Pakistan: Request for a Three-Year Arrangement Under the Poverty Reduction Growth Facility

Pakistan has established sound macroeconomic management and structural reforms under the Stand-By Arrangement. Executive Directors welcomed this step, and emphasized the need to maintain fiscal and monetary stances. They welcomed the Poverty Reduction and Growth Facility (PRGF) program, which focuses on the reform of tax policy and tax administration; public enterprise restructuring and privatization; raising growth and reducing poverty; and financial sector reforms. Directors urged the authorities for the full implementation of the reforms, and approved a Three-Year Arrangement for Pakistan under the PRGF Arrangement.

Abstract

Pakistan has established sound macroeconomic management and structural reforms under the Stand-By Arrangement. Executive Directors welcomed this step, and emphasized the need to maintain fiscal and monetary stances. They welcomed the Poverty Reduction and Growth Facility (PRGF) program, which focuses on the reform of tax policy and tax administration; public enterprise restructuring and privatization; raising growth and reducing poverty; and financial sector reforms. Directors urged the authorities for the full implementation of the reforms, and approved a Three-Year Arrangement for Pakistan under the PRGF Arrangement.

I. Introduction and Background

1. Over the previous decade, Pakistan has repeatedly failed to complete a number of adjustment and reform programs supported by Fund arrangements—prior to the Stand-By Arrangement that expired at end-September 2001. Attempts by successive governments to carry through sustained reform generally ended up in policy reversals that prevented any lasting improvements in the fiscal and external positions, and, in several instances, brought the country to the verge of a foreign exchange crisis. Average annual growth hovered at about 4 percent because of relatively low investment in manufacturing, low productivity in the large agriculture sector, and several episodes of two-digit inflation. A low tax ratio, resulting from a narrow tax base and poor tax administration and enforcement, limited the government’s ability to provide critical social services and infrastructure. For years, the fiscal deficit remained well above 6 percent of GDP, causing a continuous increase in public sector indebtedness and rising interest payments. Despite successful efforts at gradually reducing the ratio of defense expenditure over GDP, the composition of noninterest public expenditure remained skewed towards unproductive spending. Limited budgetary space for development expenditure, insufficient focus on the provision of basic social services and inefficiency (when not outright corruption) in expenditure management, resulted in poor social indicators and rising poverty. On the external front, a noncompetitive exchange rate and a strongly regulated foreign exchange regime discouraged export diversification and resulted in unsustainable current account deficits. Low private investment inflows and the recourse to short-term debt and foreign currency deposits only delayed an external debt crisis, which was eventually triggered by economic sanctions following Pakistan’s nuclear test in 1998.

2. The military government that took office in October 1999 has candidly taken stock of the economic weaknesses besetting Pakistan, including poor governance and weak social indicators. It has also made a strong start in addressing many of the long-standing structural problems facing the economy, and bringing the country back on the path of higher growth, sustainable development and reduced poverty. Pakistan’s achievements, under the more recent 12-month Stand-By Arrangement that expired end-September 2001, are encouraging (as detailed in EBS/01/161). In 2000/01, despite a severe drought, total GDP grew by 2.7 percent, supported by a rise in manufacturing output of about 8 percent, while CPI inflation declined to 4.4 percent, notwithstanding large increases in fuel and electricity prices and a significant depreciation of the rupee. Although the program’s tax collection targets were not fully achieved, the revenue collected by the Central Board Revenue (CBR) increased by 0.4 percentage points of GDP. Cuts in nonpriority development expenditures contained the budget deficit to 5.2 percent of GDP (0.1 percent below the target), compared with 6.5 percent the previous year. Official reserves reached US$1.7 billion at end-September 2001 compared with US$0.6 billion a year earlier (Table 1 and Figures 15). Low inflation and successful reserves accumulation reflected responsive monetary management, supported by the introduction of a floating exchange rate regime and measures to deepen the interbank foreign exchange market.

Table 1.

Pakistan: Selected Economic and Financial Indicators, 1998/99–2003/04

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Source: Data provided by the Pakistani authorities; Fund staff, INS and World Economic Outlook.

Includes public sector enterprises.

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.

Including interests on short term debt.

The implicit interest rate on external public debt is calculated as interest payments in percent of the average stock of debt of the current and previous fiscal year.

Excluding gold, foreign assets relating to foreign currency deposits contracted after May 1998 (FE-25s), and short-term foreign exchange swaps and outright forward sales by the SBP.

Data on short-term external debt includes public and private short-term at original maturity and amortization payments on public medium- and long-term debt of the following year.

Figure 1.
Figure 1.

Pakistan: Output and Inflation, 1995/96–2000/01

Citation: IMF Staff Country Reports 2001, 222; 10.5089/9781451830620.002.A001

Source: Data provided by the Pakistan authorities.1/ Last observation July, 20012/ Last observation September, 20001
Figure 2.
Figure 2.

Pakistan: External Sector Developments, 1994/95–2000/01

Citation: IMF Staff Country Reports 2001, 222; 10.5089/9781451830620.002.A001

Source: Data provided by the Pakistan authorities.1/ Customs basis. Last observation July, 2001.2/ Including official transfers.3/ Excluding short-term swap and forward commitments. Last observation October, 2001.
Figure 3.
Figure 3.

