The IMF Staff Report setting out the details of the IMF Programme have been released recently. This article examines the Programme strategy, proposed reforms, targets, assumptions and projections over the tenure of the Programme from 2019-20 to 2021-22.
Public finances Improvement in the state of public finances of Pakistan is a key component of the process of stabilization in the IMF Programme. Over the last few years there has been a steady deterioration in the combined fiscal position of the Federal and Provincial Governments. The budget deficit had declined to a relatively low level of 4.6 percent of the GDP with the primary deficit being, more or less eliminated by 2015-16, the last year of the previous IMF Programme. Thereafter, there has been a return to expansionary fiscal policies with the budget deficit touching 6.6 percent of the GDP in 2017-18. Now, in 2018-19, we estimate that it has risen to a record level of 8.6 percent of the GDP.
Consequently, there is exponential growth in the level of public debt. It stood at 61 percent of the GDP in 2012-13. By the end of the 2018-19 it will approach 76 percent of the GDP. This is way above the ceiling set by the Fiscal Responsibility and Debt Limitation Act, of 60 percent of GDP.
The primary cause of the worsening in the fiscal position is the poor performance of revenues and rise in public expenditure as a percentage of the GDP. The former stood at 15 percent of the GDP in 2015-16. By 2018-19, the ratio has fallen by 1.7 percentage points to 13.3 percent of the GDP. Both tax and non-tax revenues have declined in relation to the GDP. Public expenditure has increased by 2.3 percent of the GDP. Therefore, a de facto crisis situation has now been reached.
The Fund Programme proposes a strong remedy of this situation. The revenue to GDP ratio is to be raised markedly over the next three years such that by 2021-22 the fiscal deficit is brought down substantially to as low as 3.8 percent of the GDP with a large primary surplus of 1.9 percent of the GDP. The process of adjustment is heavily front-loaded with the bulk of the improvement to come in the first year, 2019-20, of the Programme.
However, there is a fundamental problem. The IMF base year (2018-19) estimates are far too optimistic. The revenue-to-GDP ratio has been taken at 14.7 percent of the GDP as shown in Table 1. The actual outcome in FBR generated revenues and in non-tax revenues implies that the revenue to GDP ratio will be close to 13.3 percent of the GDP. This is expected, according to the IMF, to rise to 16.1 percent of the GDP in 2019-20 and approach 18.9 percent of the GDP by 2021-22. The rise in the first year, 2019-20, is expected to be almost 2.8 percentage points of the GDP and the targeted increase in tax revenues equal to total tax revenues mobilized in the year 2010-11! Needless to say this is well beyond the realm of possibility, especially in the face of an economy gasping for breath.
The central point of the stabilization strategy in public finances is an almost exclusive focus on increasing revenues rapidly and not on achieving any economy in expenditure. The surprise is that, according to the IMF, public expenditure to GDP ratio will actually increase by 0.9 percent of the GDP, over the Programme period. Clearly, there is an acute need also to focus on economy in expenditure, especially of the recurrent variety.
The focus on the revenue side is, more or less, exclusively on mobilizing more revenues from the FBR. They are projected in the Fund Programme to rise by over 40 percent, from less than Rs 3,850 billion in 2018-19 to Rs 5,555 billion in 2019-20 and somehow increase to Rs 8,311 billion in 2021-22. This will tantamount to more than doubling of revenues in three years.
The surprise is the complete lack of focus on provincial tax revenues. These are expected to rise by only 0.2 percent of the GDP over the three-year period. There is considerable unexploited revenue potential in taxes like the urban immoveable property tax and the agricultural income tax. Also, if a transition is made to a national integrated value added tax of goods and services then the provincial sales tax on services could yield more revenues. This could be augmented by effective extension of the tax to the import of services by application of the 'reverse charge' principle. Overall, the Provincial tax-to-GDP ratio could be raised from 1.2 percent of the GDP to 2 percent of the GDP by 2021-22.
