Pakistan: First Review Under the Stand-By Arrangement and Request for Waivers and Modification of Performance Criteria

Pakistan showed great achievements under the program supported by the Stand-By Arrangement. Executive Directors stressed the need to implement strong fiscal, monetary, and exchange rate policies, and accelerate structural reforms. They emphasized the need for enhancing governance, rationalization of energy prices, broadening of tax base, strengthening of tax administration, and improving the financial position of public enterprises and banks. Directors agreed that the country has completed the first review under the Stand-By Arrangement, and approved a waiver.


Pakistan showed great achievements under the program supported by the Stand-By Arrangement. Executive Directors stressed the need to implement strong fiscal, monetary, and exchange rate policies, and accelerate structural reforms. They emphasized the need for enhancing governance, rationalization of energy prices, broadening of tax base, strengthening of tax administration, and improving the financial position of public enterprises and banks. Directors agreed that the country has completed the first review under the Stand-By Arrangement, and approved a waiver.

I. Introduction and Background

1. The discussions for the first review under the Stand-By Arrangement were held in Islamabad during February 7–25, 2001.1 The arrangement, amounting to SDR 465 million (45 percent of quota) was approved on November 29, 2000, on which occasion the Executive Board concluded the last Article IV consultation.2 In the attached letter dated March 18, 2001, the authorities request the completion of the first review under the Stand-By Arrangement and seek waivers for the nonobservance of one quantitative and one structural performance criteria for end-December 2000, as well as modifications of two quantitative performance criteria for end-March 2001. The accompanying Memorandum on Economic and Financial Policies (MEFP)—which updates and supplements the Memorandum dated November 4, 2000—describes economic developments and policy implementation during the first half of 2000/01 (fiscal year ending June 30) and the authorities’ policy intentions for the remainder of the fiscal year, and specifies quantitative aspects of the program that were to be agreed upon in the context of the present review.

2. In approving the arrangement, Executive Directors observed that the key policy challenges in the period ahead would be to maintain macroeconomic discipline and improve the competitiveness of the economy and public debt dynamics. They agreed that fiscal consolidation—especially an improved revenue effort—was essential for restoring macroeconomic stability. Moreover, they stressed that continued progress with structural reform will be necessary for attracting private investment, achieving high growth, and alleviating poverty. They identified enhancing governance, broadening of the tax base, strengthening of tax administration, and improving the financial position of public enterprises and banks, as particularly important structural reform areas. Directors concluded that the successful implementation of the program and the finalization of major structural reform plans could pave the way over time for medium-term financial support from the Fund under the Poverty Reduction and Growth Facility.

3. Following Board approval, Pakistan purchased the equivalent of SDR 150 million under the Stand-By Arrangement. The second purchase in an amount of SDR 105 million will become available upon completion of the first program review. As of end-February 2001, total Fund credit and loans outstanding to Pakistan amounted to SDR 1,164 million (112.5 percent of quota).

II. Performance and Policies in July–December 2000 and Early 2001

4. Economic performance during the first half of 2000/01 was better than envisaged under the program with regard to inflation, the overall budget deficit, and the external current account position. However, economic growth was lower than projected and revenue performance fell short of the program objectives. Demand for currency and private credit was much stronger than projected but monetary targets were met through unorthodox measures at end-December 2000. Implementation of the ambitious program of structural reforms was broadly on track.

5. Agricultural output was adversely affected by below-average rainfall but the industrial upswing was confirmed and the inflation performance was better than expected. Rainfall during late fall and the winter season has remained well below average and intensified the already prevalent drought. This led to a contraction of the cotton crop, currently estimated at 10.4 million bales, about 7.5 percent lower than last year’s bumper crop. Some other crops have also suffered and the forthcoming wheat crop is now estimated at 18.7 million tons, a 10 percent decrease compared to last year’s harvest. Nevertheless, the cotton crop was sufficient to sustain continued output growth in the textile sector. The available data also confirm the expected broad-based upswing in the industrial sector after last year’s cotton-based recovery. On the inflation front, developments in December-January were more favorable than expected, reflecting mostly lower-than-projected food prices but also what appears to be a smaller-than-expected pass-through effect of the recent exchange rate adjustment. In January 2001, the twelve-month inflation rate as measured by the CPI was contained at 4.5 percent (Chart 1). Wholesale price inflation began to accelerate during October-January, largely on account of rising raw material prices, especially cotton and energy prices. In January, the 12-month average rate reached 4.8 percent.