Pakistan: Exchange Rate and Stock Market Developments, 1995–2001

Citation: IMF Staff Country Reports 2001, 222; 10.5089/9781451830620.002.A001

Source: Data provided by Pakistan authorities; and Fund staff estimates.1/ Last observation October, 2001.2/ Last observation August, 2001.
Figure 4.
Figure 4.

Pakistan: Fiscal Developments, 1993/94–2000/01

Citation: IMF Staff Country Reports 2001, 222; 10.5089/9781451830620.002.A001

Source: Data provided by the Pakistan authorities.1/ Gross public debt less government deposits with the banking system.
Figure 5.
Figure 5.

Pakistan: Monetary Developments, 1993–2001

Citation: IMF Staff Country Reports 2001, 222; 10.5089/9781451830620.002.A001

Source: Data provided by the Pakistan authorities.1/ Last observation August, 2001.

3. The government also made significant progress on its ambitious reform agenda, with far broader coverage than under a typical Stand-By Arrangement, and strong emphasis on tackling a broad range of governance issues. Efforts were particularly focused at improving tax policy and widening the tax net by eliminating the General Sales Tax (GST) and some income tax exemptions, modernizing income taxation, and enhancing fiscal management and transparency by strengthening basic institutions and procedures to monitor budget execution. A restructuring of the banking sector was initiated and several credit and savings instruments were based on market-determined interest rates; IMF Safeguard Assessment recommendations were fully implemented. However, notwithstanding the progress achieved on the economic front, widespread poverty continues to affect close to one-third of the population and Pakistan compares poorly with other developing countries on several social indicators (Table 2).

Table 2.

Pakistan: Social Indicators, 1970–1999

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Source: World Bank: World Development Indicators 2001; and Pakistani authorities.

Latest available observation within the period indicated.

Education targets in the I-PRSP are not comparable with historical data for the previous years. The outstanding methodological and source issues related to the selection of education baseline indicators and output targets will be addressed during the preparation of the full PRSP.

4. In view of the post-September 11 regional tensions, and a weaker international environment, Pakistan’s economic outlook has become subject to unusually high uncertainty. On one hand, perceptions about security risks related to the ongoing military operations in neighboring Afghanistan, together with the global slowdown, have taken a substantial toll on economic activity, as well as on prospects for exports and FDI inflows in 2001/02 (Box 1). Major challenges to the implementation of the program could arise from protracted economic stagnation and social instability. On the other hand, the good performance under the Stand-By Arrangement, together with the lifting of sanctions by various industrial countries, has created a unique opportunity for Pakistan to benefit from substantial international financial support for the implementation of strong macroeconomic adjustment and structural reforms.

5. Despite the uncertainty and the existing risks, the government intends to proceed forcefully in the implementation of its medium-term poverty reduction strategy. In the attached letter dated November 21, 2001, the government of Pakistan requests a three-year arrangement under the PRGF in support of its economic reform program for the period October 1, 2001-September 30, 2004 (Attachment I). The government’s program is described in the Interim Poverty Reduction Strategy Paper (I-PRSP, EBD/01/107) and in the attached Memorandum of Economic and Financial Policies (MEFP). In a Joint Staff Assessment (JSA, EBD/01/106), the staffs of the Fund and the World Bank consider that the I-PRSP provides a sound basis for the development of a fully participatory Poverty Reduction Strategy Paper (PRSP) and for Fund and Bank concessional assistance, and recommend its endorsement by their respective Boards.

6. The requested access under the PRGF arrangement is SDR 1,033.7 million (100 percent of quota), to be disbursed in 12 equal quarterly installments. As of end-October 2001, total Fund credit and loans outstanding to Pakistan amounted to SDR 1,383 million (133.8 percent of quota) (Appendix I). Full and timely disbursements under the schedule set-out in Table 3 would raise Pakistan’s outstanding use of Fund resources to 165.5 percent of quota at end September 2004.

Table 3.

Pakistan: Reviews and Phasing of Disbursements Under the PRGF December 2001–December 2004

(In millions of SDRs)

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External Financing Gaps After September 11 1/

(In millions of U.S. dollars)
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Source: Fund staff estimates.

Including impact of revisions to the World Economic Outlook, change in reserve accumulation path, and minor data revisions.

As in the Staff Report of September 12, 2001 (EBS/01/161) less rollover of domestic special U.S. dollar bonds (80 percent) to make it comparable to the new presentation of the balance of payment.

Mainly from United States, Saudi Arabia, and Japan. Includes commodity assistance for 2002/03 and 2003/04.

In 2001/02, additional IFIs support, and short-term private inflows, including US$90 million from OPIC

Assuming enhanced terms as compared with the Paris Club agreement of 2001.

Maturities from October 2001 to June 2004.

For 2002/03 and 2003/04, the residual gap could be covered by additional bilateral support, including debt relief, and PSI.

II. Recent Developments

7. Pakistan’s prompt decision to fully cooperate in the fight against terrorism in the aftermath of the September 11 attack has been initially supported by the political parties. Protests against the decision have been led mainly by fundamentalist Islamic groups. The president has reiterated his pledge to hold parliamentary elections as scheduled in October 2002.