The other potential defect in the proposed strategy for raising more revenues from FBR taxes is the emphasis on exploiting indirect taxes rather than income tax. Only 33 percent of the increase in revenue is anticipated from income tax, when its present contribution to FBR revenues is almost 40 percent. The consequence will be a less progressive tax system by 2021-22. This runs contrary to the objective of what should the agenda of any tax reform.
Turning to the expenditure side, it has already been highlighted above that little economy is proposed in current expenditure, especially at the Federal level. There is a strong case for significantly 'downsizing' the number of Ministries/Divisions and autonomous bodies/attached departments in the Federal Government following the 18th Amendment. However, the Programme envisages that current expenditure, excluding the costs of defense and debt servicing, of this level of Government will decrease by only 0.2 percent of the GDP from 4.4 percent of the GDP in 2018-19. Operating costs, excluding salaries and pensions, aggregate to over 2 percent of the GDP, and there is considerable scope for bringing down these costs. Also, contingent liabilities of the Federal Government, from the guaranteeing of the debt of PSEs, are being met through grants. These payments will exceed Rs 300 billion in 2019-20, with a growth rate approaching 50 percent. They will need to be brought down through improved efficiency and, to some extent, higher cost recovery PSEs.
There is a contradiction in the projection of defence expenditure in 2019-20. The Federal Government had announced in the Budget that the Armed Forces had voluntarily opted for a freezing of their expenditure at the level in 2018-19 of Rs 1175 billion. This was widely appreciated. Now the statement on public finances in the IMF Staff Report is that it will be Rs 1,312 billion in 2019-20, implying a growth rate of almost 12 percent.
The exponential growth in cost of debt servicing since 2017-18 is primarily, almost two thirds of it, the result of the rise in interest rates. By 2019-20, in two years, these costs will virtually double. This brings fundamentally into question the wisdom of the strategy being followed by the SBP to raise interest rates rapidly, essentially because going forward inflation will be stoked by cost-push factors (with the already highlighted slowing down of aggregate demand) and that the federal Government's borrowings (the principal borrower of the economy) are largely inelastic. Almost 165 percent of the increase in absolute terms of the budget deficit on 2019-20 will be due to higher interest payments on Government debt. This implies that an expansionary policy on the fiscal side will largely neutralize the impact of a contractionary monetary policy. Moreover, it is difficult to see why government behavior should change on account of higher interest rates if the State Bank has to inject Rs 800 billion to enable commercial banks to invest in government securities (MTBs and PIBs), since the net interest cost to government of these borrowings (after accounting for SBP's profits from these operations) is less than 50 basis points!
Another problem with the projection of public finances by the IMF is with the level of projected expenditures of the Provincial Governments. These are expected to show a modest increase of only 0.1 percent of the GDP, in the face of an anticipated growth in transfers of almost 2.5 percent of the GDP, due to the 'windfall' from substantially larger revenues in the divisible pool of taxes. The expectation is that the Provincial Governments will show exceptionally 'good' behaviour and generate extremely large cash surpluses of almost 2.4 percent of the GDP by 2021-22. This is highly unlikely, given the autonomy of these Governments following the 18th Amendment and the pressure on them to push up spending on basic social and economic services. Consequently, in the absence of these elusive cash surpluses the attainment of the target consolidated budget deficit of 3.8 percent of the GDP in 2021-22 will remain a pipedream. In fact, in the budgets that unveiled for 2019/20 Sindh and Balochistan have declared no cash surpluses.
We now come to the size of the fiscal deficit. For the first time, the IMF has shifted its emphasis in Programmes with Pakistan from the consolidated budget deficit towards only the primary deficit. The latter is expected to fall in one year in 2019-20 from a as high as 3.4 percent of the GDP in 2018-19, to only 0.6 percent of the GDP. Achievement of this target is one of the most important performance criteria in the Programme. There is the inherent danger that there will be less emphasis on restraining the quantum of debt servicing (and the cost of its servicing) and better public debt management will get a back seat. This is an unfortunate change in the priorities with regard to stabilisation of the state of public finances in the country.
