Recent Economic Developments

This paper reviews economic developments in Pakistan during 1990–95. The authorities succeeded in reducing the budget deficit and in slowing down the growth of the net domestic assets of the banking system in 1993/94. These tighter financial policies led to a marked reduction in the macroeconomic imbalances that had flared up in 1992/93; in particular, they were reflected in a much narrower external current account deficit. Moreover, the strong stance of demand management contributed to a turnaround in private sector confidence, which was evidenced by large capital inflows.


This paper reviews economic developments in Pakistan during 1990–95. The authorities succeeded in reducing the budget deficit and in slowing down the growth of the net domestic assets of the banking system in 1993/94. These tighter financial policies led to a marked reduction in the macroeconomic imbalances that had flared up in 1992/93; in particular, they were reflected in a much narrower external current account deficit. Moreover, the strong stance of demand management contributed to a turnaround in private sector confidence, which was evidenced by large capital inflows.

I. Overview

Following two years of rapid growth, real GDP expanded at a slower rate over the last three years (fiscal years 1992/93-1994/95). This deceleration was largely attributable to exogenous shocks that afflicted the economy. Widespread floods caused unprecedented damage to crops and infrastructure in 1992. This was followed by a drought in 1993/94 which led to shortages in the supply of wheat and several other crops. The most important exogenous shock, however, was the three-year long virus disease which, starting in 1992/93, severely depressed cotton output. Given the key role of cotton for Pakistan’s industrial output and exports, the virus attack constituted a major setback in terms of aggregate growth and substantially weakened the external accounts.

Despite the difficult domestic economic conditions, and the several changes in the Government over the period under review, the Pakistan authorities have shown remarkable continuity in their approach to economic policy. The main thrust of their approach has been an emphasis on economic liberalization. In this context, they have made important gains in the area of privatization and de-regulation of economic activities; introduced significant reforms in the financial system and in the conduct of monetary policy; gradually steered the taxation system away from international trade taxes and towards greater reliance on domestic taxes; and removed all restrictions on current international payments as well as several restrictions on capital flows. These structural policies have contributed significantly to promote growth and exports. Indeed, the growth of new industries and the associated expansion of nontraditional exports provided an important cushion for the economy over the last three years given the difficulties that afflicted the traditional sources of growth and foreign exchange earnings.

The second area in which the authorities have shown continuity is emphasis on demand management, although implementation has been uneven. Their initiatives in this area enabled Pakistan to receive substantial Fund financial support during the period reviewed in this report. Most recently, this took the form of an ESAF arrangement and an extended arrangement in support of the medium-term adjustment and reform program launched by the Pakistan Government in mid-1993. In this context, the authorities succeeded in reducing the budget deficit and in slowing down the growth of the net domestic assets of the banking system in 1993/94. These tighter financial policies led to a marked reduction in the macroeconomic imbalances that had flared up in 1992/93; in particular, they were reflected in a much narrower external current account deficit. Moreover, the strong stance of demand management contributed to a turnaround in private sector confidence which was evidenced by large capital inflows. As a result, the external reserves position (which had become extremely vulnerable in mid-1993) improved sharply.

The program for 1994/95 sought to raise the real GDP growth rate and further reduce the macroeconomic imbalances. The latter was to be reflected in a lower rate of inflation and in a narrower external current account deficit; as envisaged by the program, this would form the basis for a further substantial strengthening of the external reserves position. Achievement of these objectives was predicated on a further reduction in the budget deficit and in the growth of broad liquidity which were to be accompanied by actions designed to advance deeper with the structural reforms following their intensification in 1993/94. In the event, however, fiscal and monetary policy implementation deviated significantly from the program: both the budget deficit and the rate of monetary expansion were broadly similar to those achieved in 1993/94—with the result that the inflation performance and the external current account outcomes were also similar to those achieved in 1993/94. There was an improvement in the external reserves position, as programmed, but this resulted not from the demand management policies but from unexpectedly large privatization proceeds from abroad.

In 1994/95, the slippages from the planned demand management policies have partly originated from fiscal incentives granted by the Government (mainly in the form of tax exemptions and concessions) in the pursuit of various industrial policy and social objectives. This policy was superimposed with detrimental consequences on the structural and demand management policies. Such policies were designed in a manner that sought to promote investment and growth mainly through liberalization and deregulation of domestic economic activities; removal of restrictions in the trade and exchange systems; and the creation of a stable macroeconomic environment. Social objectives were to be addressed through the combination of higher employment and lower inflation with an improvement in the quality of public expenditure (including a Social Action Program). Within this framework, fiscal incentives were not viewed as appropriate tool for promoting economic or social objectives; on the contrary, they were to be phased out in order to expand the domestic tax base and compensate for the revenue losses from the tariff reform. Nonetheless, tax exemptions and concessions were intensified in 1994/95 and broadened with the 1995/96 budget (as described in Section III), with adverse consequences for the fiscal position.

The remainder of this report, which covers developments over the five-year period 1990/91-1994/95 (fiscal years beginning July 1) with emphasis on the last two years, is organized as follows: Section II discusses output, price, and sectoral developments in the domestic economy; Section III discusses budgetary and fiscal policy developments; Section IV discusses the evolution and sources of domestic liquidity, developments in monetary and credit policy, the rates-of-return structure, and the structural reforms in the financial system; and Section V discusses balance of payments and external debt developments, exchange rate developments, and the liberalization of the exchange and trade systems.

II. The Domestic Economy

1. Overall trends in output

Following a sharp decline in the growth rate of real GDP in 1992/93, the Pakistan economy has gradually recovered its growth momentum, despite continuing adverse factors which have limited production of key crops and overall economic activity (Table 1 and Chart 1). The decline in the growth rate in 1992/93 reflected the devastating impact of widespread floods in September (which damaged crops and infrastructure), the onset of a virus attack on the cotton crop (which continued into the next two years), and political instability (which undermined confidence and contributed to a contraction in private investment). Cotton output fell by 30 percent leading to a 5 percent reduction in real agricultural GDP, with adverse consequences for the related manufacturing and service activities.

Table 1.

Pakistan: Sectoral Origin of Gross Domestic Product, 1990/91-1994/95

(At 1980/81 prices)

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Sources: Ministry of Finance and Economic Affairs; and Planning Commission.


(Annual percentage changes)

Citation: IMF Staff Country Reports 1996, 008; 10.5089/9781451830408.002.A001

Source: State Bonk of Pakistan.

Over the next two years, real GDP growth recovered gradually to 4.7 percent by 1994/95 (from 2.3 percent in 1992/93). In 1993/94, the recovery was led by nontraditional industrial activities (mainly small-scale, export-oriented enterprises) which expanded faster than the rest of the economy (at 8.4 percent) as crop-based GDP declined due to severe drought. In 1994/95, the sources of recovery were more broadly based as agricultural production bottomed out from the low 1993/94 level, with a favorable impact on the growth of the services sector. While no reliable estimates are available regarding the effect of the security developments in Karachi, they are believed to have had a significantly negative impact on real GDP in 1994/95.

2. Trends in expenditure and savings

In line with historical trends, gross domestic expenditure exceeded GDP by substantial margins in recent years (Table 2 and Chart 2). The gap widened in 1992/93 when expenditure was boosted by outlays on reconstruction following the September 1992 floods. This temporary surge was more than reversed in 1993/94 as the Government tightened demand management policies. Consumption expenditure declined from 88 percent of GDP in 1992/93 to about 86 percent of GDP in 1993/94-1994/95 reflecting a deceleration in the growth of government current outlays. Private consumption moved narrowly in the range of 67-68 percent of GDP during the last three years. Gross domestic investment declined from 20.7 percent of GDP in 1992/93 to 19.1 percent in 1994/95 due to a sharp reduction in public sector investment which more than offset a rise in private investment. The latter included sizable fixed investment in manufacturing, transportation, and communications (Appendix Tables 15 and 16). The increase in the ratio of private investment to GDP was facilitated by governmental policies aimed at encouraging industrial development and promoting export growth.

