The first IMF review

The first IMF Review on a quarterly basis has been completed of the three-year Extended Fund Facility to Pakistan. The second installment of approximately $450 million has also been received. The Government must be pleased for having met all the six performance criteria with no waivers. Simultaneously, the efforts by the IMF staff must also be recognized. The first Review Staff Report is comprehensive in nature and highlights clearly the changes in the state of the economy of Pakistan.

The objectives of this article are, first, to examine the latest macroeconomic projections by IMF for 2019-20.Second, we focus on the outlook for public finances and highlight particularly the failure to downsize the Federal Government and thereby reduce the pressure to achieve a big increase in the tax-to-GDP ratio.. Third, we examine the serious problems with the management of the power sector which have reached a scale big enough to have macroeconomic consequences. Fourth, issues with the pace and nature of the stabilization process up to the end of the Program are highlighted. Finally, attempt is made to identify the likely 'elevated risks' faced by Pakistan that the IMF Deputy Managing Director has singled out in his statement following the Executive Board meeting.

1. MACROECONOMIC PROJECTIONS FOR 2019-20

The IMF has kept its projection of the growth rate of the economy at 2.4 percent. In our opinion here are strong and increasing reasons now for lowering the projected growth rate. The large-scale manufacturing sector has shown a big negative growth rate of 6.5 percent in the first four months of 2019-20. The cotton crop has failed badly and the likely drop in output is perhaps almost 15 percent. Similarly, sugarcane production is likely to be lower also because of a decline in the planted area. As such, there is need for a significant downward revision in the projected GDP growth rate.

However, the IMF has rightly stressed that net exports will be less negative in 2019-20 due to the severe import compression. This will contribute almost 2.2 percentage points to the GDP growth rate in 2019-20 and thereby keep the original projection unchanged. However, there is need to allow for two other factors. First, the GDP at factor cost will be impacted negatively by the rise in indirect tax revenues. This could reduce the GDP growth rate by almost 1.4 percentage points. Second, private investment is likely to fall sharply in 2019-20. Import of machinery has already declined by 16 percent in the first five months of 2019-20. If this decline persists than the negative contribution to the GDP growth rate could be almost 0.9 percentage points. As such, the positive and negative factors tend to cancel each other out.

Therefore, supply-side developments will play a bigger role in determining the GDP growth rate. With the primary and secondary sectors showing decline in key outputs, it is more likely now that the growth rate will be below 2 percent. This will be the lowest GDP growth rate since 2008-09. Private consumption expenditure is used to reconcile GDP estimates from the demand and supply-side respectively. This will imply little or no growth in private consumption expenditure in 2019-20.

The first Review report has significantly revised downwards the projected inflation rate in 2019-20, corresponding to the period average, from 13 percent to 11.8 percent. No indication is given of the end of period rate of inflation in 2019-20.

The inflation rate projection has probably been revised downwards because of the expectation now of less imported inflation. The July Staff Report was written at the time when the exchange rate of the rupee was depreciating rapidly.

However, the average inflation rate in the first five months of 2019-20 has been 10.8 percent, with the end of period inflation in November of 12.7 percent. If inflation is to average 11.8 percent for the year, then the average inflation rate in the last seven months of the year will have to be 12.5 percent. This implies that there will be little decline in the monthly inflation rate from November to June 2020.

The projection of the rate of inflation by the IMF staff for the remainder of 2019-20 looks realistic. It is likely to remain in the range of 12 percent to 12.7 percent. Factors which will contribute to sustaining the inflation rate will be the impending big hike in gas and electricity tariffs and impact of rising oil prices. Overall, the IMF staff report does not expect the inflation rate to moderate in the next few months, unlike the SBP.

The Staff Report expects now a small increase in the budget deficit from 7.3 to 7.6 percent of the GDP. This is discussed in the next section.

2. OUTLOOK FOR PUBLIC FINANCES

A significant downward adjustment has been made in the projected level of FBR revenues in 2019-20. The target has been brought down from Rs 5,503 billion to Rs 5,238 billion, implying a reduction of Rs 265 billion. This presumably reflects the overstatement initially in the base year magnitude in 2018-19 of Rs 324 billion.

