan might be able to gain from such relocation, however, given the poor state of its business environment.
Pakistan''s growth has to be driven by investment and productivity. This will put it on a path to end the boom and bust cycles its economy faces," said Illango Patchamuthu, World Bank Country Director for Pakistan. "This will create more and better paid jobs and is a reliable path to future economic growth and stability."
The report notes that exports rose, and imports slowed down in the second half of the year due to a more flexible exchange rate. It recommends reduction in trade costs and improvements in the investment climate to enable Pakistan to compete in global markets.
"The key is to invest in human capital", said Enrique Blanco Armas, World Bank Lead Country Economist for Pakistan. "An educated, healthy and skilled labor force will be more productive and adaptable to new technologies, setting the country on a long-term growth path."
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