Table 2.

Pakistan: Expenditures and Savings, 1990/91-1994/95

(At current prices)

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Source: Data provided by the Authorities; and Fund Staff estimates.


(In percent of GDP)

Citation: IMF Staff Country Reports 1996, 008; 10.5089/9781451830408.002.A001

Source: Ministry of Finance and Economic Affairs.

Gross national savings remained below the domestic investment levels. The proportion of investment financed by national resources dropped sharply to about two-thirds in 1992/93 as the output and expenditure trends described above were compounded by a marked drop in private transfers from abroad. Subsequently, reflecting the implementation of demand-restraining policies and the slowdown in investment, that proportion rose to about four-fifths of total investment in 1993/94-1994/95. In relation to GDP, gross national savings showed an improvement in 1993/94 with both public and private savings increasing. However, this was partially reversed in 1994/95 as public savings shifted back to a negative level.

3. Sectoral developments

a. Agriculture

Agriculture is the critical sector in the Pakistani economy, accounting for about 25 percent of GDP (Appendix Table 17) and about half of the total employment. It also constitutes the largest source of foreign exchange earnings and provides the base for major industries like textiles and sugar.

During 1990/91-1994/95, the growth of agriculture was marked by wide fluctuations. In 1991/92, good weather propelled the sector to rapid growth (at 9.5 percent). In 1992/93, agricultural output declined by 5.3 percent, partly because of the flood-related damage to crops and infrastructure. 1/ In addition, the key cotton crop was severely affected by leaf curl virus which contributed to a decline of cotton output by about 30 percent. Rice and sugarcane output also fell (Table 3 and Appendix Table 18). As an exception to this pattern, wheat production benefitted from the floods (as they enlarged the moist areas required for wheat).

Table 3.

Pakistan: Output of Major Crops, 1990/91-1994/95

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Source: Ministry of Food, Agriculture and Livestock.

In thousand bales.

In the last two years, agricultural output more than recovered from the flood-inflicted level. In 1993/94, the sector grew by 2.9 percent, led by substantial increases in output of rice (28 percent) and sugarcane (17 percent). These gains more than offset a further drop in cotton output resulting from the virus infection and drought; and the drought-related weakness in most other crop production, particularly for wheat. In 1994/95, agriculture registered a more normal growth of 4.9 percent. The losses associated with the viral attack on cotton were more localized, as a result of which cotton output recovered by 8 percent. Wheat production grew rapidly and sugarcane production peaked for the second consecutive year. However, rice output declined and production of several minor crops was adversely affected by heavy monsoon rains.

The Government’s agricultural policy aims at a rapid but sustainable development of the sector. To this end, the Government provides production incentives comprising support prices; subsidized agricultural inputs; and concessional credits. The Pakistan Agricultural Supply and Storage Corporation (a federal agency), in consultation with the provincial governments, determines the support prices for the agricultural products, taking into account production costs as well as price movements in both domestic and international markets. 1/ Changes in relative procurement prices are used as a means to encourage crop diversification. Input subsidies include low electricity, gas, and water tariffs; fertilizer subsidies have been substantially reduced in the context of agreements with the World Bank. Concessional credit is provided through the Agricultural Development Bank of Pakistan (ADBP), commercial banks, and the Federal Bank for Cooperatives (FBC). Targets for gross disbursements were set at PRs 8.5 billion in 1993/94 and PRs 9.5 billion in 1994/95; actual disbursements amounted to 48 percent of the targeted level in 1993/94 and to 43 percent in 1994/95. As detailed in Section IV, the concessional element of such credits has been substantially reduced beginning in 1993/94. This incentive system is supplemented by public sector outlays with emphasis on irrigation and drainage projects.

b. Industry

The industrial sector—comprising manufacturing, construction, energy (electricity and gas), and mining—plays an increasingly important role in the Pakistan economy, presently accounting for about one-quarter of GDP. 2/ The growth of real industrial value added decelerated from 7.7 percent in 1991/92 to 4.8 percent by 1993/94 as the large-scale textile industry suffered from reduced availability of locally produced cotton; and there was a slowdown in the growth of the construction and energy. The reduced domestic supply of raw cotton presented serious difficulties for the domestic textile industry in 1994/95 in view of the high cotton prices prevailing in the international market. As a result, a number of less efficient and competitive textile units were forced to shut down. Nevertheless, the growth rate of real industrial value added rose slightly (to 5 percent) as a further slowdown in large-scale manufacturing was more than compensated by a pickup in construction activity and energy generation.

In recent years, industrial policy has relied on an extensive incentive system at a substantial cost in terms of budgetary revenue (see Section III). This includes tax exemptions and concessions for special industrial zones and export processing zones; sector-specific exemptions and concessions; export incentives; concessional credit; and subsidized energy prices. Recently, the Government announced a number of industry-specific incentive packages, including for the textile, pharmaceutical, engineering, electronic, and agri-food industries. The industrial sector has also been affected by the more general process of economic liberalization, particularly trade liberalization (discussed in Section V). While these policies have opened up new areas to the private sector and attracted foreign investment, the accompanying reduction in effective tariff protection has reduced investment and dampened growth for certain large-scale import-substituting industries.

In recent years, the relatively slow growth of large-scale manufacturing has been partly offset by the expansion of small-scale manufacturing (in the range of 8-9 percent per annum). 1/ This phenomenon is reflected in the strong performance of nontraditional exports such as sporting goods and various handicrafts (discussed in Section V). In view of the labor-intensive nature of small-scale industries, efforts are underway at the provincial level to support such industries through provision of investment guidance, export incentives, technical assistance, and specialized training.

The growth rate of real value added in the electricity and gas sector (production and distribution) rose sharply in 1994/95 (to 10.9 percent) following two years of decline. The Government has embarked on a policy of actively promoting energy investments in the private sector in order to overcome the chronic electricity shortage in Pakistan. In April 1995, the Government approved an incentive package for private sector energy projects which targets a sizable increase in power generation capacity. The package includes fixed power purchase tariffs, with priority for hydro-electric power plants over thermal plants.

c. Services

Developments in the services sector, which comprises almost 50 percent of nominal GDP, mirrored closely the trends in agricultural and industrial activities. The real growth rate declined in 1992/93 as trade activities contracted reflecting lower agricultural production and sluggish industrial growth. A further decline in the growth rate followed in 1993/94, partly because of the slow growth of public administration and defense resulting from efforts at fiscal consolidation under the medium-term adjustment program. In 1994/95, there was a pickup in the growth rate which was driven by improved performance in agriculture and industry as well as by faster real growth of public administration and defense. However, reflecting structural inefficiencies and disintermediation (discussed in Section IV), the banking and insurance sub-sector registered a lower growth rate in 1994/95 (at 4.7 percent, down from 6.9 percent in 1993/94).

4. Price developments

The twelve-month rate of inflation, as measured by the Consumer Price Index (CPI), increased gradually from 8.9 percent in June 1993 to a peak of 15.3 percent in January 1995 (Table 4). Subsequently, it has displayed a downward trend—having come down to 10.7 percent by October 1995. The acceleration in the twelve-month inflation rate was reflected in an increase in year-on-year CPI inflation, from 9.3 percent in 1992/93 to 12.9 percent in 1994/95. This price behavior has been associated with supply difficulties as well as with cost-push and demand-pull factors. The cost-push factors were associated with the 10 percent devaluation of the rupee (in July 1993), higher indirect taxes, increases in import prices (in 1994/95), 1/ and administered price adjustments. 2/ The latter included substantial increases in petroleum prices (at the outset of 1993/94); in electricity tariffs (in August 1993 and again in November 1994); and in gas tariffs (in early 1995). Supply constraints were an important factor in both 1993/94 and 1994/95 when shortages emerged in a variety of food crops. 3/ Finally, in both fiscal years, the rate of monetary expansion was high (as discussed in Section IV) in view of the lower-than-targeted real GDP growth rate, giving rise to demand-pull inflation.