The IMF Staff Report expects that this will be more than compensated for by significantly higher non-tax revenues. The original projection under this head was Rs 838 billion. This has now been raised by Rs 332 billion to Rs 1,170 billion. It is not clear how this will be achieved especially since privatization receipts are not in the nature of revenue but are a financing item.

There are strong reasons to believe that the overall revenue projection for 2019-20 still remains highly optimistic. Initially, the expectation was that FBR revenues would grow by 32.5 percent this year. This has, in fact, been raised somewhat now to 36.8 percent. However, this is still substantially higher than the actual growth rate achieved in the first six months of close to 17.5 percent. Consequently, the growth required to achieve the revised target in the last six months of 2019-20 remains exceedingly high at 54 percent. This is well beyond the realm of possibilities.

There is a high probability that the gap between the projected and actual FBR revenues will widen each quarter. It is likely to be over Rs 100 billion at the end of the second quarter. There will be a big shortfall of Rs 360 billion by the end of the third quarter and of as much as Rs 640 billion by the end of 2019-20.

The emerging gap in FBR's performance is the Achilles heel of the Program. The shortfall in revenues will make it increasingly difficult to meet the Performance Criteria on the size of the primary deficit. The likelihood is that by the Third Review there will be a need for a waiver on the inability to meet this Performance Criteria. Alternatively, there may be pressure following the second review to present a Mini budget with additional taxation proposals.

There is, of course, the likelihood of a cutback in expenditures, as happened in the first quarter, especially on development, grants and subsidies. This will lead to further slowing down of the economy and increase the negative impact of the stabilization process on unemployment and poverty.

The expected budget deficit is now 7.6 percent of the GDP. This is an optimistic projection. If, as highlighted above, FBR revenues do not significantly exceed Rs 4600 billion in 2019-20 then the shortfall in tax revenues could exceed 1.5 percent of the GDP. If the indicative targets on spending are to be met then there will not be much fiscal space for big cuts in expenditure. The only possibility is that of a cut of 0.5 percent of the GDP in development expenditure, grants and subsidies. As such, the budget deficit could reach 8.6 percent of the GDP in 2019-20. Consequently, the primary deficit could be much higher at 1.5 percent of the GDP than the expectation in the Program of 0.6 percent of the GDP in 2019-20.

Looking ahead to the next two years of the Program the pressure for strong contractionary fiscal policy will persist. The tax-to-GDP ratio is to be raised substantially by over 5 percent of the GDP to 16.7 percent of the GDP by 2021-22. This will enable a primary surplus of 1.5 percent to be generated, which if achieved will play a major role in bringing down the public debt to GDP ratio.

3. OUTLOOK FOR THE STABILIZATION PROGRAM The IMF and the Government have agreed to the achievement of very strong objectives with regard to the stabilization of the economy of Pakistan during the tenure of the Program. These include, first, bringing down the current account deficit in 2018-19 from 4.9 percent of the GDP in 2018-19 to only 1.8 percent of the GDP by 2021-22. Over 74 percent of the adjustment is expected in the first year, implying that the Program is heavily frontloaded.

Second, the primary deficit is to be converted from a large deficit of 3.5 percent of the GDP to a sizeable surplus of 1.5 percent of the GDP. Here again, the major part of the adjustment of 58 percent is to be in the first year. Given these outcomes of the stabilization process, the public debt to GDP ratio is projected to fall from 83.5 percent of the GDP in 2018-19 to 73.4 percent of the GDP by 2021-22. Similarly, the external debt to GDP is projected to stay at close to 38 percent of the GDP, thereby reducing the external vulnerability of the economy and enabling it to proceed on a high growth path after 2021-22.

A number of fundamental questions can be raised at this point. Why did the Government agree to such a massive front loading of the Program, after all there are no quick economic and political fixes to problems accumulated over decades? What is the choice of instruments to achieve the containment of the current account and primary deficits? What are likely to be the consequences on the lives of the majority of the population, especially in the lower three income quintiles of the population?

