Prior Actions

2. The information provided by the authorities indicates that all the prior actions listed in the supplementary Memorandum on Economic and Financial Policies (MEFP) (Table 3, Attachment I in EBS/01/101) have been implemented. In particular:

• net reserves of the State Bank of Pakistan (SBP) reached US$1,377 on June 15, 2001, compared to a target of US$ 1,340 million.

• the federal budget announced on June 18, 2001 is consistent with the financial program set out in table 4 of the MEFP, limiting the deficit, excluding grants, to PRs 186.5 billion. The budget includes published reports on contingent liabilities and a schedule of tax expenditures (thereby observing two end-June structural benchmarks). The budget for 2001/02 includes all the various tax measures in Table 3 of the MEFP, including the elimination of GST exemptions on retailers with a turnover of more than PRs 5 million, imported soya bean and palm oil, mobile phones, and jewelers, and the elimination of excises on 10 items.

• Ordinance No. 364 of June 14, 2001 authorizes the export of wheat, and with effect July 7, 2001 an amendment to the Import Trade Order eliminates the public sector monopoly on the import of wheat; the tariff on wheat imports was earlier set at 30 percent.

Structural Performance Criteria and Benchmarks for end-June 2001

3. The authorities have confirmed that with one exception all the structural performance criteria for the period end-March 2001 to July 1,2001 have been observed. The GST was extended to urea fertilizer and pesticides on March 31, 2001; the maximum customs tariff was reduced effective July 1, 2001 to 30 percent; and the number of slabs reduced to four (with a few zero rated items such as Information Technology related imports).

4. An International Accounting Standards (IAS) compliant reporting format and comparable IAS financial statements for the SBP for the year ended June 30, 2000 was prepared and made available to staff. The SBP reduced its term deposits with Pakistani banks abroad to US$172 million at end-June 2001, and plans to reduce such term deposits to US$100 million by end-September 2001. In addition, the current account position of the SBP with these banks has been capped at US$120 million.

5. To eliminate the interest rate subsidy for export finance, the rate on export finance was raised from 10.5 to 13 percent effective July 1, 2001. Elimination of the subsidy was defined in the Technical Memorandum of Understanding (TMU) as a margin of 1.5 percentage points over the average six-month treasury bill yield obtained in the auctions during the previous quarter. This performance criterion was not observed. The reason was that the authorities were concerned to take into account the last auctions in June, which resulted in exceptionally high yields (12.2 and 12.9 percent, respectively), raising the average yield for the quarter to 11.8 percent, as the SBP aggressively moved to meet the net domestic asset (NDA) and net foreign asset (NFA) targets.

Staff agrees that the last auctions in June were exceptional and that the action taken observes the spirit of the performance criteria, even if the export finance rate at 13 percent exceeded the average six-month treasury bill yield prevailing in all auctions during the previous quarter by only 1.2 percentage points rather than 1.5 percentage points as required in the TMU. In particular, staff considers that an export finance rate strictly at the level defined by the TMU could soon imply a tax on export finance once yields ease over the coming weeks, as expected. Accordingly staff recommends the granting of a waiver for the nonobservance of this performance criterion.

6. In observance of end-June structural benchmarks, the SBP has completed an independent review of its internal audit functions. However, provincial implementing regulations for the agricultural income tax have yet to become effective in each province. The report on research studies in the framework of the National Accounts project related to livestock, mining and quarrying, and public administration and defense was completed with some minor delay, and was made available to staff on July 10, 2001. Progress was also made in implementing measures that were structural benchmarks for end-March 2001: The final income tax reform report was completed at end-April 2001, and a new draft income tax law was posted on the CBR’s website inviting public commentary and scrutiny in early July 2001. Basic reconciliation processes for fiscal data have been established in all provinces.

