Our Pakistani authorities appreciate the thorough and constructive discussions held with the IMF mission for the first review under the three year Extended Fund Facility (EFF), and thank management and the Executive Board for their continued support.
Our authorities have delivered on program implementation for this first review of the Extended Arrangement, and remain firmly committed to achieve the program objectives as laid out in the Letter of Intent and the Memorandum of Economic and Financial Policies (MEFP). Growth in 2013/14 is better than expected fiscal performance has been strong, and advances have been made on the ambitious structural reform agenda. The authorities are fully aware of remaining challenges, including the need to bring down inflation and help ease balance of payments pressures, reduce impediments to growth and improve social conditions, and achieve debt sustainability. They intend to make steadfast progress in these areas as envisaged in their economic reform strategy.
All end-September 2013 performance criteria have been met, except the net international reserve target, as explained in the MEFP, for which the authorities are asking for a waiver taking into account the corrective actions that have been introduced. The indicative target on social transfers under the Benazir Income Support Program (BISP) was missed due to technical problems, which have been addressed. Most structural benchmarks have been met, including in the energy sector, business climate, and privatization of state enterprises. On this basis, our Pakistani authorities are requesting completion of the first review under the arrangement and a waiver for the nonobservance of the performance criterion on net international reserves accumulation and modification of performance criteria.
Recent economic developments and near term outlook
Pakistan’s overall economic situation remains difficult in FY 2013/14, but early signs of improvement have emerged. Prospects of GDP growth have improved as against initial estimates due to better managed energy supply, which has positively impacted large scale manufacturing. Though modest, the projected growth of 2.8 percent in FY 2013/14 is expected to accelerate to 3.6 percent in the following year and continue to expand over the medium term. The downside risks to growth appear to be diminishing with first quarter growth rising to 5 percent. The recent successful award of GSP Plus status for exports by the European Union parliament would further provide impetus to exports as well as positive synergy to economic activity.
Fiscal performance has been strong, with better than expected outturn of tax and non-tax revenue and contained government spending, reflecting prudent execution of capital spending plans. As a result, the deficit target for end-September was met with a margin, and fiscal consolidation effort for FY 2013/14 as a whole is expected to reach 2 percentage points of GDP. The provinces are also contributing to the effort and are running fiscal surpluses, mainly through slower pace of spending.
As highlighted in the report and the MEFP, the balance of payments came under severe pressure, reflecting a significant deterioration in the capital and financial account and a moderate weakening of the current account position compared to program estimates. As a result, and despite efforts by the State Bank of Pakistan (SBP) to stabilize the situation, pressure on foreign exchange reserves intensified and the NIR target was missed. The evolving macroeconomic conditions in September 2013 led SBP to take action to contain inflation and ensure orderly developments in the external sector and the foreign exchange market. As the year-on-year CPI jumped to 10.9 percent in November 2013 from 5.9 percent in June 2013, SBP raised the policy rate by 100 bps in two rounds as likelihood of inflation running into double digits was high due to second round impact of high energy prices and the need to anchor inflation expectations. The policy rate increase and SBP interventions in the foreign exchange market acknowledged emerging risks to external sector emanating largely from falling private and official foreign inflows as well as the forthcoming large repayments to IMF, which were expected to fuel speculative sentiments in the foreign exchange market.
Fiscal consolidation remains a crucial objective of our authorities. As such, they firmly remain committed to the program objective of lowering the overall fiscal deficit to 3½ percent by the end of 2016/17 to put the debt-to-GDP ratio on a declining trend. A comprehensive strategy is being deployed to this effect, involving broadening the tax revenue base, reducing tax exemptions, reforming tax administration, phasing out electricity subsidies, and improving capital expenditure efficiency. A major initiative to broaden the tax net entails elimination of most tax exemptions granted through Statutory Regulatory Orders (SROs). While the authorities reaffirm their commitment not to issue any new tax exemptions or concessions through SROs, necessary orders to eliminate the first batch will be issued by end-June 2014. In addition, the Federal Board of Revenues (FBR) has strengthened tax collection and is on track on the issuance of notices to potential tax payers, which is part of a major initiative to incorporate 300 thousand new taxpayers into the tax net. Preparatory work is underway to enhance revenue administration for sales tax, excises, and customs, which will be completed by end-December 2013. These efforts are further being supplemented by increasing the percentage of tax audits from 2.2 percent of declarations to 4.2 percent. Finally in addition to the above, a major change to strengthen compliance of tax payers and combat tax fraud is the amendment of the 2010 Anti-Money Laundering Act (AMLA) to include tax crimes in the schedule of offences.