6. The underlying external current account position was broadly in line with the program projections but program financing and foreign direct investment were weaker than envisaged during the first half of 2000/01.3 Lower exports and larger profit transfers were compensated by lower-than-expected non-oil imports and higher workers’ remittances (Table 2). The shortfall in export receipts was due to lower unit values for textile products; volumes increased as programmed, with strong growth in non-traditional exports and many categories of textile products. Despite lower-than-projected foreign direct and portfolio investment inflows and shortfalls in Asian Development Bank (AsDB) and Islamic Development Bank (IDB) disbursements, gross official reserves (excluding foreign currency deposits held with the State Bank of Pakistan (SBP), and short-term swaps and forwards) amounted to US$735 millions at end-December (equivalent to 3.2 weeks of imports of goods and nonfactor services); this was a substantial improvement compared with the US$390 million in early October, and was in line with the program projection (Chart 2).4

Chart 1.
Chart 1.

Pakistan: Output and Inflation, 1996–2001

Citation: IMF Staff Country Reports 2001, 058; 10.5089/9781451830514.002.A001

Source: Data provided by the Pakistan authorities.1/ This excludes the Food, Fuel & Lighting, and Transportation & Communications Groups.
Chart 2.
Chart 2.

Pakistan: External Sector Developments, 1996–2001

Citation: IMF Staff Country Reports 2001, 058; 10.5089/9781451830514.002.A001

Source: Data provided by the Pakistan authorities.1/ Excluding foreign currency deposits held with the SBP (State Bank of Pakistan) and short-term foreign currency swaps.

7. Renewed pressures on reserves emerged in January and February 2001 despite increased nominal exchange rate flexibility. In January, reserves started again to decline despite continued SBP purchases of foreign exchange in the kerb market, as the SBP sold foreign exchange to the interbank market for debt service payments and petroleum imports. The value of the rupee in the interbank market, which had depreciated by 12 percent during the first quarter of the fiscal year against the U.S. dollar and then stabilized during the second quarter, depreciated by another 4 percent in January and February 2001 (Chart 3). During July-December 2000, the real effective rate fell by almost 6 percent. Since the onset of the move to a market-based exchange rate system, daily and weekly exchange rate volatility has increased while the spread between kerb and interbank rates has been close to 5 percent.

8. Monetary developments were more expansionary than expected in the second quarter of the fiscal year with higher-than-programmed demand for currency and private sector credit. Currency in circulation increased by 15.4 percent during July-December 2000 instead of decreasing by 5.9 percent as programmed (Table 3 and Chart 4). The above-trend demand appears to have reflected: (a) an increased cash preference related to the tax survey; (b) a higher demand in rural areas because of the much larger value of the cotton crop; and (c) rising demand for Pakistani rupee in Afghanistan as well as by the rising number of Afghan refugees in Pakistan following the recent tightening of the UN sanctions and intensified drought conditions. In addition, currency demand was boosted by temporary factors related to the Ramadan period and the coincidence of its end-period festivities with other official holidays at end-December. The increase in currency in circulation accounted for more than 70 percent of the 5.4 percent rise in broad money during July-December (programmed at 2.2 percent).5 Private sector credit grew by 11.1 percent during the same period, roughly twice the growth that was projected in the program. This mainly reflected the much higher financing needs of the textile sector following sharp rises in cotton prices, but also the refinancing needs related to the buoyant leasing activity for consumer and equipment goods.

Chart 3.
Chart 3.

Pakistan: Exchange Rate Developments, 1996–2001

Citation: IMF Staff Country Reports 2001, 058; 10.5089/9781451830514.002.A001

Source: Data provided by Pakistan authorities; and staff estimates.
Chart 4.
Chart 4.

Pakistan: Monetary Developments, 1999–2001

Citation: IMF Staff Country Reports 2001, 058; 10.5089/9781451830514.002.A001

Source: Data provided by the Pakistan authorities.