Table 4.

Pakistan: Wholesale and Consumer Price Indices, 1990/91–1994/95

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Source: Federal Bureau of Statistics, Government of Pakistan.

For fiscal year data, refers to the change in the indices during the year. For monthly data, refers to the percentage change of current month’s index over that of the corresponding month of the preceding year.

For monthly data, refers to the percentage change in the average index during the year ending in a given month over the average index in the year ending in the corresponding month of the preceding year.

5. The privatization program

The authorities initiated a privatization program in 1990/91 which has been intensified in the last two years. As of August 1995, 88 industrial units (from a list of 119 industrial units targeted for divestment) had been privatized, with proceeds amounting to PRs 7.3 billion. The management of 67 of the privatized units has been transferred to the private owners. In the financial sector, two out of five state-owned banks have been privatized and a third bank is expected to be privatized by January 31, 1996. In addition, shares of the Pakistan Telecommunications Corporation (PTC) (12 percent) and of the Marri Gas Fields (26 percent) have been sold through the local stock markets in the form of investment vouchers. The Government has also prepared plans for the privatization of public enterprises in areas of electricity generation and distribution, gas distribution, mining, and services. In this context, preparatory steps have been taken to privatize assets of the Water and Power Development Authority (WAPDA).

III. The Public Finances

1. Overall budgetary trends

Following an improvement in 1991/92, the budget deficit widened to 8.0 percent in 1992/93 (Table 5). The floods that occurred in September 1992 had an unfavorable impact on the budgetary performance in view of the associated revenue losses combined with the need for relief and reconstruction outlays. Flood-related budgetary spending for emergency relief operations was estimated at PRs 4 billion and reconstruction outlays at PRs 9 billion (implying a combined overrun of 1.0 percent of GDP). The widening of the fiscal imbalance occurred despite revenue-raising and expenditure-restraining measures that were taken in the middle of the fiscal year.

Table 5.

Pakistan: Summary of Consolidated Fiscal Operations, 1990/91–1995/96

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In 1990/91-1991/92 this consists mainly of the surplus of the autonomous bodies which were included in the consolidated budget. Thereafter, they consists solely of privatization proceeds. Beginning in 1994/95, privatization proceeds are not fully treated as revenue, with the excess over the agreed amounts reflected as part of nonbank financing.

Excludes part of the current expenditures which form part of the public sector development program.

Includes capital expenditure, net lending, and the current outlays under the PSDP.

Detailed separate budgets for the Federal government and for the provinces are presented in the accompaning background paper.

Differs from budgetary support shown in the monetary accounts due to the change in the coverage of the banks which are used for the purpose of measuring the budget deficit. This change consisted of including two provincial banks under the supervision of SBP.

See footnote 1.

In 1990/91 -1991/92, the budget definition comprises the federal and provincial governments (including railways and post office) and autonomous bodies—WAPDA (Water and Power Development Authority), OGDP (Oil and Gase Development Corporation), NFC (National Fertilizer Corporation of Pakistan), PTVC (Pakistan Television Corporation), and PTC (Pakistan Telecommunications Corporation). Beginning in 1992/93, the operations of the five autonomous bodies are excluded from the budget coverage reflecting the increasingly independent nature of these corporations.

In the context the new medium-term economic program, the budget deficit was reduced to 5.9 percent in 1993/94 through cuts in both current and development expenditure. The expenditure reduction more than offset a revenue decline as a ratio to GDP which reflected, in part, removal of temporary measures imposed in the preceding year. Although total revenue declined, certain structural improvements were introduced with the 1993/94 budget (discussed below). Also, while reducing expenditure as a percentage of GDP, the Government succeeded in improving its composition and effectiveness (see below). Concurrent with the reduction in the budget deficit, the Government mobilized substantially higher domestic nonbank financing (Appendix Tables 24 and 25) by: (i) raising the rates of return on government securities and national savings schemes; and (ii) allowing public corporations and institutional investors to invest in certain savings schemes. As a result, domestic bank financing declined from 4.7 percent of GDP to 0.8 percent of GDP despite a drop in net external financing.

The overall budgetary performance appears to have deteriorated somewhat in 1994/95, although the reported budget deficit showed a further narrowing to 5.6 percent of GDP. 1/ On the revenue side, there was some strengthening in tax revenue but this was more than offset by substantially lower nontax revenue, mainly due to the elimination of the import license fee. As a result, total revenue declined to 17.2 percent of GDP (from 17.4 percent in 1993/94). Substantial revenue increases in direct taxes, sales tax, and excise taxes (amounting to 1.1 percent of GDP) were eroded by a decline in oil and gas surcharges (amounting to 0.6 percent of GDP). The expenditure to GDP ratio declined to 22.9 percent (from 23.3 percent) as the result of a fall in development spending (from 4.6 percent to 4.4 percent), a cut in defense spending (from 5.9 percent to 5.6 percent), and a one-time saving in interest payments (0.5 percent of GDP). These expenditure reductions offset an increase in other current spending (by some 0.6 percent of GDP. While most of this increase is still classified as “unidentified expenditure”, it is likely to have been associated with the salary increases in the range of 20-35 percent that were granted at the beginning of the fiscal year. With respect to financing, mobilization of domestic nonbank resources declined in relation to GDP, as did net external financing. These developments implied an increase in bank budgetary support in relation to GDP.

2. Budgetary revenue

a. Expansion of the domestic tax base

In recent years, the Government has implemented a series of revenue measures directed at expanding the domestic tax base and improving revenue collection. In 1991/92, this included the introduction of withholding taxes as a means to boost income tax collections. In 1992/93, the coverage of the General Sales Tax (GST) was extended by removing exemptions for 29 domestically produced items. In 1993/94, withholding taxes on income were expanded, inter alia, through a 5 percent tax on purchases of foreign exchange for travel; some excise taxes were increased and rationalized; and the GST rate was increased by 2.5 percent to 15 percent. In addition, in order to increase revenue from surcharges, prices of petroleum products were increased by an average of 19 percent.

The 1994/95 budget also included a number of measures aimed at expanding domestic taxation and improving tax administration. The income tax base was broadened by the introduction of withholding taxes on financial transactions and contracts; this was accompanied by an increase in penalties for late filing, higher prepayment of the assessed tax and fees for appeals. In the area of wealth tax, the penalty for wrong declaration was increased to 10 times the tax evaded and wealth tax returns were required to be filed jointly with income tax returns. 1/ Structural changes were also introduced in the area of indirect taxes. Several specific excise taxes were converted into ad valorem (e.g., on cement and yarn) and others were increased (e.g., gas, tires, tubes, etc.); and new items were brought under the excise net at the retail stage (refrigerators, freezers, air conditioners, TVs). Finally, the GST base was considerably expanded by bringing 266 additional goods (164 domestically manufactured goods and 102 imported goods) under the sales tax net.

b. Tariff reform

Concurrently with the efforts at expanding domestic taxation, the Government has been gradually lowering and rationalizing import duties. In 1991/92, the maximum tariff rate (excluding paratariffs) was lowered from 100 percent to 90 percent. In 1992/93, the 10 percent import surcharge was integrated into the tariff schedule without an increase in the maximum import duty rate (which was maintained at 90 percent). In 1993/94, the maximum import duty rate was reduced to 80 percent and several intermediate rates were lowered. As a result, the maximum all-inclusive tariff rate (given by the sum of the 80 percent maximum statutory rate; the 6 percent import license fee; the 5 percent Iqra surcharge; and 1 percent flood relief surcharge) was lowered to 92 percent. The pace of tariff reform was intensified in 1994/95. Specifically: (i) the import license fee, the Iqra surcharge, and the flood relief surcharge were incorporated in the statutory tariff schedule; and (ii) the resulting all-inclusive maximum tariff rate (92 percent) was reduced to 70 percent. The Government also introduced tariff measures aimed at reducing the incentive for smuggling. Duty rates on goods prone for smuggling were reduced to 35-45 percent.

c. Revenue developments

Government revenue rose to an average of 17.9 percent of GDP in 1991/92-1992/93 (from 15.6 percent in 1990/91) but declined thereafter to an average of 17.3 percent of GDP in 1993/94-1994/95 (Table 6 and Chart 3). The initial increase reflected the efforts described above at expanding the domestic tax base while the subsequent decline reflected, in part, the revenue losses associated with intensification of the tariff reform. In addition, there were substantial revenue losses in the last two years in connection with the enlargement of tax exemptions and concessions (discussed below) as a means to promote a variety of policy objectives, notably industrial and export growth. The drop in government revenue was dampened by the inclusion of PRs 5 billion from privatization proceeds (0.3 percent of GDP) in the 1994/95 nontax revenue.