The negative impact of the front loading of the Program is already beginning to be felt. The downward spiral in industrial production and other sectors is the result of a large depreciation of the rupee, big enhancement in the policy rate, heavy additional burden of taxes, escalation in power and gas tariffs and petroleum prices. The inflation rate has approached 13 percent, even though it is understated by the PBS. Food prices have gone up at even faster rate. Unemployment is on the rise due to falling production. It will not be surprising if in the first year, 2019-20, of the Program more than one million workers lose their jobs and almost ten million people fall below the poverty line.

The Program has hardly any human face. The spending in the first quarter under the BISP was only Rs 5 billion when there should have been an increase in the number receiving transfers by almost 2 million and annual outlay reaching Rs 180 billion. Initially, the IMF recognized the need for higher outlays for human development in Pakistan. But following the very first review the indicative target for public spending and education and health has been brought down from 3.9 percent to 3.4 percent of the GDP, corresponding to the level already attained last year.

There are serious questions about the choice of instruments and the intensity of their use to achieve macroeconomic stabilization. There is a strong predilection for the use of monetary policy, especially in the form of a high policy rate. The projections up to 2021-22 in the IMF staff first review report indicate that there is little prospect of the policy rate being brought down from 13.25 percent in 2019-20. At best, there is indication that the policy rate could be brought down by about 150 basis points by the end of the Program, even in the presence of single-digit inflation.

The exchange rate will continue to be used as a strong instrument for reducing the current account deficit. Despite recent stability, the IMF expects that on average the exchange rate will be Rs 161 per dollar in 2019-20 and fall to Rs 172 per dollar by June 2020. The resulting depreciation will be almost 18 percent in 2019-20. Why this is considered necessary in the presence already of a 73 percent cut in the current account deficit in the first five months of 2019-20 is completely inexplicable.

Then there is the resort to heavy additional taxation. The Budget of 2019-20 set a new record on the quantum of revenue to be raised from taxation proposals of almost 2 percent of the GDP. Consequently, the tax-to-GDP ratio is expected to go up to 13.7 percent of the GDP in 2019-20 from 11.6 percent of the GDP in 2018-19. The process of additional taxation has been resorted to in an indiscriminate manner thereby impacting on production/sales, investment and exports and also leading to a more regressive tax system. But the commitment to raise the tax-to-GDP ratio does not stop in 2019-20. Over the next two years it is to be raised further by another 3 percent of the GDP.

The expectation is that by the end of 2021-22, the tax-to-GDP ratio will have tobe raised to 16.7 percent of the GDP. This is well beyond the taxable capacity of the country. A comparison with other Asian countries will illustrate this point. Sri Lanka with a per capita income more than three times that of Pakistan has tax-to-GDP ratio of 11.9 percent only. India with per capita income 75 percent above Pakistan has a tax-to-GDP ratio of 16.2 percent. Bangladesh has a tax-to-GDP ratio of only 8.8 percent of the GDP. Similarly, Indonesia and Malaysia, with much higher per capita incomes, have tax-to-GDP ratios of only 9.9 percent and 12 percent respectively.Therefore, there is a serious question about the over use of the instruments of the policy rate and taxation. The negative impact would have been much less if other instruments would have also been used instead. The obvious choice is of rationalization of current expenditure, both of the Federal and Provincial Governments. But this has not been resorted to because of reasons discussed below.

4. NEED FOR EXPENDITURE RATIONALISATION

The narrative of the IMF is solely fixated on increased revenues as the solution to the perennial issue of fiscal deficits. The result of this obsession is that it has set tax revenue targets that are simply unachievable during the program period of just 3 years as well as being overly ambitious, as shown above, even in comparison with the accomplishments of countries with much higher per capita incomes. In our opinion, a bigger contributor to our fiscal ills is government expenditure. And this an issue well beyond the losses of SOEs like PIA, Steel Mills, Railways and uncovered costs of energy provision.The expenditure side of the equation is a black hole owing to acute structural issues arising from poor prioritization and sheer waste. Our leadership treats public money as its own.