9. The end-December NDA target was met. During the second quarter of the fiscal year, commercial banks’ liquidity position was hit by a strong demand for private credit. In the circumstances, banks reduced their treasury bill holdings, including through reverse repos with the SBP, and resorted to the SBP’s discount window to obtain liquid funds. In addition, several banks engaged in foreign exchange swaps with the SBP to increase their rupee liquidity in December. Against these developments, the targeted 1.1 percent decrease in reserve money under the program would have required a drastic tightening of the monetary policy stance. The SBP managed to avoid this tightening, yet formally met the performance criterion on its NDA through several unorthodox steps (see paragraph 5 of the MEFP for details). Adjusted for these temporary measures,6 which were fully reversed in January 2001, reserve money increased by an estimated 15 percent over the last twelve months, which suggests that the underlying monetary stance was substantially more expansionary than indicated by the actual end-December data (decrease of 2.1 percent) (Table 4). In January, broad money growth receded to the program path, while currency holdings remained substantially above the program path with a seven-month growth rate of 8.9 percent.

10. The budget deficit was lower than programmed in the first half of 2000/01 despite shortfalls in CBR revenue (Table 5). The consolidated government deficit amounted to 2.2 percent of annual GDP, 0.7 percentage points of GDP lower than programmed. Shortfalls in tax revenue were more than offset by stronger-than-expected expenditure restraint and, to a lesser extent, higher non-tax revenue. The target for CBR revenue for the first half of 2000/01 was missed by PRs 8 billion (5.2 percent of the target, or 0.2 percent of annual GDP), and the corresponding quantitative performance criterion for end-December 2000 was breached (Chart 5). Nevertheless, CBR revenue increased by 13.5 percent over the corresponding period of last year. Shortfalls arose mainly in sales and income tax receipts and reflected primarily persistent weaknesses in tax administration.

Chart 5.
Chart 5.

Pakistan: Revenue Developments, 2000/2001

Citation: IMF Staff Country Reports 2001, 058; 10.5089/9781451830514.002.A001

Source: Data provided by Pakistan Authorities.1/ Program GDP for 2000/2001 is 3543 PRs billion.

The diversion of staff resources from regular tax activities to the tax survey was a major problem in this regard, reducing audit capacity and adversely affecting collection enforcement.7 In addition, sales tax revenue remained behind expectations because of lower-than-projected imports. After widening to PRs 11 billion in January 2001, the cumulative shortfall in CBR revenue stabilized in February.

11. Total expenditure and net lending was nearly 1 percentage point of annual GDP lower than programmed, despite the advance payment of January wages in December, because of the coincidence of end-Ramadan holidays with other official holidays. The savings on the expenditure side reflect lower current and capital spending at the provincial levels, which in turn was the result of deliberate expenditure restraint and better enforcement of accountability and governance standards (Appendix II). The latter also explains why, despite full release of budgeted appropriations at the beginning of the year, poverty-reducing expenditure fell short of program objectives by about PRs 13 billion (or 0.4 percent of annual GDP). Defense expenditure remained on track.8

12. Structural reforms gained momentum in a number of areas, including governance, and structural benchmarks and performance criteria were met (attached MEFP, Table 2), except for a short delay in adjusting petroleum prices in December, for which the government is requesting a waiver as explained in paragraph 7 of the attached MEFP. The 3½-year long tariff dispute between Hub Power Corporation (HUBCO) and the Water and Power Development Authority (WAPDA) was settled, the financial situation of WAPDA is slowly improving, and cross-arrears between WAPDA and the budget are being cleared. New medium- and long-term government bonds, the Pakistan Investment Bonds (PIB), were launched as scheduled. So far, about PRs 30 billion in 3–10-year bonds have been auctioned at yields ranging from 12.5percent to 13.5 percent. The restructuring of the financial sector has continued with the ongoing closure of unprofitable branches of major nationalized commercial banks. The authorities’ governance reform agenda is broadly on track (Appendix III). In particular, the drive to improve accounting, reconciliation and reporting of public finances continued, as detailed in paragraph 9 of the MEFP. Significant steps have been made in the area of civil service reform, including the enactment of an ordinance in November 2000 that limits political interference in hiring and promoting civil servants. However, progress in improving fiscal data quality and transparency at the provincial level has been slower than envisaged under the program.

III. Report on the Discussions

13. The discussions covered developments thus far under the program, the somewhat weaker macroeconomic prospect for the remainder of 2000/01 and its implications for macroeconomic policies, the specification and modification of quantitative program targets, program monitoring issues, and a review of the structural policy agenda in collaboration with the World Bank. The authorities remain committed to implementing the structural reform agenda laid out in the original MEFP of November 4, 2000, which is a crucial part of their strategy to revive the economy and to address the many distortions that had impeded higher sustainable growth and contributed to a trend of growing poverty. Improving governance is one of the pillars of the agenda. Indeed, a large number of reforms throughout all sectors aim directly at, or contribute indirectly to, enhancing governance and transparency.