Table 6.

Pakistan: Consolidated Federal and Provincial Revenue, 1990/91–1995/96

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Source: Ministry of Finance and Economic Affairs.


(In percent of GDP)

Citation: IMF Staff Country Reports 1996, 008; 10.5089/9781451830408.002.A001

Source: Ministry of Finance and Economic Affairs.

In 1993/94, total revenue (including tax and nontax receipts) rose by 13 percent in nominal terms, but decreased in relation to GDP from 18.0 percent in 1992/93 to 17.4 percent. Tax revenue increased by 17 percent and remained unchanged as a percentage of GDP (at 13.3 percent). In line with the tax policies described above, the composition of tax revenue shifted from taxes on international trade towards domestic taxation. The GST share of tax revenue increased noticeably due to the new higher rate while the share of income taxes continued to rise. The largest advance was recorded in oil and gas surcharges, whose share increased to 12.7 percent of tax revenue (from 6.8 percent in 1992/93) as a result of the adjustment in retail prices. Nontax revenue decreased by 0.6 percent of GDP to 4.1 percent in 1993/94. The largest fall was recorded in profit transfers from the State Bank of Pakistan (SBP) which was halved to 0.4 percent of GDP due to significant increases in central bank losses on account of its forward cover operations following the July devaluation.

In 1994/95, total revenue decreased to 17.2 percent of GDP. Tax revenue increased by 0.5 percent of GDP to 13.8 percent. The composition tax revenue continued to shift from taxes on international trade towards domestic taxes. Revenue from income taxes increased by 0.7 percent of GDPto 3.4 percent as a result of the intensified administrative efforts. Revenue from excise taxes increased by 0.2 percent of GDP to 2.4 percent. Revenue from the GST increased by 0.4 percent of GDP to 2.3 percent reflecting the expanded coverage and administrative improvements. Despite the tariff reform measures, taxes on international trade remained stable at 4.2 percent of GDP. Collections from oil and gas surcharges decreased by 0.6 percent of GDP to 1.1 percent due to the failure to pass through higher import prices to the retail level. Nontax revenue decreased by 0.4 percent of GDP to 3.5 percent primarily due to the elimination of the import license fee. Profit transfers from the SBP increased by 0.5 percent of GDP to 0.9 percent because of a sharp drop in losses arising from foreign exchange guarantees.

d. Exemption and concessions

The above-described revenue developments are consistent with the authorities’ objectives as regards the change in the composition of government revenue in favor of domestic taxes and away from trade-based taxes. However, the decline in total government revenue as a ratio to GDP in 1993/94-1994/95 was not an intended result. Indeed, it has seriously undermined the Government’s key objective of creating a stable macroeconomic environment which would provide the basis for a sustainable growth with improvement in the country’s social indicators.

As noted, one of the key factors contributing to the weakness in government revenues has been the excessive reliance on the granting of tax exemptions and concessions as a policy tool in recent years. In 1992/93, a temporary tax holiday from income and property taxes was granted for the industrial zones established in rural areas. Also, temporary exemptions from import duties were granted to ease price pressures and replace lost domestic production due to the floods. In 1993/94. the eligibility for the five-year income tax holiday for investments in exploration and extraction of mineral deposits was extended until June 1998. Another unfavorable development was the extension, until June 1995, of the exemption from custom duty and sales tax available to certain industries.

The practice of granting exemptions and concessions intensified markedly in 1994/95, In the area of direct taxes sectoral concessions were granted: (i) foreign contractors executing power projects were taxed at a concessionary rate of 4 percent; (ii) in order to promote oil production, income tax concessions were granted to small refineries; and (iii) a five year income tax holiday was granted to fruit processing plants and to soft and stuffed toy industries set up by June 1997. Direct taxation was also used as an instrument of social policy through: (i) an increase in the basic exemption limit for salaried working women; (ii) a tax rebate of 25 percent for citizens above 65 years of age earning less than PRs 100,000; and (iii) a deduction from taxable income of up to PRs 50,000 for the repayment of educational loans for higher education in specific fields. In the area of wealth tax, the exemption limit on agricultural land was increased from PRs 100,000 to PRs 1 million (and the definition of exempted tools was expanded to include tractors, tube-wells, and other farm machinery used for agriculture; in addition, farm animals and livestock—other than those used for commercial purpose—were also exempted).

For purposes of social and industrial policy, a number of goods and their imported components remained exempt from GST in 1994/95. While the budget proposed to eliminate capacity taxes for the remaining 33 industries under this treatment, small firms (with annual sales below PRs 0.5 million) in these industries were still assessed on a capacity basis. Manufacturers with capital employed below PRs 2 million (cottage industries) remained exempt from GST. In addition to the already existing exemptions and concessions from the GST, several additional ones were granted in 1994/95. For example, around 260 categories of foods were exempted from GST with the budget. Also with the budget, the time-bound exemptions for the Northwestern Frontier and Baluchistan provinces were extended.

During the 1994/95 fiscal year, numerous post-budget exemptions and concessions were granted on GST, customs, and income tax in order to pursue several policy objectives. The most important were those for the development of special Industrial zones (GST, customs, and income tax holidays); the energy sector (GST, Customs, and income tax holidays); agro-based industries (income tax-holidays); and imports of tractor components (customs and GST).

In the 1995/96 budget, imported and domestically manufactured machinery for the engineering sector was exempted from GST. Also, several exemptions from customs duty and GST on imported and domestically produced capital goods and intermediate goods were granted for export-oriented and import-substituting industries.

3. Budgetary expenditure

a. Expenditure developments

Budgetary expenditure declined from the flood-related high level of 26.0 percent of GDP in 1992/93 to an average of about 23 percent of GDP in 1993/94-1994/95 (Table 7). In 1993/94, defense expenditure was reduced by 0.6 percent of GDP to 5.9 percent. Interest payments fell by 0.1 percent of GDP to 5.5 percent due to the depreciation of the dollar in the second part of the year. Federal subsidies declined by 0.1 percent of GDP to 0.4 percent as an upward revision in wheat prices reduced wheat subsidies. 1/ Development expenditure decreased by 5 percent in nominal terms to 4.6 percent of GDP (from 5.6 percent in 1992/93). This was due to elimination of large Infrastructure projects and postponement of low priority projects.

Table 7.

Pakistan: Consolidated Federal and Provincial Expenditure, 1990/91–1995/96

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Source: Ministry of Finance and Economic Affairs.

Includes payments of interest and principal on military debt; excludes military imports financed by external grants and disbursements.

Unidentified expenditures are estimated residually as the excess of identified financing over the deficit implied by recorded revenues and expenditures.

As of 1992/93, development expenditure of autonomous bodies was only partly included in the budget.