Overall, the Fund Programme recommends a strategy for mobilizing revenues which is misplaced and largely infeasible. There is little or no emphasis on containment of expenditure. Attainment of the deficit targets will hinge not only on aggressive mobilization of revenues by FBR but also on the generation of extraordinarily large cash surpluses by the Provincial Governments.
Rather than being contractionary, fiscal policy will remain more expansionary in nature, especially in 2019-20. The expectation that the level of Government debt will fall from over 76 percent of the GDP in 2018-19 to almost 70 percent of the GDP by 2021-22 is unlikely to be realized. The country will remain lumbered with a huge debt burden even after the so-called 'stabilization' under the IMF Programme.
Balance of payments (BoP) The targets in the IMF Programme with regards to the reduction in the current account deficit over the tenure of the Programme are ambitious and probably not reasonable given the limited variety and magnitude of instruments (essentially the exchange rate and the interest rate) assumed for realizing the target. This could jeopardize the success of the Programme in its initial stages of execution because the IMF assumes a more elastic response of exports and imports to the exchange rate.
Using the assumed movement in the exchange rate over the Programme period (Table 2 below) we employed our Macro Econometric Model to determine the change in the magnitude of imports and exports. The IMF's projections indicate an expected depreciation of the rupee by 27.3% in 2019-20, 6.1% in 2020-21 and 4.7% in 2021-22.
TABLE 2
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% change in the Value of the Rupee
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IMF Other Scenarios
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I II
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2019-20 27.3 45.0 27.3
2020-21 6.1 0.0 15.0
2021-22 4.7 0.0 5.0
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Our Model suggests that the cumulative three-year magnitude of the current account deficit will be close to $24 billion. This is over $6bn higher than the cumulative deficit projected by the IMF of $17.5 billion.
The problem is magnified by the IMF's desire that other instruments for containing imports like cash margins and regulatory duties be withdrawn. Furthermore, there is an assumption that there will be little change in the international terms of trade over the next three years. As such, any deterioration in the volume of world trade due to the ongoing US-China trade war has not been anticipated.
The IMF projects a cumulative growth in exports of as much as 31% over the three-year Programme period. This optimistic expectation does not seem to factor in the negative impact of the partial withdrawal of the zero-rating system and the end to the tax credit offered for balancing, modernization and replacement. The IMF does not enlighten us on whether our key export sectors like textiles will have the competitiveness or the capacity to raise export earnings substantially to such levels following these revocations.
Given the proposed policy framework in the Programme, the rupee probably will have to be depreciated at a faster rate. Our Model suggests that there will be a need for a much sharper depreciation of 45% in 2019-20- under Scenario (Table 2), if the cumulative current account deficit over the next three years is to be restricted to $17.5bn as projected in the Programme. Alternatively, if this adjustment is staggered over the first two years of the Programme, as shown in Scenario II, a higher depreciation of the rupee would be required in the second year.
The basic problem is that if there is primary reliance on the exchange rate to reduce the current account deficit then much more depreciation in the rupee will be required. The implication thereof is that the rate of inflation will be higher than that projected in the Programme. In Scenario I, for example, the inflation rate could approach as high as 15% in 2019-20.
Financing of the Balance of Payments According to the IMF's projections external debt repayments (including private debt), based on the original maturities of these obligations, over the next five years will cross $106 billion (and close to $61 billion over the tenure of the Programme). After factoring in their estimate of the accumulated Current Account deficit of $17.5 billion over the same period, it estimates the gross financing requirement at a massive $ 140billion (including our dues to the Fund).
As already argued above the IMF's projections of the Current account Deficit are fairly optimistic. Our model suggests that the cumulative deficit over the Programme period is likely to be $6 billion higher than the projections of the Fund.
Achieving the projected growth in exports and the compression in imports (without supplementary instruments in the policy arsenal e.g. regulatory duties and non-tariff administrative measures like cash margins) will require a sharp downward adjustment in the exchange value of the rupee.