8. Available data for the period July-September 2001 point to a deterioration of the real economy. Sluggish export growth (1.8 percent in U.S. dollar terms with respect to the same period of the previous year) reflects a slowdown in world demand, as well as a drastic rise in freight and insurance costs, exacerbated by reductions in air cargo services. Since mid-September, a reported widespread cancellation of export orders, especially from the United States, has affected export prospects and is already slowing investment and production. Imports dropped by 8 percent (in U.S. dollar terms) compared with the same period of the previous year, with a dramatic fall in the second half of September exacerbating an already downward trend, evenly accounted for by volume and unit value effects. Favorable preliminary data on sugar cane and cotton crops indicate that the recovery of agriculture from the drought could be somewhat stronger than envisaged, thus partially offsetting lower-than-projected manufacturing growth. However, recently discovered signs of pest contamination in the cotton crop may result in a substantial reduction in its value added, and together with declining international cotton prices (which have now fallen to a level 37 percent below the average of the last five years) could reduce income of farmers and textile exporters and affect domestic demand. Price developments in September have remained benign and the twelve-month CPI inflation rate has declined to 2.9 percent.

9. Tax collection has been severely affected by the large decline in imports and higher-than-expected tax refunds to exporters. Lower custom and import-related sales tax revenue explains part of the cumulative shortfall during July September 2001, compared with the target discussed during the last review under the Stand-By Arrangement. In addition, a faster-than-expected reduction in the stock of sales tax refunds, which had been allowed to accumulate at the end of last fiscal year, also contributed to the shortfall. Despite these unfavorable revenue developments, effective control over the release of budgetary allocations allowed the authorities to meet their budget deficit target for the quarter.

10. International reserves reached US$2 billion in early November 2001. The SBP’s end-September indicative target on international reserves was narrowly missed, despite substantial purchases, mainly from the kerb market, because expected capital flows were delayed. However, facing increasing demand for rupees, in October the SBP stepped up its intervention on the interbank market, buying more than US$300 million, and in early November reserves crossed the US$2 billion level for the first time in years. In part, this appears to reflect a large repatriation of holdings abroad by Pakistan residents through the official banking channel since end-September, triggered by the tightening of anti-money laundering legislation in Gulf countries. Combined with the market’s perception that large external flows of assistance to Pakistan will stabilize the rupee, these capital inflows have at least temporarily increased the supply of dollars on both interbank and kerb markets and reversed the dollarization of bank deposits. These inflows may also have been a factor behind a recovery in the Karachi Stock Exchange (KSE) index, which at end-October stood about 13 percent above its pre-September 11 level. Similarly, between September 11 and November 1, the rupee has appreciated by 3.4 percent on the interbank market and by 8.3 percent on the kerb market, reducing the spread to virtually zero.

11. During July-September 2001, the SBP managed to keep broad money growth (including foreign currency deposits) and reserve money growth at 9.2 percent and 9.7 percent (on an annual basis), respectively. The rupee cash-to-deposit ratio at end-September remained close to its end-June level despite an increasingly volatile economic and political situation. On the asset side, the government’s borrowing temporarily crowded out credit to the private sector, reflecting external budget financing shortfalls, notably a delay in complying with reform measures needed to allow expected World Bank disbursements. In October, in an effort to jumpstart activity, the SBP reduced the discount rate by 2 percentage points to 10 percent, and set the auction yield for six-month treasury bills at 8.5 percent.

III. Pakistan’s Adjustment and Reform Strategy

A. The Medium-Term Strategy and Post-September 11 Scenario

12. The solid performance under the Stand-By Arrangement and the government’s continued pursuit of macroeconomic stabilization since has strengthened the basis for higher and sustainable growth. However, Pakistan has yet to tackle in a forceful way widespread poverty and weaknesses in basic social services that preclude large parts of the population to share in, and benefit from, higher growth. In clear recognition of this challenge, Pakistan’s emerging poverty reduction strategy is being elaborated in a broad participatory process. An interim draft of the I-PRSP was posted on the Web to facilitate public comment and debate. As detailed in the I-PRSP, this process will intensify in the months ahead in preparing the full-fledged PRSP, to be finalized by the government emerging from the parliamentary elections in October 2002. The broad strategy builds on the comprehensive structural reform process initiated under the Stand-By Arrangement, but puts additional emphasis on basic social service delivery, growth, and sustainable development. As a poor and heavily indebted country, Pakistan is seeking financial support for such a program under the Fund’s PRGF, and from other international financial institutions (IFIs) and bilateral creditors and donors.

13. Pakistan’s emerging poverty reduction strategy as laid out in the I-PRSP has three main objectives: increasing growth potential, improving social outcomes, and reducing vulnerability to shocks. It recognizes that higher growth and a more diversified economy cannot be achieved without a dynamic private sector. Building private investors’ confidence requires continued macroeconomic stability, improved governance, and a rapid exit from Pakistan’s debt trap. Accordingly, the medium-term macroeconomic framework features continued fiscal adjustment, based on a broadening of the tax base and a major tax administration reform, as well as spending restraint. The authorities also seek external support for a sizable reduction in the net present value (NPV) of external debt, without which recovery of business and investor confidence and mobilization of public resources for social services and infrastructure will remain severely constrained (see below). To improve governance, the authorities will rely on a four pillar strategy: (a) devolution to the local authorities of the responsibility for delivery of public services; (b) civil service reforms; (c) judicial reforms and fight against corruption; and (d) greater fiscal and financial transparency. The strategy also aims to support the poor directly through a reorientation of public expenditure toward education, health and social services, public support for rural development and small and medium enterprises, as well as job creation and social safety net programs. Macroeconomic vulnerability to shocks will be contained through a flexible exchange rate and lower debt, while various social programs aim to reduce the vulnerability of the poor.