In 1993/94, the government formulated and implemented, with assistance from the World Bank, a core investment program (CIP) consisting of high priority development projects; outlays on the core investment program amounted to 2.8 percent of GDP. Concurrently, outlays on some large infrastructure projects, including motorways, were scaled back. At the same time, a three-year rolling Public Sector Development Program was also formulated, comprising both the CIP and other public sector outlays.

In 1994/95, although measured expenditure declined, the staff estimates that budgetary expenditures remained about the same as a ratio to GDP. A significant adjustment was achieved in defense expenditure, which was reduced by 0.3 percent of GDP to 5.6 percent (resulting in a total decrease of 0.9 percent of GDP since 1992/93). Interest payments decreased by 0.5 percent of GDP, to 5.0 percent, due to the one-time effect of recording interest payments on treasury bills at the time of maturity (rather than at issuance) for all treasury bills issued from February, 1995. Development expenditure decreased by 0.2 percent of GDP to 4.4 percent reflecting, in part, the improved disbursement policy of the Ministry of Finance. 2/ However, budgetary expenditures for the core investment program decreased to 1.8 percent of GDP (from 2.3 percent in 1993/94), with the ratio of core to total budgetary development expenditure decreasing to about 38 percent (from 50 percent in 1993/94). The core investment program emphasized electricity generation and distribution, irrigation and drainage, repair and maintenance of the transport infrastructure, and health and nutrition programs. Expenditure on the Social Action Program, which contains allocations both in current and development expenditure, declined to 2.05 percent of GDP (from 2.11 percent in 1993/94) (Appendix Table 27). The Federal releases of development funds to the provinces for the SAP followed a quarterly pattern agreed with the World Bank. 3/

To help improve the quality of current expenditure, the Government initiated a reform of the public administration in 1993/94. This includes: (i) a ban on hiring and creation of new posts in the Federal Secretariat and affiliated Departments and Organizations; (ii) elimination of 20 departments and organizations; (iii) reduction in the number of divisions in the Federal Secretariat; (iv) elimination of 2,500 civil service posts (out of a total secretarial work force of some 15,000); and (v) closing down seven foreign missions and abolishing 130 posts in the remaining missions. 1/

b. Expenditure control

Over the last two years, the Government enhanced its efforts aimed at improving expenditure control. In 1993/94, the Budget Wing of the Ministry of Finance exercised a strong control on disbursements to spending agencies. Releases of funds were effected on a quarterly basis, and the budget allocation for each quarter was only released if the allocation for the previous quarter had been fully utilized. This expenditure control mechanism was further tightened during the last quarter by releasing funds on a monthly basis, for the main expenditure items. In 1994/95, measures were implemented to avoid current expenditure overruns. A system of monthly monitoring by the Budget Wing of the Ministry of Finance on spending agencies was implemented for major expenditure items, according to which funds were released only if those previously allocated had been spent (in previous years, this strict monthly monitoring had been carried out only during the last quarter). Moreover, any expenditure by any federal agency above PRs 50,000 had to be personally authorized by the Additional Secretary of the Ministry of Finance, even if the expenditure allocation had been authorized in the budget law.

4. Federal-provincial fiscal transfers

The Federal Government transfers to the provinces consist of both unconditional and conditional components. Unconditional transfers are determined by an independent body, the National Finance Commission (NFC), that is appointed every 5 years to conduct a review of these transfers. The NFC makes recommendations as to which of the federally collected taxes go into the divisible pool of taxes (which, by constitutional mandate, has to be shared on a 20:80 basis among federal and provincial governments). According to the recommendations of the latest NFC award, the following taxes constitute the divisible pool of taxes: income taxes, sales tax, excise duty on tobacco, sugar and natural gas, royalties on gas and crude oil, and the gas development surcharge. 2/

Over the last 3 years, the shift in taxation from international taxes to domestic taxes has led to a significant increase in the divisible pool as a proportion of federally collected taxes (Appendix Tables 28 and 29). This share increased from 29 percent in 1992/93 to 38 percent in 1993/94, and further to 44 percent in 1994/95. This trend has channeled more and more resources to the provinces under the unconditional transfer mechanism. In the absence of a new NFC award, this development has been partly counteracted by reducing conditional transfers to the provinces. These transfers, which are of lesser magnitude, include matching grants for provincial resource mobilization, development grants, and federal contribution to the provinces’ development expenditure (mainly under the Social Action Program).

5. The 1995/96 budget

The 1995/96 budget envisages a budget deficit target of 5 percent of GDP. The budget is predicated on a 0.6 percent of GDP increase in revenue to 17.8 percent. Budgeted expenditures amount to 22.9 percent of GDP. Defense outlays are budgeted to decrease by 0.3 percent of GDP to 5.3 percent. Development expenditure is unchanged, at 4.4 percent of GDP. The deficit is expected to be financed mainly through recourse to domestic (primarily nonbank) sources.

The budget incorporates net revenue measures amounting to PRs 16.3 billion (0.7 percent of GDP), PRs 4 billion of which are expected to originate from reduced smuggling. The measures in the area of income tax (PRs 6.9 billion) consist mostly of increases in withholding taxes. In the area of personal income tax, the exemption threshold was raised by PRs 10,000; and the scope of the self assessment scheme for income tax was broadened to include incomes higher than PRs 200,000. In the area of wealth tax, the value of the PIU was increased by 25 percent to PRs 250.

Some measures were introduced in the area of indirect taxes. Excise duties were levied on services of certain professions (10 percent) and on ship plates, wastes, and scrap (5 percent). 1/ The excise duty on bank and travellers’ cheques was doubled to PRs 2. In order to reduce smuggling, excise duty rates on cigarettes, soaps, detergent, and cosmetics were lowered. A composite regime of 5 percent excise duty and 10 percent sales taxes was adopted for certain industries. This regime was introduced to reduce the inequity in the tax structure due to area-bound GST exemptions (in Baluchistan and NWFP). 2/ The GST rate on selected raw materials—both locally produced and imported—used as Inputs for manufacturing paints, soaps, detergents, laminates, plastics, foundry products, and steel pipes, was increased to 20 percent. 1/ While the tariff reform proceeded, including through a reduction in the maximum tariff rate by 5 percentage points to 65 percent, several intermediate rates were raised for revenue purposes.

Prices of petroleum products were increased by an average of 5 percent, which is budgeted to generate an additional PRs 5 billion from the development surcharge.

Federal current expenditures are budgeted at 13.8 percent of GDP. The Government granted a 7 percent tax-free cost-of-living allowance; and pension increases of 5 to 15 percent, depending on time of retirement. However, no additional funds were allocated in the budget for the salary and pension increases—spending agencies will have to find the necessary resources from current allocations. Any purchase of durable goods by federal ministries and agencies will have to be approved by the Ministry of Finance. No transfers are budgeted for the Employee Old Age Benefit Institution (old age insurance in the industrial sector) because it currently runs a surplus and does not require federal transfers. Additional grants are allocated to the Pakistan International Airways (PIA) (PRs 1 billion), the Pakistan Railways (PRs 1 billion), and the Water and Power Development Authority (WAPDA) (PRs 2.3 billion). Interest outlays are budgeted to increase by 0.6 percent of GDP. Provincial current spending is projected to increase by 0.5 percent of GDP.

As noted, budgetary development expenditure is planned at 4.4 percent of GDP. Federal development spending is budgeted to increase by 30 percent, and provincial development spending by 5.5 percent. The core investment program is planned at 2.9 percent of GDP (up from 2.2 percent in 1994/95). The budgetary portion of the core investment program expenditure represents 40 percent of the budgetary PSDP. Allocations for the SAP are increased by 0.3 percent of GDP to 2.2 percent.