A. Macroeconomic Objectives and Policies for the Remainder of 2000/01

14. Lower growth and shortfalls in external financing have weakened macroeconomic prospects for 2000/01. Real value added in the agricultural sector is projected to increase by only 0.3 percent (compared with the 2.6 percent projected in September), as the drought conditions have intensified. Consequently, growth as measured by real GDP at factor cost is now forecast at 3.8 percent, compared with 4.5 percent as under the original program (Table 1). Inflation, as measured by the annual average change in the CPI, is now expected at 5 percent, 1 percent less than in the original projections, even after taking into account anticipated pressures on food prices, programmed increases in electricity and gas tariff rates, and some additional pass-through effects. With the envisaged policy mix as detailed below, the current account deficit for 2000/01 is still estimated at 1.6 percent of GDP. However, with the expected shortfall in external financing, the reserves target for end-June was reduced by about US$100 million to US$1.6 billion (equivalent to 6.6 weeks of imports).

Table 1.

Pakistan: Macroeconomic Framework, 1995/96-2003/04

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Sources: Pakistan authorities; IMF, World Economic Outlook; and Fund staff calculations.

In U.S. dollar terms, import-based weights.

Unit value deflators for exports of goods and services of partner countries.

Includes public sector enterprises throughout the projection period even though some of them may be (partially) privatized.

The implicit interest rate on public debt is calculated as interest payments in percent of the end-of-period debt stock of the previous year. The growth-adjusted real interest rate is the implicit interest rate minus the nominal GDP growth rate.

In July 1996, 6-month treasury bills were replaced by 6-month short-term federal bonds.

Nominal rate minus average annual inflation rate as measured by the CPI.

Defined as sum of receipts from exports of merchandise and services exports, and from private transfers.

Scheduled debt service minus rescheduled debt service plus debt service on previously rescheduled debt.

The implicit interest rate on external public debt is calculated as interest payments in percent of the end-of-period debt stock of the previous year. The growth-adjusted real interest rate is based on the growth rate of current foreign exchange receipts.

Excluding gold, and foreign assets relating to foreign currency deposits contracted after May 1998 (FE25s), and short-term foreign exchange swaps and forward contracts.

Short-term external debt includes public and private short-term at original maturity plus actual amortization payments on public medium- and long-term debt of the following year (including payments on debt that was rescheduled earlier). Rescheduled public short-term debt at original maturity is excluded from 1999/2000 onward, rescheduled private short-term debt at original maturity from 1998/99.

Table 2.

Pakistan: Medium-term Balance of Payments, 1998/99-2003/04 (concluded)

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Sources: State Bank of Pakistan; Ministry of Finance, and Fund staff estimates.

The State Bank of Pakistan includes in private transfers an adjustment for the workers’ remittances through informal channels. The adjustment is based on SBP’s purchases of foreign exchange on the kerb market.

Includes financing from Saudi Arabia for oil imports that has been agreed through 2001/02.

Starting in 2000/01, actual or envisaged IBRD, IDA and AsDB disbursements are included in exceptional financing.

Includes repayment of FCDs held in NBFIs (reschedulings shown as exceptional financing).

Includes repayment of FCDs held in banks (reschedulings shown as exceptional financing).

Includes $1.1 billion in FCDs, $300 million in deposits at the SBP, and $500 million in deposits at the NBP.

Excluding new foreign currency deposits (FE25s) held with the SBP, and net of outstanding short-term foreign currency swap and forward contracts.

Table 3.

Pakistan: Monetary Developments, 1995/96-2000/01

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Source: State Bank of Pakistan; and Fund staff estimates.
Table 4.

Pakistan: Accounts of the State Bank of Pakistan, 1995/96-2000/01

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Source: State Bank of Pakistan; and Fund staff estimates.

At program exchange rates

Table 5.

Pakistan: Summary of Consolidated Federal and Provincial Budgetary Operations, 1999/2000-2000/01

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Sources: Ministry of Finance; and Fund staff estimates and projections.

