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/01/161) have been implemented. In particular:

• Net reserves of the State Bank of Pakistan (SBP) reached US$1,726 on September 13, 2001, compared to a target of US$1,631 million. Reserves stood at US$1,679 million on September 24, 2001.

• Nostro limits on commercial banks’ foreign exchange holdings with correspondent banks were eliminated effective August 31, 2001 (SBP’s foreign exchange circular No. 11).

• A reformed income tax law was promulgated on September 13, 2001, to apply for income earned from July 1, 2002 as described in paragraph 7 of the supplementary MEFP (EBS/01/161, Attachment I).

• In all four provinces amendments to the agricultural income tax were passed, and accompanying rules and regulations notified, providing clearer and uniform definitions and specifying important rules (e.g., deductible costs for computing net agricultural income) to be applied equally in all provinces. Accordingly, filing for agricultural income taxes can commence end-September this year as envisaged under the program.

Recent Economic Developments

3. Inflation data for August indicate that the CPI increased 3.4 percent over the year ending August (from 2.5 percent in July), reflecting mainly an increase in the price of various food items. However, core inflation (excluding food and energy) slowed, and the average annual CPI declined from 4.2 percent through July to 4.1 percent in August. The wholesale price index decelerated to 6.0 percent in the year to August, compared to 6.5 percent in the year through July 2001. Preliminary trade data indicate an improvement in the trade balance in July–August 2001 by US$63 million compared to the same period a year earlier, as exports stagnated while imports recorded a small decline. Worker’s remittances in July were at about the same level as a year earlier, while net foreign investment recorded an inflow of US$18 million compared to an outflow of US$15 million in the same period a year earlier.

4. Financial markets have been under pressure since early September reflecting global capital market developments as well as domestic uncertainties arising from the merger of the failed National Finance and Development Corporation (NFDC), a publicly owned development finance institution, with the state-owned National Bank of Pakistan (NBP) in the context of a World Bank supported banking sector reform. As a first step toward the merger, on August 30, 2001, the Ministry of Finance declared a 180 day moratorium on all NFDC operations, including deposit withdrawals. The moratorium triggered sharp withdrawals from National Savings Scheme (NSS) instruments until the SBP clarified that NSS holdings were not affected by the merger, and eased the freeze on NDFC deposits.¹ The situation has since stabilized. The terrorist attack on New York and Washington on September 11 triggered further pressures, in particular on the Karachi stock market. The main stock market index fell by 12 percent between September 11 and September 24, 2001, bringing the cumulative decline to 19 percent from end-June 2001. Pakistan’s stock exchanges had been closed during September 15–23. The exchange rate of the Pakistani rupee against the U.S. dollar was broadly stable during July-September; the spread in the kerb market also remained stable at about 4–5 percent. Kerb market purchases by the SBP reached US$374 million during the period July 1–September 24, 2001 (compared to US$596 million in the quarter ending June 30, 2001).

5. Preliminary data on CBR revenue indicate that collection for July–August 2001 reached PRs 46.5 billion, a decrease of 2 percent over the corresponding period last year, broadly as expected under the program. The average annual growth rate for the year through August thus slowed to 10.3 percent, from 13.5 percent through June. To a large extent the slowdown reflects clearance of a large backlog of refunds (mainly for GST and customs) which should result in higher net collections in the months to come.

Impact of Terrorist Attacks on New York and Washington

6. Recent events have changed the outlook for Pakistan’s economy. Export growth is likely to be lower than projected in the staff report, both because of the expected further weakening of the external environment and greater concerns about the domestic socio-political situation, which may affect freight and insurance premia as well as trade finance. In addition, the envisaged privatization program and the expected improvement in FDI flows may materialize at a pace slower than initially expected. As a result, growth is likely to be lower than projected and external imbalances larger. Lower tax revenue, rising inflows of Afghan refugees, and potentially greater domestic security concerns could exacerbate budgetary pressures.

7. In the context of the forthcoming discussions of a successor arrangement to be supported under the PRGF, staff will work with the authorities to quantify the above implications, which however will remain subject to an unusually large degree of uncertainty. The authorities have already indicated that they will seek additional international support, including the lifting of bilateral sanctions, elimination of quotas on Pakistan’s textile exports in industrial countries, and greater financial assistance, including more concessional debt relief from bilateral creditors.²

Staff Appraisal

8. The information above does not change the thrust of the staff appraisal. However, the socio-political as well as the economic-financial fallout from the recent terrorist attacks on the U.S. has clearly increased the risks to Pakistan’s economic outlook. Staff is concerned in particular about a possible further weakening of export opportunities, and greater difficulties in implementing the planned privatization program on time and attracting FDI inflows. As a result, staff believes that the implementation of the stabilization policies and structural reforms outlined in the MEFP has become even more important, and that international assistance for the program will need to be larger than anticipated even a few weeks ago. The staff looks forward to working with the authorities in formulating a new three-year program that could be supported under the PRGF.