14. Discussions with the staff on the poverty reduction strategy focused on the consistency between social goals and the budgetary allocations, the monitoring of progress in achieving these goals, and the tracking of social sector expenditures. On the social goals, in particular for health and education, the authorities recognized that the I-PRSP targets for the next three years were highly ambitious when assessed against Pakistan’s achievements over the last ten years. The authorities stressed at the same time that the targets reflected a broad-based consensus on the urgency of forcefully tackling dismal social indicators. They recognized that future budgetary allocations for education and health would likely have to be raised substantially if the social targets of the I-PRSP were to be met, once a preliminary costing of the I-PRSP social programs is prepared in the context of the preparation of the next budget. The staff pointed out that within the proposed fiscal framework, given the limited prospects of achieving revenue gains higher than currently envisaged, this would require a more forceful reorientation of expenditure, including in the PSDP and away from defense. Such allocation was pressing given the current low levels of public spending on health and education. However, in the authorities’ view, performance will not be determined by budget allocations only, but also by the fundamental reforms undertaken in the delivery of social services. In particular, in strong agreement with, and support from, the World Bank and the Asian Development Bank (AsDB), they expect major efficiency gains from the ongoing fiscal devolution, which will allow districts and provinces to set their own targets and to monitor progress, while strictly limiting districts’ ability to borrow and to hire. The authorities concurred with staff on the need to monitor social progress through close tracking of social expenditure and key intermediate targets. To this end, they are in the process of establishing a preliminary set of such indicators for this current fiscal year (MEFP, paragraph 14) while working on a more comprehensive and reliable system to be established with the full PRSP. The full PRSP, scheduled for next fiscal year, will be based on the elaboration of poverty reduction strategies for each province.

15. If the strategy is fully implemented in a timely manner, and assuming a return to normal security conditions in early 2002, the staff views the authorities’ medium-term macroeconomic objectives as attainable. The program projects a gradual increase in real GDP growth to 5.2 percent in 2003/04, while annual inflation would be kept at about 5 percent (Table 1). Growth would be driven by productivity gains and modest increases in investment (mainly by nongovernment). Nongovernment savings are cautiously assumed to remain broadly unchanged as a share of GDP, as the impact of higher per capita GDP may be offset by financial liberalization, the gains in government saving, and the financial difficulties of public enterprises. Further fiscal consolidation would bring the deficit excluding grants to 3.2 percent of GDP in the third program year. The maintenance of the present free float exchange rate regime will protect the competitiveness of the economy, while facilitating the buildup of foreign exchange reserves to about three months of imports of goods and services by June 2004.

B. Macroeconomic Policies for 2001/02

16. The revised macroeconomic framework for 2001/02 is based on a preliminary assessment of the fallout of the September 11 attacks, and is highly dependent on the assumption that the impact of current military operations on the economy would be limited, and that normal economic conditions are restored from early 2002 onward. Compared with pre-September 11 projections, the framework for 2001/02 includes a downward revision in export growth (from 7.6 percent to -0.3 percent in U.S. dollar terms), and real GDP growth from 4 percent to 3.7 percent. The latter reflects a weaker manufacturing sector, while agriculture output projections, including in the cotton sector, have been revised upward. The inflation target (5 percent) has not been revised.

17. The proposed fiscal program involves some revision of both revenue and fiscal deficit targets for 2001/02, and the measures necessary to achieve the new targets. The revised macroeconomic assumptions imply a projected shortfall in CBR revenue of about PRs 14 billion (0.3 percent of GDP) from the targets specified under the last Stand-By review, of which PRs 12 billion stem from the fallout of the September 11 attacks, that is, lower imports and activity up to December 2001. While staff would have preferred offsetting part of this shortfall by additional tax measures, the authorities did not consider such steps feasible in the present delicate political context, and before careful analysis of the social impact. They noted furthermore that the budgetary grants already pledged by the United States and other bilateral donors would more than cover this exceptional revenue shortfall. However, they decided to protect the tax revenue objective against any further shortfall by taking commensurate tax measures if needed, as specified in the MEFP.

18. The authorities have set the revised target for the fiscal deficit excluding grants for 2001/02 at 5.3 percent of GDP in 2001/02, with the possibility to increase it up to 5.7 percent of GDP to make room for additional social spending financed by grants. Including grants, the deficit is projected at 2.6 percent of GDP against 3.6 percent in the initial budget, entailing therefore a positive impact on the public debt dynamics (Table 4). Any additional budgetary spending would emphasize job creation and specific social programs detailed in the MEFP, in particular in the provinces bordering Afghanistan. Last year’s strict budgetary expenditure management mechanism will continue to be implemented. Only social sector allocations are being released in full at the start of each fiscal exercise, to protect core social and poverty related expenditure. To contain the expenditure to targeted levels, in particular in case of prolonged security problems, the authorities would cut nonpriority spending as needed.

