While Pakistan's economy remains on a high-growth trajectory during fiscal year 2006, the real GDP growth rate for the year seems increasingly likely to be lower than the 7 percent target.
The expectation of the slowdown relative to the fiscal year 2006 annual target owes principally to the (estimated) weakness in the commodity producing sectors of the economy, the impact of which will be partially offset by an anticipated above-target performance of the services sector.
It is important to understand here that the forecast deceleration in economic activity during fiscal year 2006 does not presage a general weakening of the trend growth of the economy.
With the substantial investments in the current (and preceding) year, strong domestic demand, buoyant exports and a relative improvement in FDI (even after excluding privatisation receipts), the economy is poised to deliver real growth rates in excess of 6 percent through the decade, provided that progress is made towards removing infrastructural bottlenecks, implementing second generation reforms to improve institutions and governance, as well as to further liberalise the economy.
Moreover, in the short-run, it would be necessary to address emerging macroeconomic imbalances while these are still small and not threatening.
Some of the key macroeconomic imbalances include the downtrend in savings that has led to a widening savings investment gap, the growth of the trade deficit (and concomitant rise in the current account deficit) and, a weakening in fiscal indicators (even after adjusting for exceptional earthquake related spending) (see Table 1.1).
Also, while inflationary pressures show a very welcome decline, the downtrend is still unsettled, and inflation remains at relatively high levels.
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Table 1.1: Major Macroeconomic Indicators
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July-December
FY04 FY05 FY06
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growth rates(percent)
Large-scale manufacturing 19.0 21.2 --
Exports 13.2 10.9 23.7
Imports 14.1 35.0 53.1
Tax revenues (CBR) 13.7 15.0 21.7
CPI (12-month moving average) 2.9 7.5 9.1
Private sector credit 13.2 22.3 17.4
Money supply (M2) 9.0 9.8 8.1
million US$
Total liquid reserves1 12,172 11,987 11,712
Home remittances 1,874 1,946 2,055
Foreign private investment 198 452 1,411
percent of GDP2
Fiscal deficit 0.6 1.2 1.8
Trade deficit 0.8 2.2 4.5
Current a/c balance 0.9 -0.7 -2.3
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1 With SBP & scheduled banks. End December.
2 Calculated by taking fiscal year GDP but variable numbers on half yearly basis. Projected GDP has been used for fiscal year 2006.
While inflation has declined from double-digit near term highs in FY05 and is expected to fall to the 8 percent levels by end- fiscal year 2006, it must be recognised that reducing it further is necessary for a host of reasons.
These include the need to encourage a rise in savings (by keeping real returns on savings positive), maintaining the purchasing power of incomes, making exports more competitive (by holding down the cost of production and thus lowering pressure on the exchange rate), etc.
It is important to realise here that while the tight monetary posture of the central bank, (supported by the government's administrative measures) has contributed to a reduction in inflationary pressures, aggregate demand remains strong.
During July-February fiscal year 2006, private sector credit growth was a very substantial 18.1 percent, albeit weaker than the 25.3 percent rise seen in the comparable period of FY05, and while growth in LSM also decelerated, this appears to owe more to factors other than a substantial weakness in demand (eg capacity constraints, high-base effects, technical problems, etc).
In this background, a reduction in the volatility of inflation and establishment of a clear downtrend will be important priorities for the central bank, and therefore, the possibility of a further monetary tightening cannot be ruled out.
However the monetary policy will need to be supported by fiscal prudence. While fiscal discipline had been good in recent years, there appears to be a trend deterioration in fiscal indicators during FY05 and fiscal year 2006.
The revenue balance is in deficit in both years, and even the primary balance deteriorated significantly in fiscal year 2006. Going forward, not only does the government need to maintain low fiscal deficits, these should primarily be caused by developmental rather than current expenditure. While development spending generates economic activity to pay off the debt, current spending only adds to the debt burden.
Moreover, the mode of financing the fiscal deficit is also important. Borrowings from domestic sources other than SBP simply result in a shift of demand from the private sector to the government, but borrowings from SBP are more inflationary as they add to aggregate demand, and therefore financing of the deficit should be through a healthy mix of bank and non-bank borrowings.