15. The fiscal policy stance is to remain broadly unchanged, but achieving the revised reserve targets will require the tightening of monetary policy even with further flexibility of the exchange rate. The authorities agreed that the fiscal policy stance should remain essentially unchanged. However, reflecting developments in the first seven months of 2000/01, some revisions to targets for revenue and expenditure levels and composition were undertaken (see below). The March and June 2001 targets for SBP NDA were somewhat eased, because demand for currency is unlikely to revert in the near future to the levels that were programmed originally. Nevertheless, compared with the underlying monetary policy stance during October 2000 to February 2001, monetary policy will need to be tightened in the next few months, notably in support of the revised foreign exchange reserves targets.

16. Fiscal revenue targets are reduced but remain appropriately ambitious. The annual and quarterly targets for overall and CBR tax revenue were revised, since the cumulative revenue shortfall in the first seven months cannot realistically be expected to be reversed during the remainder of the fiscal year notwithstanding the determined short-term corrective actions, and considering the now somewhat lower annual growth rate for imports. For the fiscal year as a whole, the overall revenue target has been reduced by PRs 16 billion (3.3 percent of original target or 0.5 percent of GDP), of which PRs 13 billion is on account of CBR revenue. Nevertheless, the revised targets remain appropriately ambitious, implying improvements in overall tax revenue of 16 percent and in CBR revenue of 20 percent over the last year. To avoid further shortfalls, the government has adopted and started to implement a short-term action plan for improving tax administration prepared with FAD technical assistance (see attachment to the MEFP). Important elements of the plan include measures to ensure more rigorous and timely enforcement of action on the stock of tax arrears and reported sales tax nonfilers, with emphasis on the largest defaulters; intensification of sales tax audit activity through resource redeployment and improved auditor productivity; imposition of penalties for nonfiling and late payment significantly above market interest rates; and a public commitment by the government to no further amnesty-type arrangements. In view of the remedial measures that have been put in place to prevent further slippages in CBR revenue performance and the expenditure control measures that are being implemented to ensure the achievement of the original budget deficit target, the government requests a waiver for the nonobservance of the end-December 2000 performance criterion and modification of the end-March 2001 performance criterion on CBR revenue.

17. In tandem with revenue objectives, the target for total expenditure has been reduced by PRs 15 billion. The reduction will be achieved primarily through cuts in low-priority development spending, lower net lending due to the higher-than-expected repayments of government loans by the Oil and Gas Development Corporation (OGDC), and improved financial control. Cuts in the public sector development program (PSDP) will reduce primarily expenditure on low-priority projects, including of the National Highway Authority, Pakistan Railways, and WAPDA. The containment of expenditures will also be facilitated by the package of measures to strengthen WAPDA’s finances (discussed below). The objective of increasing social and poverty-related spending by at least 0.4 percent of GDP remains unchanged.

18. Adjusted monetary targets aim at accommodating higher-than-initially-expected currency demand and supporting the targets for the accumulation of reserves. The authorities and the mission agreed that the original March and June targets for the SBP’s NDA would be excessively tight since the demand for currency was unlikely to revert to trend levels in the near future. The authorities argued that the above trend expansion of currency holdings since early 2000 has proved to be more permanent than expected and that this money demand shock should be largely accommodated in an environment of low inflation. They also argued that the special factors underlying the above-trend expansion of currency demand are likely to have reduced its interest sensitivity. The mission maintained that the underlying monetary policy stance had been insufficiently tight in view of the low levels of available foreign reserves, nominal interest rates should have been increased more aggressively to signal a more restrictive stance and prevent foreign exchange outflows, and that monetary policy would need to be more supportive of the external sector targets. The monetary policy stance implied by the proposed revisions of the NDA targets strikes a balance between the concerns of the authorities and of the mission. Reserve money growth on a year-on-year basis is now programmed to slow to 9.7 percent by end-March 2001 and 5.5 percent by end-June 2001. Compared to the current stance, these targets require a gradual tightening of the monetary policy stance in the next few months. The three-month treasury bill rate was increased by 50 basis points on February 21, and a further increase is expected soon. In light of the above considerations and commitments, the government requests a modification of the March performance criterion on the NDA of the SBP.