Table 4.

Pakistan: Consolidated Government Budget, 1999/2000–2003/04

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

Military pensions are included in defense expenditure.

In 2001/02, includes PRs 10 billion and PRs 3 billion of spending related to drought and fiscal devolution, respectively.

In 2001/02, projections include one-off expenditure of PRs 10 billion for drought and PRs 6.5 billion for bank restructuring.

Expected to be filled by bilateral debt rescheduling.

As defined in the I-PRSP.

19. The SBP intends to maintain a prudent monetary policy under the current floating exchange regime, in support of its inflation and international reserve targets. While the SBP will look into the merits and disadvantages of moving toward an inflation-targeting framework, and once uncertainties regarding financial sector reforms are resolved (see below), monetary policy for 2001/02 will continue to focus on the targeting of monetary aggregates. Broad money and reserve money targets for 2001/02 have been set broadly in line with nominal GDP growth, and assuming that the rupee cash-to-deposits ratio continues to revert to historical trends over the current fiscal year. The projected reduction in net bank lending to the public sector should ensure adequate space for private sector credit expansion (Tables 5 and 6).

Table 5.

Pakistan: Monetary Developments, 1997/98–2001/02

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

At indicative program exchange rates.

end-June 2001 actual exchange rate.

Table 6.

Pakistan: Accounts of the State Bank of Pakistan, 1997/98–2001/02

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

At indicative program exchange rates.

Starting 2000/01, including reserves on foreign currency deposits.

end-June 2001 exchange rate.

20. Uncertainties will continue to surround the monetary projections in general, and the money multiplier in particular. A protracted economic slowdown could prompt a return to stronger cash preference. The SBP, therefore, is fully committed to keep monetary conditions under close review, and adapt promptly the monetary stance, if needed, to meet its reserves and inflation targets. The SBP has been stepping up its intervention in the foreign exchange interbank market so as to limit the appreciation of the rupee against the U.S. dollar triggered by (likely temporary) capital inflows, and maintain the competitiveness of exports.

C. Fiscal Reform

21. To achieve the targeted medium-term fiscal consolidation, tax policy measures to widen further the tax base and a fundamental reform of the CBR will be critical. The authorities aim for tax revenue to increase by 1.5 percentage points of GDP over three years, to 14.3 percent in 2003/04. Tax policy discussions centered on the scope and timetable for the further elimination of GST and income tax exemptions and other measures to rationalize the tax system (Box 2). Reforming the CBR will be one of the cornerstones of the structural reform agenda under the PRGF-supported program, and several key measures will be implemented during this fiscal year. These include the organizational restructuring of the CBR headquarters and the establishment of a large taxpayer unit (MEFP, paragraphs 20–21).

22. The authorities intend to ensure that the establishment of the new tax administration structure will not affect the ongoing improvements of tax collection. Sales tax audit and enforcement activities will continue to be strengthened, on the basis of a detailed monthly plan elaborated by CBR. Altogether, tax and tax administration reforms are expected to increase revenue by 0.3 percent of GDP in 2001/02.

Tax Reforms Under the PRGF-Supported Program

The government is committed to further rationalize the tax system through tax policy and administration reforms, with particular focus on the major federal taxes (sales and income tax). The authorities will not introduce any new exemptions or special privileges under the sales tax, income tax, and customs tariff regime, and will allow all time-bound exemptions to lapse without extension. Additional tax policy measures include the following:

  • The base of the general sales tax (GST) has been broadened significantly in recent years, but several non-standard exemptions remain (including edible oil, vegetable ghee, pharmaceuticals, GST subsidy on electricity). While the current situation calls for a cautious approach to avoid price increases for important consumer goods, the authorities intend to adopt by end-March 2002 a firm timetable for the phasing out of these and other exemptions, starting with the 2002/03 budget. Experiences with the special GST rate (20 percent; the standard rate is 15 percent), which was introduced for certain inputs with the last budget, will be reviewed by March 2002, with a view to return to the single-rate regime with the next budget if the measure is found to have brought little additional revenue or compliance.

  • On the income tax, the authorities will take further steps to broaden the base and simplify taxation on the basis of the recently promulgated Income Tax Ordinance. The following measures are envisaged for the 2002/03 budget: (a) elimination of at least 55 exemptions (about one-third of the total); (b) lowering of the threshold on National Savings Schemes (NSS) instruments subject to withholding tax on interest income; (c) further steps toward unifying the corporate tax rates; and (d) elimination of two minor withholding taxes. The latter two steps imply revenue losses in the short-run, and more ambitious steps in these directions will have to be phased in cautiously later.

  • Tariff reforms include a further reduction in the maximum tariff (to 25 percent) in mid-2002, cutting the number of exemptions provided through Statutory Regulatory Orders from 13 to 6 by June 2003, and eliminating the remaining nonstandard exemptions by June 2004. In the area of petroleum taxation, the authorities intend to reduce the bias in favor of diesel consumption by raising the levy on diesel fuel to bring it more in line with that of gasoline, which will also be environmentally beneficial. The structure of excise taxes will be rationalized further through a number of specific reforms with the 2002/03 budget (MEFP, paragraph 19).