It should be recalled that the large Rs 178.2 billion increase in budgetary borrowing from SBP during July-February fiscal year 2006 was an important driver of monetary expansion in the period.
A part of the government's greater reliance on SBP borrowings was driven by weak non-bank receipts, but another contribution was also due to the non-issuance of long-term treasury bonds; almost half of the Rs 31.0 billion net retirement of government borrowings from scheduled banks was due to maturities of these instruments.
It is important that the government make fresh PIB issues to lower dependence on SBP borrowings and to provide a market driven benchmark, which is needed for the development of the corporate bond market.
While low inflation would help providing impetus to growth in years ahead, a disappointing level of national savings and low investment need immediate attention. Specifically, during FY03 and FY04, imports were financed through current account flows.
Unfortunately, thereafter imports continued to grow; the growth in non-debt creating forex inflows was no longer keeping pace with the growing needs of the economy. This is reflected in the widening current account deficit, and resulting in a rising savings-investment gap.
This means that in years ahead the country will be increasingly constrained in its ability to meet the growing consumption and investment needs without generating inflationary pressures and an accelerated growth in the country's debt stock, unless there are substantial policy revisions and sustained reforms to meet the challenge of increasing both investment (to increase productive capacity) and savings (to fund Pakistan's investment needs).
Unfortunately, the growth in the imports, and therefore the current account deficit, cannot be easily contained. Data suggests that much of the growth in imports comprises of either capital goods or input for industries. Curtailing these directly would therefore result in significant fall in economic activities.
Moreover, some further growth in imports is inevitable for a developing economy such as Pakistan, particularly as it seeks to address infrastructural shortcomings.
The large current account deficit can be sustained in fiscal year 2006, but hard choice will have to be made in future years, if it continues to persist. The policy options available will revolve around reducing the need for imports by containing the growth in aggregate demand, promoting exports, and attracting non-debt creating flows (eg FDI). Less desirable options would be to fund the current account deficits through a mix of privatisation receipts and higher debt levels or a significant drawdown of the country's foreign exchange reserves.
The trends in Large Scale Manufacturing (LSM) growth are, however, unclear, due to non-availability of adequate data from the Federal Bureau of Statistics. The SBP GDP estimate therefore incorporates the limited FBS data releases to date, and other available market information, and may be subject to revision when the complete FBS data set becomes available.
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Table 1.2: Major Economic Indicators
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Fiscal Year 2006
Provisional Original SBP
FY05 targets projection
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growth rates (percent)
GDP 8.4 7.0 6.3-6.8
Inflation 9.3 8.0 7.7-8.3
Monetary assets (M2) 19.3 12.8 14.3
billion US$
Exports (fob-Customs record) 14.4 - 16.9
Imports (cif-Customs record) 20.6 - 28.8
Workers' remittances 4.2 4.0 4.3
percent of GDP
Budgetary balance -3.3 -3.8 -4.5
Current account balance -1.4 -2.2 -4.7
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Headline inflation is projected to fall in the 7.7 - 8.3 percent range during fiscal year 2006. While the deceleration is certainly welcome, the downtrend in inflation may prove unstable, and could pose a challenge to macroeconomic stability. SBP will therefore continue to retain a tight monetary stance.
However, it is important to note that monetary policy alone will not be able to contain all of the rise in inflationary pressures. In particular, there is an urgent need for the government to supplement its very laudable supply-side measures with policies to address market structure problems.
Specifically, anecdotal evidence clearly suggests that in recent years, speculative hoarding and collusive price setting have been significant contributors to domestic inflationary pressures in markets for many key commodities. Such pressures respond more to legal and administrative measures, and are less sensitive to monetary tightening.
In contrast to the welcome decline in inflation, the external balance deteriorated significantly in fiscal year 2006. Although remittances are expected to show reasonable growth and exports are likely to remain strong, the current account deficit is expected to swell to 4.7 percent of GDP by end- fiscal year 2006.
While this is not low, it is quite sustainable in the short run. In the longer run, however, large current account deficits cannot be sustained, as these would initiate a vicious circle of debt creation, exchange rate deprecation and inflation.