19. Risks of instability in key monetary policy parameters remain high. The authorities recognize that in view of the risks of further unexpected shifts in the cash to deposit ratio, the money multiplier and market sentiments, vigilance is needed to ensure that the monetary policy stance remains sufficiently tight to achieve the reserves target and to keep inflation under control. They are also committed to relying on indirect instruments of monetary policy to achieve the monetary targets and to refrain from using the weekly and daily CRRs as a day-to-day instrument to affect monetary conditions.9

20. Move toward a market-based exchange rate system to achieve the external sector objectives will continue. The authorities reiterated their commitment to continue the passage to more exchange rate flexibility. To sustain the momentum during the remainder of the fiscal year, the SBP will stop providing foreign exchange to the interbank market to finance petroleum imports, and limit its interventions to smoothing out the temporary effects of bulky transactions in the thin interbank market, while reducing its total purchases in the kerb market in 2000/01.10 The targeted build up in reserves by end-June reflects largely the expected disbursements from International Financial Institutions in the second half of 2000/01, amounting to about US$875 million. Nevertheless, a careful coordination of foreign exchange interventions with monetary policy would be essential to prevent unsettled conditions in the foreign exchange market. Indeed, with the recent increase in interest rates, official reserves were built up to US$660 million by mid-March.

B. Structural Reforms and Social Policies

21. Measures are being put in place to strengthen the tax buoyancy and tax administration. The authorities feel that the tax survey has been successful in many respects, in particular by extending the tax net to many new taxpayers, including a number of large taxpayers. They acknowledged, however, that the payoff in terms of revenue has so far fallen short of expectations and that regular tax administration activities have suffered. In the circumstances, the aforementioned short-term action plan to improve tax administration has been adopted and is being implemented. At the same time, progress on the fundamental reform of the CBR and its operations has remained somewhat behind expectations. The task force on tax administration has delayed the submission of its report to the government until end-March 2001 because of technical reasons and some resistance from the CBR to the reform effort. However, the government remains committed to a strategy that will start restructuring the CBR with the next budget. The planned reforms of the General Sales Tax (GST) and the income tax are on track. The GST will be extended to pesticides and urea fertilizers on March 31, 2001 and to all remaining agricultural inputs by September 1, 2001. The government has publicly reiterated its intention to make GST compulsory at the retail level (for turnovers exceeding PRs 5 million) as planned on July 1, 2001; a campaign to prepare retailers for the associated filing and documentation requirements is underway. Preparations for the overhaul of the income tax have advanced; the report of the relevant committee and a draft law will be submitted to the cabinet by end-March 2001. The new law is to be promulgated with the next budget. Progress on the agricultural income tax has been slower than expected, as rules and regulations that would allow for the collection in 2001/02 of taxes on agricultural income earned this year have not yet been finalized by the provinces.

22. Role of market-based pricing in the energy sector is enhanced. With regard to public enterprises, the focus now is on steps to improve the financial situation of major enterprises through further moves toward market-based pricing policies, greater efficiency through labor shedding and reduction in subsidization and cross-subsidization, and settlement of arrears. To pave the way for privatization and foreign direct investment in the production and distribution of natural gas, the authorities have decided first to achieve and then to maintain parity of gas prices with world market prices through biannual adjustments. A first adjustment of 14.4 percent was implemented in mid-March 2001. More generally, the process of deregulation of the energy sector is continuing. The authorities have decided to deregulate the import of high speed diesel fuel from April 2001 and to start with the gradual dismantling of the residual freight pool for petroleum products.

23. Resolution of disputes with Independent Power Producers (IPPs) requires urgent measures to address the financial implications for WAPDA.11 Following the settlement of all tariff disputes with IPPs, WAPDA has to absorb an increase in payments to IPPs (fixed capacity charges and electricity purchases) of about PRs 15 billion compared with the path of payments implied by the court orders issued during the dispute (Table 6). As the revised capacity charges remain frontloaded, the authorities intend to mobilize the needed financial resources with a combination of measures rather than through tariff adjustments alone. Nevertheless, tariff adjustments remain important for WAPDA’s medium-term financial viability, and the independent National Electric Power Regulatory Authority (NEPRA) is expected to authorize WAPDA to raise its tariffs by at least an additional 4.5 percent in March 2001, in addition to the 4.9 percent rise that became effective in January 1, 2001. The increase would be effected in conjunction with a rationalization of its tariff structure and the introduction of an automatic fuel price adjustment clause in electricity tariffs. Other measures include the rationalization of WAPDA’s operational and development expenditure. Agreement has now been reached between WAPDA and Sindh on the settlement of PRs 6.7 billion of overdue receivables. The federal government will continue to ensure that federal agencies and provinces remain current on their electricity bills, including if needed through deduction at source from the provincial share in tax revenues. These measures should allow WAPDA to remain current on its remaining debt service payments and its obligations toward the IPPs and other suppliers.