IV. The Financial Sector

1. Institutional set-up

The financial system in Pakistan consists of the State Bank of Pakistan (SBP), 25 locally owned commercial banks, 19 foreign commercial banks, 12 development finance institutions (DFIs), three stock exchanges, more than 50 insurance companies, and a growing number of leasing companies, investment banks and modarabas (a form of limited partnership). Of the 25 locally owned banks, four are fully government-owned, two are partly privatized and there are four specialized banks which cater to specific sectors of the economy. The remaining 15 banks are privately owned. The DFIs are government-owned financial institutions catering to the long-term financing needs of the public and the private sector. The Government has also set up three joint-venture companies in association with other governments that operate as general purpose DFIs.

In the banking sector, there has been an increase in the number of new banks, both locally-owned and foreign, since the decision to allow private banking activity. Nevertheless, the three state-owned banks (National Bank of Pakistan, United Bank Limited, and Habib Bank Limited) and the two partially privatized commercial banks (Muslim Commercial Bank and Allied Bank Limited) still dominate the banking system. In 1992, these institutions accounted for 79 percent of commercial bank assets, received 82 percent of commercial bank deposits, and owned an overwhelming 97 percent of the commercial bank branches.

The financial sector reforms (discussed below) have encouraged deposit mobilization by financial institutions and contributed to greater intermediation through the banking system. This has led to a steady increase in real money balances and to a shift in their composition from currency holdings to bank deposits (Table 8 and Appendix Tables 30 and 31). Velocity declined steadily from 2.77 in 1990/91 to 2.36 in 1993/94; it increased somewhat to 2.41 in 1994/95. The ratio of currency to total liquidity decreased from 39.1 percent in June 1991 to 30.0 percent in both June 1994 and June 1995. This reflected a gradual increase in the rate of return on deposits, especially on time deposits. Time deposits grew faster than either currency in circulation or demand deposits, thereby reversing the shift to more liquid components of the money supply observed in previous years. Accordingly, the share of time deposits in total liquidity rose from 26.6 percent in June 1991 to 31.8 percent in June 1995. The most pronounced expansion, however, occurred in residents’ foreign currency deposits following the Government’s decision to allow Pakistan residents to hold such deposits with the domestic banks (effective from March 1991); their share in broad liquidity rose from 2.6 percent in June 1991 to 13.6 percent in June 1995.

Table 8.

Pakistan: Factors Affecting Changes in Domestic Liquidity, 1990/91–1994/95

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Source: State Bank of Pakistan.

Reflects mainly the increases in SBP net foreign assets and in government deposits resulting from sales of shares in the telecommunications company to foreign investors.

Reflects, inter alia, the increased capitalization of the banking institutions in accordance with more stringent prudential regulations introduced in August 1992.

Notwithstanding the above-described trends, the market for loanable funds continues to be marked by segmentation, with bank deposits yielding lower rates of return than nonbank instruments (mainly government savings schemes). This situation is associated with structural distortions in the banking system, in particular with inefficiency in the operations of the publicly-owned banks. In the last two years, however, it has been aggravated by the Government’s efforts to mobilize nonbank financing for the budget which have required an enhancement in the rates of return offered by the government savings schemes (and opening some of these to financial institutions).

Since 1991/92, the foreign exchange generated by the rapid growth in residents’ foreign currency deposits (which is surrendered to the SBP) has been an important source of financing for Pakistan’s balance of payments. Resort to this type of financing has given rise to large uncovered foreign currency liabilities for the banking system. As of end-September 1995, the banking system’s foreign currency liabilities amounted to US$6.6 billion (of which US$3.5 billion was residents’ foreign currency deposits) while its foreign assets amounted to only US$3.1 billion (or 47 percent of foreign currency liabilities).

2. Evolution and sources of domestic liquidity

a. Overall monetary developments

Following a sharp increase in 1991/92, the growth rate of broad liquidity (comprising currency in circulation, demand deposits, time deposits, and residents’ foreign currency deposits) decelerated to 16 percent in 1993/94 and picked up slightly to 16.6 percent in 1994/95 (see Table 8). The largest source of liquidity in 1991/92 was, by far, bank credit for budgetary support (which expanded by the equivalent of 19.1 percent of the initial stock of broad liquidity). In 1992/93, budgetary support was less expansionary but credit to the nongovernment sectors accelerated markedly (partly in an attempt to alleviate the difficulties arising from the September floods). Thus, the deceleration in broad liquidity that occurred in that year was attributable to a sharp deterioration in the net foreign asset position of the banking system (discussed in Section V).

While the rate of monetary expansion in 1993/94-1994/95 was not much reduced from that in 1992/93, the sources of liquidity expansion shifted strongly from net domestic asset expansion to net foreign asset accumulation. As discussed below, net domestic credit (particularly budgetary support) decelerated sharply in 1993/94 while the monetary impact of net foreign assets shifted from contractionary to expansionary (Chart 4). This change in the sources of liquidity expansion reflected the tightening of demand management in the context of the Government’s new medium-term economic program. In 1994/95, the domestic credit policy was looser. This loosening was only partly offset by a somewhat weaker balance of payments; as a result, liquidity expansion rose to 16.6 percent.


PAKISTAN: MONEY AND CREDIT, 1990/91 - 1994/95

(Changes as percent of initial money stock)

Citation: IMF Staff Country Reports 1996, 008; 10.5089/9781451830408.002.A001

Source: State Bank of Pakistan.

b. Net domestic assets

Developments in net domestic assets were dominated by the domestic financing requirements of the government sector. Net domestic asset expansion accelerated in 1991/92 reflecting increased bank borrowing by the Government. In particular, bank borrowing for budgetary support peaked at PRs 70 billion in 1991/92. This reflected, in large measure, the redemption of maturing long-term government debt instruments whose encashment was financed by borrowing from the banking system. In 1992/93, net domestic asset growth slowed somewhat to 25.1 percent of the initial stock of broad liquidity (compared with 27.9 percent during the previous year). Although the budget deficit widened, bank lending for budgetary support declined to PRs 64 billion due to an increase in nonbank domestic financing. The adoption of a new medium-term economic program in mid–1993 resulted in a sharp reduction in net domestic asset growth to 10.1 percent of the initial stock of domestic liquidity during 1993/94. A major contributory factor was the decline in budgetary support to only PRs 12.5 billion. Net domestic asset growth accelerated to 12.6 percent in 1994/95 as bank borrowing for budgetary support more than trebled to PRs 25 billion.

During most of the period under review, the growth of credit to the private sector has been constrained through strict enforcement of the credit control regime (discussed below) by the SBP. In 1992/93, however, bank credit to the private sector increased by PRs 58.3 billion (equivalent to 12.1 percent of the initial stock of domestic liquidity). This included about PRs 15 billion in subsidized credits to rehabilitate public transport. Elimination of that scheme in October 1993, together with an upward adjustment in the lending rates of charge, resulted in lower private sector credit growth (at PRs 35.4 billion, or 6.2 percent of the initial liquidity stock) in 1993/94. In 1994/95, the rate of private sector credit growth accelerated markedly to PRs 67.8 billion (10.2 percent of initial liquidity). This was due to: (i) increased credit extension to the cotton sector; (ii) large loan disbursements under government-sponsored credit schemes; and (iii) relaxation of prudential regulations relating to the provision of additional credit for “sick” industrial units. 1/

The banking system’s claims on public sector enterprises have declined steadily since 1990/91. The underlying factors have been: (i) the restructuring of these enterprises’ obligations in 1990/91; (ii) the Government’s privatization program and efforts to enhance public enterprise efficiency; and (iii) greater reliance domestic on bond financing.

c. Net foreign assets

Following a sharp deterioration in 1992/93, the net foreign assets of the banking system improved markedly in the last two years. During 1993/94, NFA improved by PRs 33.4 billion in reflecting tightened demand management, an exchange rate adjustment, and strengthened private capital inflows (see Section V). The improvement exerted an expansionary impact on domestic liquidity equivalent to 5.9 percent of the initial stock of broad money. During 1994/95, a further increase of PRs 27.0 billion was recorded in NFA (equivalent to 4.1 percent of the initial liquidity stock). A major factor contributing to this development was an inflow of US$862 million on account of privatization of the telecommunications company. However, the balance sheet of the banking system continues to be characterized (as noted above) by large uncovered foreign currency liabilities (amounting to US$5.1 billion at end-September, 1995).

d. The money multiplier

Reflecting the financial sector reform—most notably the removal of bank-by-bank credit ceilings, and the liberalization of the credit to deposit ratio—and its impact on banking intermediation, the money multiplier increased sharply both in 1991/92 and in 1992/93 (see Table 8). Indeed, domestic liquidity grew by 30.3 percent in 1991/92 despite an expansion in reserve money by only 22.4 percent; and it decelerated to only 18 percent in 1992/93 despite the much sharper cut in reserve money expansion to 7.7 percent (Table 9 and Appendix Table 32). In 1993/94 and in 1994/95, the money multiplier stabilized and the expansion of domestic liquidity has been more or less in line with the expansion of reserve money.