To begin with there is the continued bloated size of the Federal Government even after the 18th Amendment under which several functions were hived off to the provinces. Resultantly, we now have as many as 43 Divisions with individual budgets of less than Rs.1.5 billion, with either redundant functions or functions overlapping those of lower formations of government! Their consolidation, if not closure of most, will be resisted by bureaucrats because it would result in fewer posts of Secretaries; meaning that many of them would simply retire as Joint Secretaries. The politicians would oppose it because it would reduce the number of Ministerial positions for which elected representatives aspire. And then even within the Federal government interrelated functions have been fragmented across two or more attached departments and autonomous bodies. Resultantly, today there are more than 200 such agencies, of which the majority should be wound up, with many having outlived their utility or relevance with changing times and technological developments.There is an entrenched 'entitlement culture' at tax payer expense which has resulted in overstaffing of public sector agencies and the salaries, perks and privileges (cars, housing, etc.) of elected representatives and all variety of officials being much more than what the country can afford.

The situation is no different in the provinces. For instance, in the year 2000 Punjab had 22 departments (already more than those needed to manage the province). It is now a huge employment bureau of 48 departments

Next on this list is the spending on development, which is poorly designed and highly politicized. It is in everyone's interest to get schemes approved and started with extremely small allocations, even though at the time of commencement it is obvious to all that the project will not be finished on time and the cost estimates will become irrelevant fairly quickly. Project staff, related or connected to important decision makers get hired while cars, mobile phones and laptops and other equipment is procured, at times at least 2 years before the real work starts.We understand that in these tough economic times it would be politically difficult to discharge personnel. Therefore, the strategy going forward should be to a) immediately surrender all vacant sanctioned posts as well as posts as incumbents retire through natural attrition and b)seriously consider closing down offices of many of these institutions, placing staff in a resource pool for absorption as and when a need arises, but saving a lot of scarce funds expended on rents, cars and utilities. The non-salary operating costs are in excess of Rs.900 billion. Significant savings should be realized in such expenditure.

5. MANAGEMENT OF THE POWER SECTOR On the seemingly intractable issue of the circular debt, the IMF, with its limited understanding of the woes of our power sector and a three-year time horizon cannot, justifiably, think beyond tariff escalations to fully recover costs of service provision as the solution to the problem. The problems of our energy sector stem from embedded structural fault lines. Donors and the IMF, on whose insistence NEPRA was established in the first place, do not themselves believe in the need for, and efficacy of, such institutions, since the conditionalities attached to their loans have built-in clauses for tariff revision that require NEPRA to merely serve as a rubber-stamping authority.Our power sector suffers from a host of factors. Political interference has contributed to weak governance, poor maintenance of technologically outdated equipment, rickety distribution systems, non-merit appointments, over-staffing, free provision of electricity to WAPDA employees (costing consumers at least Rs 100 million a day), larceny at a grand scale, and literally no accountability. We hear of poor collection of bills. A significant proportion of these "dues" are actually from fictitious consumers- being simply theft in collusion with GENCO staff and reflected/ 'parked' under customers consuming less than 300 units, non-existing consumers and "unmetered connections" (most of them who somehow never get disconnected for non-payment of bills) and of-course, theft through collaborative/abetted corruption with customers. This theft is euphemistically classified as 'technical losses", a bane that we have failed to tackle adequately. The theft simply gets underwritten by a tariff increase. i.e. there is the privatization of public theft! These issues are well known. But instead of addressing them the approach has been to burden honest consumers through higher tariffs