Table 6.

Pakistan: Summary Accounts of Seven Key Public Sector Enterprises, 1995/96-2000/01

(In millions of Pakistan Rupees)

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Source: Pakistan authorities; and Fund staff estimates.

Gross operating revenue minus operating expenditure (accrual basis).

Gross operating surplus plus other revenue minus other expenditure plus noncash expenditure (depreciation).

Revenue minus expenditure.

24. The restructuring program for the Karachi Electricity Supply Corporation (KESC) was launched in December 2000 as scheduled. The financial situation of KESC remains of even greater concern. A financial and technical restructuring operation supported by the AsDB aims to turn around KESC’s financial position and prepare it for privatization by end-2002. As an important step, KESC will implement an increase in the average tariff of 9.5 percent by end-March 2001. While KESC will need nonetheless exceptional financing for its projected cash shortfalls, borrowing from the banking system for FY 2001 will be limited to PRs 7.5 billion.

25. Financial sector reforms are on track. The planned overhaul of the National Saving Scheme (NSS) is underway. Following the linking of interest rates on Defense Certificates to market rates, beginning July 1, 2001 interest rates on all other NSS instruments will also be market-based, and the tax-exempt status for new NSS instruments will be removed. All subsidies under the existing export finance scheme (EFS) will be eliminated by mid-2001. Consistent with this objective, the SBP raised the interest rate for the EFS by 1 percentage point to 9 percent in January 2001, and will raise it further in April 2001. The authorities intend to accelerate their drive to strengthen the financial soundness of the banking system, especially the major nationalized commercial banks, and promote competition between banks. In addition to the ongoing operations, which include the closure of nonprofitable branches in the rural sector and efforts to recover nonperforming loans, the government is discussing World Bank support for plans involving major labor shedding of the nationalized commercial banks and the liquidation or merger of a number of development financial institutions. However, a substantial recapitalization of some of these nationalized banks will be needed before their envisaged privatization. To support their effort in developing a sound and effective financial system and assess remaining weaknesses, the authorities reiterated their request for participation in the Financial Sector Assessment Program (FSAP) as early as possible. The restriction on commercial banks’ placement abroad of the funds associated with the mobilization of new foreign currency deposits (FE25s) will be withdrawn effective April 1, 2001 and prudential norms will be put in place to ensure their safety (MEFP, paragraph 24). To deepen the interbank market, nostro limits on banks’ balances held abroad on account of trading activities would be relaxed around mid-2001.

26. Preparations for the transition to a financial system based on Islamic principles are underway. In December 1999, the Supreme Court of Pakistan set end-June 2001 as the deadline for transformation of the country’s financial system to one which complies with Islamic finance principles, as is necessary in order to be consistent with the Constitution. Reasonable progress has been achieved by the authorities in preparing the legal and accounting frameworks needed in the new system. Several small Islamic banks have been in existence for some time so that bank supervisors, for example, have familiarity with the underlying concepts and the implications for bank supervision. In some important areas, however, including the design of specific financial instruments, advancement has been slow. Little has been done so far on developing a plan with the conventional banks of how to implement the transformation of their activities. Fund technical assistance missions have stressed to the authorities that the transformation should only be done in a careful and orderly manner. The Government has announced that foreign public debt will continue to be raised using conventional instruments and existing foreign debt will not be affected by the transformation of the financial system.

27. The SBP should in principle be able to continue to operate monetary policy in the new system in much the same way as at present. Much of the work to date on the transformation has focused on the introduction of an initial government funding instrument that satisfies Islamic principles. If such an instrument could be launched successfully, it would support most of the same monetary operations that the SBP currently undertakes, with the exception that repos would almost certainly not be permissible as they incorporate a predetermined yield. Outright purchases and sales on an interbank market at market determined prices would, however, be possible and should enable the SBP to manage banking system liquidity.

28. The government remains committed to the trade liberalization measures to be implemented with the 2001/02 budget. The maximum tariff will be reduced to 30 percent; the number of tariff slabs will be reduced to four; the differential excises on imported and domestically produced goods will be eliminated; and all remaining regulatory duties will be allowed to lapse. Quantitative import restrictions maintained for balance of payments reasons will be phased out by end-June 2002 according to a schedule agreed to with the WTO Committee on Balance of Payments Restrictions in November 2000. In December 2000, Pakistan removed import restrictions on a number of textile products, complying with the terms of the revised phase-out schedule, as well as on a number of other products well ahead of the phase-out schedule. In December 2000, the anti-dumping duties law according to WTO guidelines and a patent law were promulgated, which will greatly contribute to strengthening the legal framework of Pakistan’s trade policy.