Moreover, even our current account deficit estimates may be lower than the actual outcome if the availability and the linked interest rates on commercial borrowings through Euro Bonds, Sukuks and commercial bank loans remain sticky (despite the country having adopted an IMF Programme and a surfeit of liquid private capital seeking better returns). And there are reasons for the continuing misgivings of markets on a) the likelihood of the fiscal consolidation targets being achieved; b) the level of public debt and our ability to service it; c) the risks associated with the negative base level of Net International Reserves; d) our ability to graduate from the FATF 'grey list' quickly; and e) the time it is likely to take for the quality of improvement in the key economic indicators to give markets greater assurance about the attainment of the objective of sustainability.
The prospects for external inflows in the form of FDI and privatization receipts of $10.5 billion over the duration of the Programme (and $26 over 5 years) look somewhat demanding.
Official circles are also hinting that attractive real interest rates may be able to entice Foreign Portfolio Investment in government MTBs and PIBs. And if these hopes do materialize it will raise concerns about their conceivable impact on the vulnerability of the external account (and the exchange rate). Moreover, high real rates of interest may have to be maintained simply to sustain their appeal to foreign investors, with all its implications for the budget deficit and domestic investor sentiment.
In view of the arguments made earlier above there are reasons for harbouring serious doubts regarding our ability to raise this volume of funding to discharge even the liabilities of $78 billion due during the currency of the Programme, let alone the $135 billion (excluding the amount owed to the IMF) needed over the full five years.
Part of this gross financing requirement will require a rollover/rescheduling of debt in excess of $57.4 billion over the next five years and as much as $30.5 billion over the term of the Programme, of which only $14 billion, going by the government's announcement, has been arranged to date-essentially relating to our outstanding obligations to the Saudis, the Gulf States (including Qatar), the Chinese and the Islamic Development Bank. However, there is no indication of lenders having either registered their consent or expressed their willingness to consider rescheduling of their loans as reflected in the projections of the IMF.
Furthermore, of the $75 billion approximately $38billion (including the rollover of $14 billion), as already stated by both the IMF and the Government, will flow as funding support from "international partners" (IMF, World Bank, Asian Development Bank, DFiD/UK Aid, Islamic Development Bank, the Saudis, the Gulf States and the Chinese). Programme loans are expected to touch $4.3 billion during the tenure of the Programme while Project Loans of $8.8 billion have been assumed over the same period. Mobilization and allocation of adequate counterpart rupees and ensuring requisite absorptive capacity at the institutional level will pose serious challenges.
After accounting for this support we are left with a funding gap of $40 billion in the duration of the Programme and close to $ 100 billion over the next five years, a large proportion of which, as mentioned above, will have to be met through additional rollovers ($16.5 billion over the Programme duration and $43.4 billion in the 5 years covered by its projections (over and above the committed US414 billion); a heroic assumption on which the Programme seems to have been based. The rest of the financing gap is to be plugged through FDI (including privatization proceeds) of $ 26 billion in next 5 years and by raising loans at commercial rates of interest, and to this end the Fund projects net inflows of $ 30 billion in the form of private capital during the five years. The potential availability of such magnitude of financing and its price and tenor has already been discussed above. These flows are projected to account for much of the $20 billion increase in external debt after 5 years.
To summarize the discussion of our assessment of the IMF Programme, we are of the view that its strategy and choice of reforms is misplaced. The targets, assumptions and projections of the key economic indicators under focus are overly optimistic. The Programme may flounder even in its initial implementation period.
Table 1
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Revenues and Expenditure to GDP Ratios
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(%)
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% of GDP 2018-19 2018-19 2019-20 2021-22
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(IMF) (Likely) (IMF) (IMF)
Revenues 14.7 13.3 16.1 18.9
Expenditure 21.7 21.9 23.4 22.8
Budget Deficit -7.0 -8.6 -7.3 -3.9
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