No country can afford robbery with such aplomb. It is also ridiculous to expect DISCOs to operate as commercial enterprises without any equity capital. Instead of having an equity base they can only finance their operations from bank loans raised at unbelievably high interest rates (presently KIBOR plus 2 percent), higher than those being paid by blue-chip companies!Then there is the matter of the high returns guaranteed to the IPPs. Since capital follows the course of least resistance, we are paying a heavy price for attracting investment on almost any terms. The investors have literally taken no risk. The guaranteed returns on equity built into the tariff structure are excessive. which continue to keep electricity tariffs high, forcing the role of the middle class to keeping these IPPs afloat.The outflows of foreign exchange to those investing in power systems has become an unsustainable burden for the economy. For a product or service to be sold in local currency, it is a mistake to provide a guarantee against exchange rate fluctuations. The heavy outflows in foreign exchange to 'service' these investments/loans will continue encumber our external account.Therefore, the only options we have left are, to begin with closure of inefficient public sector GENCOs and the IPPs using high cost and environment unfriendly furnace oil. Next, we need to discontinue the sovereign and capacity commitment guarantees given by the government to IPPs that were established as far back as the first half of the 1990s-all of them practically Pakistani investors. These IPPs have by now recuperated their investments several times over. In their case, the market should be allowed to operate with consumers free to buy electricity from them based on the tariff they offer. Furthermore, there is no option but to renegotiate the Chinese run IPPs guaranteed rates of return of 17% to 22% on equity in dollar terms for 23 years because these high utility tariff rates are making our economy uncompetitive, at a time when the rest of the world is fast adopting renewable energy options because its costs are falling dramatically. This is important because relying on adjustments in the exchange rate as the principal instrument to maintain competitiveness will not be able to neutralize the impact of high energy tariffs on the cost of doing business.Finally, it is the distribution end of the electricity supply chain where management and governance are at their worst. Although privatizing these monopolies (DISCOs) will be a complex task without a highly competent regulator in the form of NEPRA. the reality is that the public sector cannot be restructured; you cannot change a mule into a zebra by painting stripes on it. In an earlier piece in these columns we had proposed a potential way forward on this matter.

6. DMD REFERENCE TO ELEVATED RISKS In IMF jargon use of words like "risks remain" fall in the realm of SOPs, simply to protect themselves from criticism by referring to possible outcomes not in sync with their predictions. However, in IMFese the choice of words like 'Elevated Risks' by the DMD is meaningful and intriguing, if not provocative (without its purport being elaborated), when contrasted against the somewhat generous assessment of the government's performance in the first quarter of the year. Was the DMD hinting at the possible complications in getting endorsement on FATF associated compliances and its potential impact on foreign inflows? It is somewhat disturbing that even after innumerable submissions on FATF queries and expressed concerns, our responses are such that the certifying agency still feels that 150 odd questions remain unanswered to its satisfaction or the evidence in support of our claims is still viewed as inadequate.

Another aspect of these 'elevated risks" may well be about the realization of the projected foreign financing required to settle this year's external debt servicing obligations. The gross financing requirement of just over $27 billion is projected to be met from a) public sector short-term debt rollovers of US$2.1 billion; b) the continuation of the Saudi oil deferred payment facility; c) ensuring the availability of counterpart rupees to finance donor aided projects or getting other necessary tasks accomplished (e.g. land acquisition) in time to solicit and utilize donor committed project aid of $3.7 billion; d) privatization proceeds and FDI flows of $2.2 billion; and e) with hopes for inflows of close to US$11 billion in the shape of rollover of private sector short-term debt of $2.8 billion and commercial loans, Euro bonds and 'hot money' (short-term investments of foreign banks in our T-Bills) with a combined total of more than $8 billion to fill the remaining financing gap. The approach to seek foreign investments in short tenor government instruments is worrisome because it has led to an appreciation of the exchange rate, making it vulnerable to a nasty shock from any sudden outflow of these funds. A better strategy would have been to pick up more dollars from the market to build the foreign exchange reserves, while shielding the economy from the avoidable outcomes of any abrupt flights of capital.Finally, the requirement of rollover/rescheduling of Saudi, UAE and Chinese deposits and loans and the preservation of the Saudi oil facility is merely increasing our excessive dependence on grants from foreign countries, resulting in severely compromising our national sovereignty, vividly already experienced in the shape of the Kuala Lumpur fiasco.

To summarize the import of the discussion above an alternative plan could have been put together with more sequencing for achieving similar results on stabilization by 2021-22, but with greater human face. There is need for more discussions on the strategy for achieving stabilization in coming weeks. Apparently, the Prime Minister is convinced that stabilization has already been achieved and the time has come in 2020 for proceeding to economic revival and providing substantial relief to the people. It will be interesting to seeing how the IMF reacts to such moves.

(The writers are former Federal Minister and former Governor of the SBP respectively)