In summary, given the fast growing trends of aggressive globalisation and increasing regional competition, Pakistan can ill afford to derail its macroeconomic stability which, besides political stability, has been the lynchpin of restoring both domestic and foreign investor confidence.
Macroeconomic management today is complicated by Pakistan's need to continue growing which does require it to stretch its both financial and physical resource base, and the country will have to carefully gauge its priorities in seeking to meet these challenges.
This is likely to be complemented by higher credit disbursements, enabling farmers to increase the use of quality inputs to increase productivity. Thus, with a little luck, wheat yields could surpass the record (2586kg/hectare) set last year.
On the same lines, in aggregate, minor crops could also do significantly better than targeted during rabi fiscal year 2006. However, even if this happens, the overall growth of the crops sub-sector may remain below target due to the considerable underperformance by two major kharif fiscal year 2006 crops, ie cotton and sugarcane.
The overall performance of the agricultural sector could yet receive a significant boost, however, if growth in the livestock sector proves to be significantly above the 3.5 percent fiscal year 2006 target.
While there is little hard data to support this hope, anecdotal evidence suggests that above-target growth could be achieved. Specifically, the dairy industry seems poised to deliver significant production increases in fiscal year 2006 on the back of sustained government and private sector efforts in recent years.
However, there is some evidence that LSM growth has decelerated in July-January fiscal year 2006 relative to the corresponding period of FY05. Available information suggests that while the largest industrial group in LSM, the textiles witnessed a satisfactory growth of 7.7 percent YoY during the first seven months of fiscal year 2006, it is far below the 26.4 percent YoY growth witnessed in the corresponding period of FY05.
Growth in textiles, despite a high base set in the preceding year and higher prices of cotton, was achieved on the back of continued strong external demand.
Similarly, despite rising construction activities, a slowdown was observed in non-metal industries largely because of deceleration in the growth of the cement industry, where production growth slowed to 8.8 percent in July-January fiscal year 2006, reflecting capacity constraints.
The chemical industry also recorded deceleration, posting only 4.4 percent YoY growth in output during July-January fiscal year 2006 primarily due to capacity constraints, in caustic soda production, where capacity utilisation reached above 130 percent. Similar to chemical industry, fertiliser industry also facing capacity constraints witnessed 16.4 percent growth YoY as compared with 42.7 percent growth in the same period last year.
Contrary to above, automobiles industry showed acceleration in growth, recording a 28.2 percent rise in production during July-January fiscal year 2006 over the strong 27.9 percent YoY growth in the preceding year.
Similar to automobile industry, growth in the paper & board sub-sector accelerated to 11.7 percent during July-January fiscal year 2006 as compared to 4.5 percent during the corresponding period of FY05, mainly, due to expansion in production capacity by some manufacturers.
While the rate of increase in the consumer price index has been declining since last quarter of FY05, the same in the wholesale price index has also started deceleration with the beginning of the second half of the current fiscal year.
The reduction in CPI inflation is particularly notable as it dropped from 9.3 percent YoY in June 2005 to 8.0 percent in February 2006 despite sustained high oil prices and the supply shocks. This drop in inflation was more pronounced in food inflation as compared to the non-food inflation.
The core inflation, both measured as non-food non-energy inflation in consumer prices and 20 percent trimmed mean, also maintained its declining trend throughout the first eight months of fiscal year 2006. Inflation in wholesale price index remained high around 11 percent during the first half of the current fiscal year; however, it declined to below 10 percent by February 2006.
The decline in WPI inflation is quite broad-based, with all the sub-groups of the index recording deceleration.
Keeping in view the current scenario of key economic indicators and macroeconomic policy environment, SBP forecasts suggest that the average annual inflation for fiscal year 2006 is likely to be in the neighbourhood of the 8 percent annual target.
Unfortunately, the impact of these gains was offset by the rising expenditures. Consequently, in addition to the decline in fiscal and revenue deficits, the primary balance also slipped into deficit after recording surpluses over the years.
The weakness in the fiscal indicators was primarily due to the spending required for relief and rehabilitation efforts for the earthquake struck regions of the country.
However, this increased spending does not explain all of the deterioration; the Ministry of Finance has put the earthquake-related increase in spending at Rs 30 billion, and even after adjusting for this amount, the fiscal indicators for H1- fiscal year 2006 continue to depict a weakening trend, relative to corresponding periods of the preceding two years.