  • Tax policy measures will be accompanied by a major reform of the federal government’s tax administration, the Central Board of Revenue (CBR), which has already started with Fund and World Bank technical assistance. On the basis of a medium-term strategy and action plan, prepared as a prior action for the program, the reform focuses on reorganization, large taxpayers, self-assessment, human resource management, and enhancing the use of IT and improving accommodation (for details, see Box 1 in EBS/01/161). Critical milestones during the first program year are the completion of the new organizational setup for CBR headquarters by end-February 2002 and the establishment of a large taxpayer unit by end-June 2002 (both are structural performance criteria).

23. The authorities are planning a substantial reorientation of public expenditure towards development and social spending over the medium term. While current expenditure as a share of GDP is projected to decrease over the medium term, due mainly to declining interest payments and defense spending, development expenditures under the PSDP are projected to increase from 2.7 to 3.9 percent of GDP over three years, and social and poverty–related expenditure to increase from 3.4 to 4 percent of GDP during the same period.1 Consistent with the devolution program, this implies that provincial spending (both current and capital) will increase from 5.1 percent of GDP last fiscal year to 5.7 percent at the end of the program period. Given the need for the provinces to increase their tax collection efforts, and in particular enforce the potentially buoyant agricultural income tax, the National Financial Awards Commission will review the future resource allocation and revenue sharing formula between the federal government and the provinces this year. With help from the World Bank, the authorities are envisaging to conduct a public expenditure review, including the PSDP, before the next budget.

24. The government will continue its efforts to reform the civil service and the pension system. A major pay and pension reform package is currently being implemented, with technical support from the World Bank, with a view to rationalizing and streamlining pay structures while removing various distortions in the pension system to contain future pension liabilities (EBS/01/101, Box 2). Even after these reforms, preliminary studies suggest that the present pension system may not be sustainable over the long term. Without further measures, pension payments could reach, in ten years, amounts comparable to the public wage bill. The authorities are therefore ready to prepare further steps to put the pension system on an actuarially sound footing, in conjunction with another pay package for the 2003/04 budget. As a first step, a new contributory regime for new entrants will be introduced in July 2002.

D. Exchange System and Financial Sector Reform

25. The program includes several measures to further deepen and unify the foreign exchange market. Effective November 25, the restriction that transactions in the interbank market should be backed by commercial transactions will be eliminated. The measure was introduced to limit the commercial banks’ ability to take speculative positions in 1998, at a time when the exchange rate regime was still a heavily managed float. After the 1999 shift to a cleaner float, and with the recent increased confidence in the rupee, the SBP considers that prevailing tight foreign exchange exposure limits are sufficient to protect the banking system against the risks of taking excessive intra–day open positions, and that the measures will not put undue pressure on the exchange rate.

26. The SBP’s plans to better integrate the kerb and interbank markets will be facilitated by the elimination of the spread in recent weeks. The authorities are ready to use this opportunity to speed up the integration between the two markets, by favoring the channeling of workers’ remittances into Pakistan through the banking system and by encouraging the conversion of informal money changers into foreign exchange companies (MEFP, paragraph 27). The SBP will also clarify its regulations to ensure that no restrictions on payments or transfers for current transactions remain, including on travel, and more generally streamline foreign exchange regulations to reduce the “hassle” associated with buying foreign exchange for current transactions through the banking system.

27. Financial sector reforms in 2001/02 include continued pursuit of the privatization of nationalized banks and the elimination of a remaining credit allocation system for agricultural credit (MEFP, paragraph 26). A comprehensive long-term strategy to develop the financial sector is currently being discussed with the main domestic actors and the multilateral creditors. The envisaged Financial Sector Assessment Program (FSAP) mission is now expected to visit Pakistan in early 2002 and its findings will be reported to the Board in the context of the next Article IV consultation. Its recommendations, notably in the area of prudential and anti-money laundering regulations, will be discussed with the authorities during the first program review and, as appropriate, be incorporated into the program.

28. Implementation of several measures will complete the government’s long-lasting efforts to restructure and privatize the state-owned entities in the financial sector. With support from the World Bank through a Banking Sector Restructuring and Privatization (BSRP) project, the authorities will complete last year’s measures to close excess branches of United Bank Limited (UBL), Habib Bank Limited (HBL), and the National Bank of Pakistan (NBP). As of end-October 2001, 650 branches have been closed, and the remaining closures (out of a total estimate of 1,800 unprofitable branches) should be completed by March 2003. The BSRP project finances about 70 percent of the severance payments granted to 25,000 employees of the closed branches, for an estimated total of US$340 million. Part of the operation will be financed through a bridge loan from the SBP to the nationalized banks, but such quasi-fiscal operations will cease with the next budget. The authorities aim to privatize all the nationalized banks over the program period, starting with bringing UBL to the point of sale by end-May 2002. Through merger and acquisition, the authorities are also liquidating several nonviable nonbank financial institutions, including the recent merger of the National Developing Financial Corporation (NDFC) (whose negative net worth was estimated at US$370 million) with the NBP. The Government will finance part of the restructuring costs through the public selling on the stock exchange of remaining shares in Allied Bank and Muslim Commercial Bank, as well as 5 percent of the NBP’s capital. The SBP will also eliminate a mandatory credit scheme in the agricultural sector.