Key to fiscal adjustment on the expenditure side has been the phasing out of the electricity subsidy, starting with elimination of tariff differential subsidy for all consumers, except the most vulnerable. On an annualized basis, the net impact of this measure has been ¾ percent of GDP. Besides, apart from scaling down nonwage current expenditure of about 0.15 percent of GDP, some capital spending has been delayed until realization of additional revenues from Gas Infrastructure Development Cess (GIDC). Additional measures on the spending side will be carried out in the outer years, including further reductions in untargeted subsidies and streamlining of wages and salaries through civil service reform.
Pakistan moved towards fiscal decentralization after the 7th National Finance Commission (NFC) Award 2009 (revenue sharing arrangement between federal and provincial governments) and the 18th constitutional amendment adopted by the parliament in April 2010 that devolved all social sector functions to provinces and eliminated any duplication of functions at the federal level. Negotiations on the next NFC would begin in July 2014 and based on the recent experience, would provide an opportunity to review and further balance revenue generation with expenditure responsibilities if so needed.
Our authorities’ are committed to further enhance their support to the poor and most vulnerable segments of the society through the Benazir Income Support Program (BISP). With the adoption of electronic means of transfer, initial technical difficulties occurred, resulting in delayed payments in the first quarter. However using the outreach and mobilization campaigns, the gap between the enrolled and paid beneficiaries will be significantly reduced in due course. Besides, as phasing out of non-targeted subsidies generate fiscal space, the coverage of the program will be expanded to 5.5 million families before end-June 2014. The authorities firmly believe that this is a fair mechanism to reduce the initial impact of adjustment on the vulnerable segments of society before structural reforms and prudent macroeconomic policies pursued under the program start paying dividends.
Monetary and exchange rate policies
As challenges on the balance of payments front persist in the near-term, our authorities reaffirm their commitment to take firm actions in rebuilding foreign exchange reserves and aligning monetary and exchange rate policies to this objective while maintaining price stability. Monetary policy was further tightened in November 2013 by increasing the policy rate as indicated above, which will help address the external sector weaknesses, and contain inflation. SBP is also firmly committed to take additional policy actions as and when needed to achieve its reserve target and maintain price stability. In doing so, the SBP will seek to balance the need of rebuilding its reserves with those of ensuring adequate liquidity and orderly conditions in the foreign exchange market. Therefore, while the exchange rate will continue to reflect market conditions, calibrated interventions will be aimed at mitigating the adverse effects of excessive volatility in the exchange rate.
The banking system remains sound, with high liquidity, capitalization, and the profitability intact. Steps are being taken to ensure compliance of all banks with the minimum capital adequacy ratio (MEFP 18), and the regulatory authority is taking cognizance of the rising NPLs and marginal deterioration of asset quality of the banking system. While provisioning for the system as a whole is high (70 percent), the authorities are exploring options to reduce NPLs, by speeding the recovery process, providing favorable tax treatment for write-offs, and supporting markets of distressed debt. Consultations on a deposit insurance scheme and new bankruptcy law are at an advanced stage and a draft Deposit Protection Fund (DPF) is expected to be submitted to Parliament by end-September 2014.
Safeguarding the financial sector stability remains an overarching goal, and the authorities are embarking on wide-ranging initiatives to strengthen the regulatory and supervisory framework to this effect as outlined in the MEFP, which includes amendment in SBP laws to strengthen operational independence.
Efforts are also underway to develop the government domestic debt market and SBP is in the process of developing the operational framework. Over time, the composition of domestic debt portfolio has been changing from high dominance of unfunded debt to increased dependence on short term floating debt with high roll over and refinancing risk. Moreover, efforts are underway to centralize the debt management function, which is currently fragmented across different agencies. Our authorities, in consultation with the Fund and the World Bank, have initiated technical work for developing a medium term debt strategy.
Our authorities’ ambitious structural reform agenda aims at sustaining robust growth that will generate employment and improve social conditions while maintaining macroeconomic stability. They have rightly focused on tackling the energy sector problems, further liberalizing the investment and trade regime, improving the business climate, and reforming and privatizing public sector enterprises. In this regard, the National Energy Policy spearheads the reform process, encompassing removal of price distortions, improving collection, phasing out costly subsidies, strengthening collection, and addressing governance and regulatory deficiencies as detailed in the MEFP (24–32). With regard to public enterprises, a comprehensive road map for privatization of 31 PSEs has been prepared and approved by the Cabinet Committee on Privatization (CCOP). This involves restructuring, improving governance and regulatory deficiencies, removing price distortions and preparing the PSEs for capital market transactions as well as strategic partnerships. This, together with wide-ranging efforts to improve the business climate and further liberalize the trade regime, will help foster competition and attract domestic and private investment.
Our Pakistani authorities are off to a good start on implementing their economic reform program and the steps taken under this first review bode well for future performance. While risks and challenges remain, the authorities are committed to a successful outcome of their reform strategy and will continue to work closely with the Fund and with their development partners toward this objective. They look forward to the continued support from management and the Board.