Table 9.

Pakistan: Factors Affecting Changes in Reserve Money, 1990/91-1994/95

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Source: State Bank of Pakistan.

Reflects mainly the increase in foreign assets, and accompanying increase in government deposits, resulting from sales of shares in the telecommunications company to foreign investors.

3. Developments in monetary and credit policy

a. Monetary policy

A number of policy actions were taken during 1992/93 to tighten monetary conditions. The Statutory Liquid Asset Ratio (SLAR) was raised from 35 percent to 40 percent in August 1992; and further to 45 percent in December 1992, concurrent with an increase in the penalties for noncompliance with the Statutory Cash Reserve Ratio and the SLAR. At the same time, the SBP’s three-day repo (discount) rate was raised from 14 percent to 15 percent per annum. These policy changes contributed to the slowdown in the rate of monetary expansion.

Early in 1993/94, two monetary policy measures were implemented with the objective of reducing monetary growth. First, all rates of return, including the repo rate, were raised in August 1993. Second, the specialized credit scheme to rehabilitate public transport (which was a source of unprecedented private sector credit expansion during 1992/93) was discontinued in October 1993. These measures contributed to a significant slowdown in the rate of monetary expansion in the first half of the fiscal year. However, following this tightening, the SBF took steps to ease monetary conditions. In this context, it lowered the rate of return structure and revised the SLR downward in March 1994. These measures contributed to an acceleration in the rate of monetary expansion during January-June 1994.

In 1994/95, in the context of the move toward indirect monetary control (discussed below), the SBP initiated the use of open market operations (from January 1995). These operations (transactions in short-term government paper) are aimed at regulating domestic liquidity in accordance with the SBP’s reserve money programming. 1/ So far, reflecting excess liquidity in the money market, the operations have involved, almost exclusively, sale of treasury bills by the SBP to the authorized dealers. The yields have been in the range of 10.5-12.75 percent. During 1994/95, outright sales of treasury bills through open market operations amounted to PRs 19.9 billion while those on repurchase contracts amounted to PRs 81.6 billion. 2/

The SBP raised its reserve requirement to 6.5 percent (from 5 percent) in December 1994. This decision was taken in view of the accelerating growth in domestic credit during the second quarter of 1994/95. 3/ It is estimated that the rise in the reserve requirement resulted in a contraction of liquidity by PRs 10 billion (1.5 percent of the initial stock of broad liquidity). In March 1995, the repo rate was raised to 15.5 percent. The incremental reserve requirement was withdrawn on July 18, 1995.

b. Credit policy

The SBP has continued to allocate mandatory credit targets for the commercial banks (Appendix Table 33). Targets for agriculture are given on a gross disbursement basis and those for small business and industry on a net disbursement basis. Agriculture loans are provided at concessional rates and are directed primarily to small farmers for working capital during the production cycle (the banks are allowed to extend up to 15 percent of their target as development loans). Actual gross disbursement for agriculture has tended to fall short of the mandatory target while the targets for small business and industry have been exceeded. Mandatory credit targets for tobacco marketing were eliminated in late 1994. During 1990/91-1994/95, total outstanding credit under mandatory targets declined from 13.2 percent to 11.5 percent of total credit outstanding to the nongovernment sector (Appendix Tables 34, 35, and 36).

Concessional credit schemes have been introduced by the Government to provide subsidized credit to the private sector for specific purposes. Loans under these schemes are provided, inter alia, for agricultural production, export finance, locally manufactured machinery, youth promotion, and support for the self-employed. The share of concessional credits in total credit outstanding to nongovernment sector declined from a peak of 36.8 percent in 1992/93 to 32.9 percent in 1994/95. Nevertheless, the expansion of concessional credit contributed 15 percent of the expansion in domestic liquidity in 1994/95. This was due, in part, to the introduction in September 1994, of the Awami Tractor Scheme for financing the purchase of tractors by farmers owning up to 50 acres of land. The scheme envisaged the importation of 20,000 tractors in 1994/95, with a corresponding credit allocation of almost PRs 3 billion. The loans carry a rate of charge of 13.5 percent with ten-year maturity.

c. Level and structure of rates of return

The rates of return on financial instruments have been considerably liberalized in recent years. As research of bank deposits, the banks are free to set the rates of return. Rates on foreign currency deposits are subject to a ceiling of 0.25 percent per annum above the Eurodollar bid rates of Barclays Bank (London). The weighted average rate of return on bank deposits declined to 9.19 percent in 1994/95 (from 9.27 in 1993/94) reflecting the low profitability of domestic banks arising from high administrative costs and the larger bank’s sizable portfolio of nonperforming loans (Appendix Table 37). Accordingly, the rates of return on bank deposits have remained significantly below the rate of inflation, with a detrimental effect on financial intermediation.

As regards lending rates, the SBP prescribed, until recently, a maximum lending rate for private sector credit extended by the commercial banks. The maximum rate was increased to 22 percent in August 1993 (from 20 percent); and the rates on all concessional credits were raised by 3 percentage points to 11 percent. The rate of return charged on bank lending for commodity financing was raised to 14 percent (from 12.5 percent) in November 1993. In March 1994, the maximum lending rate was lowered to 19 percent. However, in order to the reduce the subsidy on concessional lending, the rates on all such credits were increased by 1 percent to 12 percent. The maximum lending rate was lowered further to 17.5 percent in November 1994 concurrent with a 1 percent increase in the rate for concessional lending to 13 percent. The new ceiling was also made applicable to “investment-type modes of financing” (for banks) and “trade-related modes of financing” (for nonbank financial institutions); previously, the rates for these lending operations were not subject to a ceiling. The ceiling on rates of charge for trade-related and investment-type modes of financing was abolished on March 26, 1995.

4. Structural reforms in the financial sector

During 1992/93-1994/95, the Pakistan authorities intensified financial sector reforms aimed at establishing a flexible system of monetary management (with greater reliance on market mechanisms) and improving the efficiency of financial intermediation. Specifically, the reforms sought to establish a market-based system of monetary control, to enhance the autonomy of the central bank, to restructure and privatize financial institutions, and to enhance prudential regulation and supervision.

a. Liberalization of credit ceilings

Until 1992, the principal instrument of monetary control in Pakistan was the mechanism of bank-by-bank ceilings on nonpriority private sector credit. On this basis, lending by banks was held well below the level warranted by the deposit base while a major portion of the loanable funds was channeled to the Government and other privileged borrowers at low rates of return. Implicitly, this constituted a tax on banking activities and discouraged the banks from actively mobilizing deposits, thereby encouraging disintermediation.

In August 1992, as a first step in the transition toward indirect monetary control, the SBP abolished the bank-by-bank credit ceilings and replaced them with the credit-deposit ratio. Under the new system, commercial banks were required to keep their credit to the private sector within limits given by a certain proportion of their average weekly deposit base during the previous quarter. 1/ Excluded from the credit subject this form of control were: (i) credit provided under the concessional credit scheme for export finance; (ii) advances for commodity operations; (iii) credit to the Pakistan Telecommunications Corporation, autonomous bodies, public sector enterprises, and the Cotton Export Corporation; (iv) financing under the Self Employment Scheme; and (v) loans to holders of Special National Fund Bonds.