29. The authorities consider that Islamic banking should be viewed as an opportunity to diversify the supply of financial products and deepen financial intermediation. The government will develop and seek Supreme Court approval for a dual approach where traditional and Islamic finance institutions would coexist, ahead of the July 1, 2002 deadline set by the Court for implementation of a financial system in conformity with Islamic principles. It does not plan to restrict traditional financial practices and instruments. The SBP also intends to rely on other countries’ experiences of such a dual approach to develop its capacity to regulate and monitor Islamic finance products and operators.

E. Governance Reforms and Private Sector Development

30. Improved governance and promotion of private sector development will constitute the core of the structural reform agenda. As detailed in the MEFP (paragraphs 11–16 and 23), the agenda involves: (a) the pursuit of the reforms to improve fiscal and financial transparency; (b) the restructuring of public enterprises and the privatization program in the banking, energy, and telecommunication sector; (c) the elimination of red tape through the streamlining of current administrative regulations and procedures that affect the private sector and provide incentives for corruption; (d) the launching of judicial reforms to strengthen the rule of law and foster a better access to justice for all; (e) further liberalization of the agricultural sector; and (f) further trade liberalization.

31. Building on progress made under the Stand-By Arrangement, the authorities are committed to improve fiscal transparency and data quality further, with particular focus on the monitoring and publication of pro-poor public expenditure data and trends in social indicators. With the beginning of this fiscal year, disaggregated pro-poor public expenditure data will be tracked and made available to the public on a quarterly basis. At first, these data will be provisional and unreconciled, but the authorities are committed to improve their quality over time. Also, the authorities intend to combine the tracking of pro-poor spending with the monitoring of intermediate and outcome indicators, for which work has recently been stepped up as part of the preparation of the I-PRSP. More broadly, fiscal data accounting and reporting will be improved at the federal level and, especially, in the provinces where progress in data reconciliation and fiscal transparency has lagged behind. In collaboration with the World Bank, the authorities want to press ahead with the modernization of government accounting in the context of a follow-up project to Pakistan Improvement of Financial Reporting and Accounting (PIFRA).

32. The authorities concurred that the financial situation of Karachi Electricity Supply Corporation (KESC) and, to a lesser extent, of other public enterprises present important risks for macroeconomic balances. To improve accountability of public enterprise managers, the authorities will adopt clear performance targets and enforce regular and transparent reporting on progress in achieving these targets. Regarding Water and Power Development Authority (WAPDA), in close collaboration with the World Bank, the corporatization of energy production and distribution is being pursued. KESC has been put on a fast track towards privatization, within an AsDB-supported project.2 The staff emphasized the need to accelerate the move towards a market-based and private sector driven energy sector. It stressed in this regard the urgency to elaborate, in the context of a planned World Bank operation, a framework for private investments that avoids granting special fiscal privileges or guaranteed profits, reduces regulatory uncertainties by clarifying rules for tariff-setting, and phases-out below-market gas pricing and the related fertilizer subsidization.

33. The government will further enhance the efficiency of commodity markets, with support from the AsDB. In this perspective, the government will gradually remove remaining restrictions on marketing and distribution of basic commodities such as wheat and sugar and agricultural inputs and phase-out remaining commodity price supports and subsidies, including for the marketing of cotton. In particular, the government will limit its role to ensure the procurement and management of a wheat strategic reserve for the purpose of food security. Sales prices will reflect the procurement price (based on international reference prices), storage, distribution, and management costs.

F. Social Impact and Safety Net Programs

34. The social impact of the program should be strongly positive as a whole. Higher investment and growth should boost job creation in the private sector. In the I-PRSP, the authorities outline several complementary sectoral initiatives aimed at developing labor-intensive activities in the rural areas and for small and medium enterprises (Box 3). To ensure a long-lasting reduction in unemployment, this strategy may have to be complemented by a phasing out of labor market rigidities.3 Income-generating activities and direct cash support will be boosted by several social safety net initiatives targeting the poor (Box 3). At the same time, as detailed in the I-PRSP, the authorities will further reinforce programs aimed at eradicating child labor. The authorities agreed with the staff on the need to enhance the poverty and social impact analysis (PSIA) of reform measures. They welcomed that the World Bank and the Fund will conduct a joint pilot study on the social impact of past economic stabilization programs, notably increases of public utility prices and petroleum taxation. This study is expected to help guide, and create capacity for, the PSIA of key policy measures under the program, and improve the design of social safety net measures in the outer years of the program.

35. Already in fiscal year 2001/02, increased budgetary allocations target the poor and vulnerable segments of the population, along with higher spending on health and education. In addition, the establishment of local implementation and monitoring structures should improve social service delivery. Starting by end-December 2001, the authorities will publish an annual report on the progress achieved in this area, based on a list of intermediate outcome indicators. The staff expressed concern at the apparent weaknesses in the institutional mechanism for monitoring such indicators; and stressed that there was a strong need to strengthen these mechanisms to allow timely identification of any problems or shortcomings.

Social Safety Net Initiatives 1/

Pakistan’s multi-pronged poverty reduction strategy seeks to reinvigorate growth through macroeconomic stabilization and strong structural reforms, and improve public service delivery, especially in the social sectors, through better governance and increases in pro-poor expenditure. In addition, the strategy relies on a number of key initiatives and programs targeted at the poor and vulnerable, including the Kushal Program, the Food Support Program, and Zakat grants.