29. The authorities’ strategy to improve governance is based on reforms in five areas: (a) devolution of power to the local levels; (b) civil service reform; (c) improved fiscal and financial transparency; (d) the fight against corruption; and (e) legal reforms. The first three areas focus on improving the management of the public resources and are incorporated in the Fund-supported program. Progress so far in these three areas is encouraging and the authorities are committed to implementing the next steps as programmed (Appendix III). However, as discussed in detail in Appendix II, much work remains to be done in the preparation of the fiscal devolution initiative.

30. Other structural reforms also contribute to improving governance. Elements of the structural reform program in the tax, energy, financial sector, and trade areas have also positive implications for governance in Pakistan. These reforms will contribute to the development of a transparent and predictable economic and regulatory environment that would establish a level playing field for private economic activities, bring back confidence in the economy and further stimulate the return of private capital to Pakistan. In the tax and customs reform area, this is being achieved through measures that simplify the present system, and broaden the tax base in a fair and transparent manner. In the energy sector, the objective is to fully liberalize energy imports and prices, while privatizing or restructuring public enterprises in the energy sector, under the supervision of transparent and autonomous regulatory bodies. Several significant steps have already been taken as described above. In the financial sector, progress is being made in the area of deregulation, restructuring of the state-owned financial institutions, as well as in the area of the financial transparency and accountability of the SBP. Considerable progress has been made in implementing remedies to mitigate the vulnerabilities identified in the Stage-Two Safeguards Assessment report, including the completion of the two prior actions to be taken before the first review under the Stand-By Arrangement (Appendix IV). The deregulation includes the elimination of all subsidies under an export-financed scheme by end-June 2001 (which has been reportedly misused to finance working capital needs for many enterprises). The forthcoming FSAP mission will provide key inputs to improve the financial standards and codes and other policies to encourage financial transparency and accountability of the financial system.

IV. Balance of Payments Outlook and External Financing Issues

31. The projected external current account deficit for 2000/01 remains as programmed despite a deterioration in the terms of trade. The structure of the underlying flows is, however, expected to change. A lower trade deficit and somewhat higher workers’ remittances should offset higher-than-expected service payments on account of larger profit repatriation by foreign-owned companies. The projected growth rate of exports in value terms has been lowered, as unit values are expected to remain below originally projected values with the anticipated slowdown in the world economy. Export volumes, however, are expected to evolve as projected under the program. The growth of import values during the remainder of 2000/01 is forecast to slow down on account of lower oil prices, leading to a significant reduction in import values on an annual basis compared with earlier projections.

32. External financing from debt rescheduling is on track but shortfalls in program financing are expected in 2000/01 (Table 7). The Paris Club creditors agreed to reschedule Pakistan’s medium- and long-term debt covering arrears current maturities though September 2001 on loans contracted before end-September 1997 (Appendix V). The debt relief provided by the Paris Club is in line with that assumed under the program. The authorities will proceed expeditiously with the bilateral negotiations with Paris Club and other bilateral creditors. As expected, representatives of institutional FCD holders agreed to rollover 75 percent of their US$ 1.1 billion deposits until end 2001/02, while US$900 million in deposits (of private and official sector depositors) either with the SBP or the National Bank of Pakistan have also been rolled over on existing terms and conditions.12 The authorities will implement in a timely manner all agreed-upon measures required for disbursements by the AsDB of several program loans and by the World Bank of the structural adjustment credit as envisaged under the program. However, disbursements from the AsDB will be about US$125 million less than envisaged in the original program, mainly due to delays in the processing of the Agricultural Program Loan, which is now expected to be disbursed in the first half of 2001/02. On the basis of the revised current account projections and taking into account the above-described financing elements, the targeted level of reserve at end-June 2001 would fall slightly short of the program objective, as noted above.

Table 7.

Pakistan: External Financing Requirements, 1998/99-2003/04 1/

(In millions of U.S. dollars)

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Sources: State Bank of Pakistan; Ministry of Finance, and Fund staff estimates..

See Table 2 for explanatory notes.