March 30, 2001

Our authorities wish to thank staff for a clear and well-written report and concur with the broad thrust of their appraisal and policy recommendations. Despite the intensification of drought conditions and an external environment that is becoming more difficult as export unit values fall amid a generalized slowing of external demand, economic performance in Pakistan during the first six months (July-December 2000) offers grounds for cautious optimism. While the setback to the agricultural sector stemming from the drought hurt overall GDP growth, the industrial upswing gathered strength, inflation performance was better than expected, the underlying current account position was broadly in line with program projections, and gross official reserves rose to more comfortable levels—a shortfall in capital inflows and official assistance notwithstanding. More importantly, fiscal adjustment, which is seen by the authorities as the anchor of the program and crucial to the task of achieving macroeconomic stability and external adjustment, was better than programmed with an overperformance equivalent to 0.7 percent of GDP.

Good progress was also achieved on the structural side. The IPP issue was settled: the long drawn-out tariff dispute between the Water and Power Development Authority (WAPDA) and the Hub Power Company. (HUBCO) was finally resolved in a manner satisfactory to both parties; new medium- and long-term bonds (the Pakistan Investment Bonds) were issued on schedule; the restructuring of the financial sector continued; and the authorities made further headway on their governance agenda, especially with regard to the drive to improve the reporting of public finances.

There were, however, some less propitious developments. The authorities’ wide-ranging and unprecedented tax registration and documentation drive did not produce the quick results they had expected. Tax revenues fell short of the very ambitious target, but this shortfall was more than offset by expenditure cuts so as to protect the target for the fiscal deficit. The task of monetary policy was complicated by an unanticipated surge in the demand for currency and credit to the private sector. As a consequence, meeting the very tight end-December performance criteria required some drastic and unconventional steps.

Looking at the overall economic performance in the first six months under the SBA, the authorities believe that Pakistan is off to a good start in implementing its adjustment and reform agenda despite the challenges posed by adverse exogenous developments. To be sure, as staff note, lower growth and shortfalls in external financing have weakened macroeconomic prospects. Nevertheless, there are still a number of positive developments which, taken together, suggest that Pakistan will succeed in meeting program objectives. A momentum has been built up in the structural reform area and it will gather strength in the period ahead, setting the foundation for higher growth and poverty alleviation over the medium term.

Fiscal policy will remain on track with an unchanged deficit target for the year. The revenue target for the year has been lowered in recognition of earlier shortfalls, but, the target—while still ambitious—is realistic. To preclude further shortfalls, the authorities are implementing a short-term action plan—the elements of which are well described in the staff report and the attachment to the MEFP—for improving tax administration that is based on recommendations of FAD. Total expenditure has also been reduced, mainly through cuts in low-priority development spending. The authorities are concerned with the shortfall in social and poverty-related spending in the first half of the year although much of this shortfall may actually reflect a more cautious attitude to spending in line ministries/departments in the context of the emphasis on improved accountability and governance.

Monetary policy has been tightened with two recent increases in interest rates to protect the external sector and to keep inflationary pressures at bay. The authorities recognize that the external reserves, while improving, are still at a low level, which calls for vigilance and prompt action, should the situation warrant. The exchange rate has been, and will continue to be, managed flexibly as the authorities discontinue sales of foreign exchange in the interbank market to finance oil imports and gradually phase-out purchases from the kerb market. The revised monetary program takes into account the more permanent nature of high demand for rupee cash and, accordingly, envisages a gentler deceleration in reserve money growth. It will, however, still entail a considerable tightening in monetary policy compared to the end-January period.

The structural reform agenda is comprehensive and demanding. It envisages further tax, energy, financial sector, and governance reforms. In the tax area, the authorities remain committed to extending the GST to the retail sector and agricultural inputs, a major reworking of the income tax, a meaningful agricultural income tax, and a plan to reform tax administration. These reforms will durably strengthen the fiscal position and make room for urgently needed spending on physical infrastructure and social and poverty-related programs. Steps are being taken to improve the financial position of WAPDA and the Karachi Electric Supply Corporation (KESC), including, as a prior action, an adjustment in their tariffs. KESC is to be restructured with the assistance of the Asian Development Bank (ADB). The World Bank is preparing a Structural Adjustment Credit (SAC), which will focus on governance, growth, and human resource development issues. The Bank is considering a further operation in support of the planned reforms in the financial sector, which, inter alia, will entail major labor shedding and liquidation and/or mergers of a number of development financial institutions.

As the staff report clearly brings out, improving governance is a theme that runs through virtually all the government’s reform agenda. This is a multi-faceted task, and the staff report describes well the scope and breadth of this effort. The government’s devolution plan, which is anchored on greater accountability and delivery of services, is proceeding well and with due recognition of the challenges it may pose for fiscal management. Good progress also continues to be made on data-related issues, although the authorities recognize that the accounts reconciliation and reporting process in the provinces need to be strengthened further.

The staff report suggests that there remain “significant risks” to achieving program objectives. Clearly, if domestic and external shocks intensify, the risk of not meeting key program objectives will rise—as it would in any program that is buffeted by unanticipated adverse events. Barring that gloomy scenario, however, the authorities are confident that they are up to the challenges confronting them and that the known risks are manageable. At the same time, they recognize that this review constitutes only one small step on the long and arduous road of adjustment and reform and that the benefits of their reform actions in terms of improvements in the life of the people of Pakistan will be felt only slowly. Nevertheless, their commitment to continue along the path of reform remains undiminished, and they look forward to the Executive Board’s discussion and advice, as well as its support for an early negotiation on a program that can be supported by the PRGF.

As before, the Pakistan authorities have agreed to the full release and publication of the LOI/MEFP as well as of the staff report.