The Kushal Program

The Kushal program is a poverty alleviation initiative of the federal government that finances community-level public works programs, including the construction or rehabilitation of farm-to-market roads, water supply schemes, water and drainage canals, schools, and health facilities. The program directly helps the poor through the creation of employment and income, and it reduces poverty indirectly by generating, or rehabilitating, economic and infrastructure assets from which the poor benefit disproportionately. The initiative fits well into the new decentralized administrative set-up, and it fosters ownership of the beneficiaries at the community level. The federal government only pays for the development and rehabilitation costs, while recurrent costs and maintenance requirements are expected to be taken over by the communities or local governments.

Under this program, so far, more than 2,000 rural roads and 1,000 water supply schemes have been constructed, and close to 3,000 schools have been rehabilitated, creating employment opportunities for about 350,000 persons. In the North Western Frontier Province (NWFP), more than 2,000 schemes have been initiated under the Kushal program, with funding allocated to districts and communities on the basis of need as determined by social indicators (including literacy and infant mortality rates) and infrastructure requirements. The Kushal program started in 1999/2000 and expanded last fiscal year during which PRs 5.2 billion (0.2 percent of GDP) were spent. This fiscal year, the budget has allocated PRs 7 billion (0.2 percent of GDP) for the Kushal program, but under the PRGF supported program, the government is committed to use additional external grants to increase spending under the Kushal program and other poverty and social sector programs by as much as PRs 15 billion.

Food Support Program

The objective of this program is to mitigate the impact of food price increases on the poorest segments of the population. Those with monthly incomes below PRs 2,000 (equivalent to about US$1 per day) are eligible to receive cash support (PRs 2,000, paid out in biannual installments) from district governments on the basis of means testing. Last fiscal year, about 1.2 million persons benefited from this safety net program, with budgetary costs of about PRs 2.5 billion (0.1 percent of GDP). This fiscal year, a budget allocation of PRs 2.9 billion is available to finance this program, which could be expanded further (for example, to cover the urban poor) as more external grants become available.

Zakat Grants

In addition to budgetary safety nets, the Zakat charity program provides help to the poor and vulnerable through income transfers (PRs 500 per month and person in 2000/01), stipends for students at primary and other schools, free medical service at local government health facilities, and emergency relief. The Zakat program has recently been strengthened and reorganized, providing now also one-time rehabilitation grants (PRs 10,000-50,000) to Zakat beneficiaries as start-up capital for small income-generating business ventures. During 2000/01, 2 million persons benefited from Zakat grants, and funds are available to support an additional 1.5 million people. The program is financed through a 2.5 percent levy on the value of declared financial assets above certain limits; it is collected each year at the beginning of Ramadan.

1/ Sources: I-PRSP; World Bank; and Pakistani authorities.

G. The External Sector and Balance of Payments Outlook

36. The September 11 attacks have lead to a substantial revision of the balance of payments projection for 2001/02, increasing the need for exceptional financing in 2001/02 (Table 7 and Box 1). Compared with the projections elaborated for the third review under the Stand By Arrangement, the current account deficit excluding grants has been revised upward by about US$300 million. Exports are expected to remain broadly flat in U.S. dollar terms, against an 8 percent growth target before the September 11 attacks, reflecting cancellation of export orders, temporary difficulties in freight, and other disruptions in normal trade relations due to the war in Afghanistan, as well as lower prices for cotton and other textile products. Some recovery is expected during the second half of the year, in part boosted by the European Community’s decision to increase quotas for textile and clothing products by 15 percent and to reduce duties by about 7 percent effective January 1, 2002 on all Pakistani exports except textiles and leather products.4 The impact of this measure has been conservatively estimated at US$100 million for this fiscal year, and US$200 million per year for the following two years. Imports of goods have also been revised downward, because of lower activity and commodity prices, while the services’ balance is deteriorating due to higher insurance premia for cargo trade to and from Pakistan. The annual cost of the latter is estimated at about US$160 million, although it is expected to be partly offset by lower travel expenditure abroad. Shortfalls are also projected in the capital account reflecting lower foreign direct investment and privatization proceeds. At the same time, the projections assume that the estimated short-term capital inflows that have already taken place in the immediate aftermath of the attack will not be reversed, although continuation of such inflows is not expected. All the projections depend critically upon the assumed return to normal economic and trade conditions by early 2002. Should the current conditions prevail for another two quarters, an additional deterioration of external balances in the order of US$500–600 million would seem likely.

Table 7.

Pakistan: Balance of Payments, 1999/2000 2003/04

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

Includes budgetary grants and commodity assistance.

Includes repayment of foreign currency deposits held in NBFIs and banks (reschedulings shown as exceptional financing).

Includes rescheduling of bilateral debt in 1999 and 2001, and rescheduling of commercial bank credit and Eurobonds in 1999.

Includes rollover of FE-45 deposits with the banking system, of Kuwait’s and UAE’s deposits with the SBP, and Bank of China’s deposits with the NBP.

The gap for the first program year is assumed to be filled as illustrated in Box 1.

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