The credit-deposit ratio was liberalized in several steps (Appendix Table 38). Initially, commercial banks’ outstanding credit to private sector was restricted to 30 percent of their rupee deposits plus 40 percent of their foreign currency deposits (for institutional foreign currency deposits, the ratio varied from 50 percent to 65 percent). In March 1993, these ratios were unified at 30 percent. The coverage of the credit-deposit ratio was widened in October, 1993 to include all incremental credit provided to public sector enterprises and under the Self-Employment Scheme, at which time the ratio was raised to 32 percent. This ratio was raised further to 34 percent in December 1994 and to 36 percent in March 1995. The credit-deposit ratio mechanism was abolished in October 1995.

b. Auctioning of government securities

As credit ceilings have been liberalized, the monetary authorities have undertaken efforts to develop alternative methods of monetary control, the foundation for which has been provided by the auction system for government securities introduced in March’ 1991. This system replaced the previous practice of direct government borrowing from the banking sector at a fixed price. Two types of securities are offered at the auctions: short-term treasury bills (of six month maturity) Federal Investment Bonds (of three-, five- and ten-year maturities). Since the inception of the program, the scope of the auctions has been enlarged through the expansion of the primary dealer network and the removal of constraints on bidding procedures.

During the last two years, the authorities introduced operational improvements in the auction system. In 1993/94, the Government started announcing separate targets for each auction and varying the size of the targets. With a view to promoting the development of secondary markets the SBP streamlined the clearance system providing for same day settlement of transactions. At the same time, nonresidents were allowed to participate in the auctions and to trade freely in auctioned securities. Starting in January 1995, the SBP was entrusted with the authority to determine the cutoff yield at treasury bill auctions based on financing requirements of the budget, maturing government debt, its reserve money target, and liquidity conditions in the market. With this key structural measure, the treasury bill auctions started to function effectively as a monetary control tool.

The weighted average yields at the treasury bill auctions rose from 7.75 percent in March 1991 to a high of 14.1 percent in December 1994 as the authorities raised the maximum accepted bid rates in order to counteract expansionary monetary conditions. However, they subsequently allowed the yields to gradually decline to 10.7 percent by June 1994. Following the transfer of the decision-making regarding cut-off points to the SBP, the weighted average yield increased steadily to 12.7 percent by June 1995. In view of the prevailing inflation rate (about 13 percent), this average was still negative in real terms. Up to end-June 1995, the treasury bill auctions attracted cumulative bids of PRs 895.4 billion of which PRs 496.2 billion (55 percent of total bids) were accepted; commercial banks accounted for about 96 percent of the accepted bids.

The Federal Investment Bonds were introduced to establish a market for government bonds and extend the maturity structure of domestic public debt. The bonds, which are auctioned monthly, carry a fixed coupon paid semiannually at 13 percent, 14 percent, and 15 percent for three-, five- and ten-year maturities respectively. For the most part, the yields at issue on these instruments have remained close to coupon rates. The cumulative amount of bids received at the FIB auctions up to June 1995 was PRs 278.2 billion, of which the Government accepted PRs 190.1 billion (68.3 percent of total bids); commercial banks absorbed about 72 percent of all initial offerings.

c. Autonomy of the State Bank of Pakistan

In 1993/94, steps were taken to increase the autonomy of the SBP with a view to enhancing the effectiveness of monetary policy. The State Bank of Pakistan Act (1956) was amended to give the SBP’s Central Board of Directors full authority to implement the range of available monetary instruments and regulate the monetary and credit system. Under the revised provisions, the Board determines, in consultation with the Government, the annual limit on bank borrowing for budgetary support. Moreover, a Monetary and Fiscal Policies Coordination Board was established to coordinate monetary policies with fiscal and trade policies. The amended SBP Act also provides for complete freedom for the SBP to set cash the reserve requirement for financial institutions; and the Central Board is also empowered to issue regulations on all matters relating to the internal administration and the conduct of business of the SBP. Concurrently with the changes in the SBP Act, an amendment was made to the Banking Companies Ordinance (1962) authorizing the SBP to set the statutory liquidity ratio for scheduled banks.

d. Privatization and restructuring of financial institutions

As part of its broader strategy to privatize and liberalize domestic economic activities, the Government has opened the banking sector to private entities. As a result, a number of private banks, both domestic and foreign, have been set up. In addition, the Government has privatized two of the four nationalized commercial banks (NCBs). During 1991, the Government sold 51 percent of its shares in the Muslim Commercial Bank to a group of domestic private investors; and sold 26 percent of its shares in the Allied Bank to management and staff (with transfer of management). An additional 25 percent of government shares in Allied Bank was sold in August 1993. These privatized banks have outperformed the other NCBs in terms of deposit growth and containment of administrative costs. Encouraged by this initial success, the Government is currently taking steps to privatize one of the three remaining NCBs (United Bank Limited). Moreover, the Government, in collaboration with the World Bank, is undertaking measures to restructure or privatize three of the four largest Development Finance Institutions (DFls).

e. Regulation and supervision of financial institutions

The SBP has strengthened substantially the prudential regulations governing financial institutions and improved its supervision function. A set of 17 prudential regulations for scheduled banks was issued in August 1992 including rules covering classification and provisioning requirements; concentration of credit; limits on exposure against contingent liabilities and unsecured advances; and stricter guidelines on separation of ownership and management. Also, the SBP has increased markedly the number of staff in the supervision and inspection departments; and it has provided ample training in this area, including with technical assistance from the Fund.

The SBP’s enhanced autonomy and supervisory capability have been reflected in several concrete steps to improve financial intermediation. In 1993, the SBP issued a regulation prohibiting scheduled banks from lending to borrowers who were in default to the banking system unless the outstanding liabilities were rescheduled or restructured. 1/ In March 1994, the SBP took action against a domestically-owned private bank for failing to meet its statutory obligations and for noncompliance with several SBP directives; the management of the bank was removed and a thorough audit was undertaken. 2/ In September 1994, the coverage of banks under the SBP’s supervisory authority was broadened to include two important provincial banks (the Bank of Punjab and the Khyber Bank)

V. External Sector Developments

1. Balance of payments developments

a. Overall trends

Over the period under review, balance of payments developments were influenced by the Government’s adjustment and structural reform program. The structural initiatives have fostered strong growth in exports, including a diversification toward nontraditional exports. During the five-year period, imports have grown less rapidly than exports reflecting a strengthening of demand management (in particular in 1993/94), exchange rate adjustments, and progressive import liberalization. Private transfers remained strong.

The current account deficit (excluding official transfers) narrowed from a high level of over 7 percent in 1992/93 (associated with the flood-related fiscal expansion) to 3.9 percent of GDP in 1993/94, largely reflecting a 14 percent drop in imports (Table 10 and Chart 5). In 1994/95, imports recovered sharply reflecting looser demand policies (particularly in the second half of the year) and the current account deficit widened to over 4 percent of GDP despite strong export growth.

Table 10.

Pakistan: Balance of Payments, 1990/91–1994/95

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Sources: Ministry of Finance and Economic Affairs; and State Bank of Pakistan.

In the data for 1989/90- 1991/92, defense-related external debt service payments are included in imports.

The capital account as defined in this report excludes official transfers and includes changes in the medium and long-term net foreign assets of the deposit money banks.

Includes Foreign Currency Bearer Certificates and Eurobond issue of US$148 million in 1994/95.

Includes net sales of Foreign Exchange Bearer Certificates and Dollar Bearer Certificates.

Mainly holdings of export bills.

Changes in foreign exchange holdings.

Excludes gold