Other Structural Reforms

7. The authorities have implemented further steps towards the liberalization of petroleum product markets. Effective June 13, 2001, following a final adjustment of prices according to the formula under the program, the oil marketing companies (OMC) have been authorized to freely import petroleum products, and will jointly determine every two weeks the prices charged at the 29 central depots to reflect import prices (calculated as weighted average of the prices paid by the various OMCs), exchange rates, primary freight up to the 29 depots and domestic costs, while incorporating all taxes and duties. Any price changes need to be approved by the regulatory authority. The new pricing system allows retail prices to reflect differences in transport costs from the depots to retail outlets, up to a fixed margin over ex-depot prices (e.g. 11 percent for high-speed diesel).

8. Deadlines for expression of interest for the privatization of United Bank Ltd., Pakistan Oils Ltd, Pakistan Telecom Company Ltd, and National Investment Trust expire during July, 2001. On July 5, 2001, the Privatization Commission invited expressions of interest by end-July, 2001 to divest the government’s remaining equity stake (16.6 percent) in Muslim Commercial Bank, the largest private bank in Pakistan.

Recent Economic Developments

9. Latest real sector data indicate that through April large-scale manufacturing grew by 8.3 percent in real terms, and latest official estimates put the 2000/01 wheat harvest at 19.1 million tons, both somewhat higher than expected. Sugar production also is growing faster than expected, and real GDP growth (at factor cost) may reach close to 3.0 percent, slightly higher than programmed. Total exports for 2000/01 reached US$9.1 billion, an all-time high and an increase of 11 percent over last year in value terms, slightly better than programmed.

10. Net official reserves of the SBP on June 30, 2001 exceeded the program target, reaching US$1,677 million (but declined to US$1,608 million by July 9 mostly on account of debt service due). This strong performance, which was not expected to be achieved in the MEFP or the staff report, reflects a high level of foreign exchange purchases by the SBP in both interbank and kerb markets in the last week of June, early settlement of some long-term swaps in rupees and contracting of additional long-term swaps, as well as additional short term borrowing by the government. The depreciation of the Pakistani rupee against the U.S. dollar (interbank rate) rose to 22.9 percent for the year ending June 30, 2001; the spread between the interbank and kerb market rates was 4.3 percent on June 30, 2001. The fact that the rapid pace of building reserves in late June did not unsettle markets—which had been a major concern of the authorities and the staff—may in part reflect the better-than-expected export performance.

11. Monetary data for May 2001 indicate that, in the year through end-May 2001, broad money expanded by 7.8 percent and reserve money by 7 percent. The rupee currency-to-deposit ratio was stable during April-May at about 40 percent, contrary to the decline underlying the program projections. The authorities have indicated that NFA of the SBP reached PRs 40.2 billion (at program exchange rates) and NDA of the SBP PRs -24.2 billion; based on preliminary estimates of the value of the various adjusters the authorities are confident that the performance criteria on both NFA and on NDA of the SBP at end-June 2001 have been met with comfortable margins. Reflecting the indication that the NFA target has been met, the authorities no longer request a waiver of nonobservance for the performance criteria on NFA of the SBP at end-June, and a revised draft decision to this effect is attached.

12. Preliminary data on CBR revenue indicate that collection for the year 2000/01 reached PRs 393.4 billion, an increase of 13.5 percent over the preceding year, but PRs 23.6 billion (0.7 percent of GDP) short of the program target of PRs 417 billion, and still PRs 13.1 billion (0.4 percent of GDP) below the projections in the staff report. Revenue from direct and indirect domestic taxes remained below expectations by roughly similar magnitudes ; customs revenue was on target. Based on past experience, the final data is likely to be revised upwards, albeit by at most PRs 1–2 billion.

12. Data on other end-June 2001 quantitative performance criteria are not yet available.

Staff Appraisal

13. While the information above does not change the thrust of the staff appraisal, staff considers the shortfall in CBR revenues from already lowered expectations as highly disappointing. Staff therefore urges the government and the just-appointed new CBR management to redouble their efforts to strengthen tax administration, and to accelerate the streamlining of tax policies, including the speedy elimination of tax exemptions.