The risk of a further deterioration in fiscal performance needs to be guarded against. Some key risks include: (1) an exceptionally strong rise in imports underpinned the H1- fiscal year 2006 rise in CBR tax revenues, accounting for 48.0 percent of the share in collections (receipts could therefore slowdown if, as expected, import growth falls back to historical norms); and (2) dependence on potentially volatile non-tax revenues.
Thus, there is clear need for further tax effort to raise the tax-GDP ratio substantially over the next few years. In this context, the reported plan of the CBR to seek a one percentage point increase in the tax-GDP ratio in the next five years needs to be vigorously implemented.
Particular attention needs to be given to the broad-basing of the tax net and improving collections from under-taxed areas of the economy such as agriculture, the services sectors, and equity markets.
The higher interbank rates, amidst declining market liquidity and rising credit-deposit ratio of the banking sector, contributed significantly to the 196 basis point increase in the weighted average lending rate during July-February fiscal year 2006, and a consequent relative deceleration in non-government credit growth.
Although credit growth to private sector remained strong at 18.1 percent during July-February fiscal year 2006, it was substantially lower than the very high growth of 25.3 percent during July-February FY05.
Thus, the lower monetary expansion during the period was contributed principally by the slowdown in non-government credit growth, and depletion in banking system NFA.
Large government borrowing during July-February fiscal year 2006, which contributed significantly to the M2 growth was mainly due to the relief spending needs of the earthquake affected areas, retirement of long-term government paper (PIBs and FIBs), and less than anticipated receipts from NSS instruments.
However, when the anticipated external receipts (PTCL privatisation, Euro bond etc) materialise, some of the decline in NFA of the banking system caused by the external account deficits will be reversed, and there will also be an offsetting fall in government borrowings from the banking system.
Although, such a development would have no material change on overall M2 growth for the full year it would bring the government borrowing and the NFA close to annual targets.
SBP estimates indicate M2 growth is likely to slow from 19.3 percent in FY05 to an estimated 14.3 percent in fiscal year 2006, which would be slightly below the rise in nominal GDP for the first time since FY02.
While the current account deficit posted substantial deterioration of $2.4 billion during July-January fiscal year 2006 on YoY basis, this was more than offset by a significant increase in the capital & financial account surplus.
This sharp deterioration in the current account was principally due to higher import related activities that include: (1) an exceptional 31 percent YoY rise in imports during July-January fiscal year 2006 (based on exchange record), which overshadowed a reasonably strong 13 percent YoY growth in exports; and (2) higher import freight payments, which increased the services account deficit.
Approximately 28.0 percent of the July-February fiscal year 2006 growth in imports is due to the higher POL import bill, and even this owes mainly to rising international prices.
Similarly, another substantial portion of the growth in imports during the period is due to a rise in machinery imports, most of which is catering to the economy's rising demand to increase productive capacity and improve infrastructure.
It has been argued that the domestic economic growth has also stoked the import demand for some consumer durables as well, particularly of cell phone, personal cars, TV, refrigerator etc. However, this is not a consequential development as their share in overall imports growth during fiscal year 2006 is very small.
As the current transfers posted modest growth during July-January fiscal year 2006, most of the deterioration in the trade deficit translated into the current account. However, a significant increase in the capital and financial account surplus more than offset the deterioration in the current account.
A further analysis of financial account inflows however highlights some concerns. While a substantial part of the improvement in financial flows was contributed by foreign private investment especially rising FDI, including a substantial sum of $255 million received as privatisation proceeds that are one-time flow.
Further, portfolio investment also saw a substantial rise during July-January F06; the volatile nature of this flow reduces its desirability as a source of financing.
Medium to long term policy options must therefore revolve around reducing the need for imports (eg reducing energy imports by promoting energy efficiency and raising domestic production), promoting exports, and attracting non-debt creating flows (eg FDI).
Although the current account deficits could also be financed through a mix of privatisation receipts and higher debt or a drawdown of reserves, these are less desirable options. SBP's 2nd quarterly report for fiscal year 2006
(An overview of State of economy)