Statement by Mohammed Daїri, Alternate Executive Director and Meekal A. Ahmed, Advisor to the Executive Director for Pakistan

This paper evaluates Pakistan’s First Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility (PRGF) and a Request for Waiver and Modification of Performance Criteria. Developments in October 2001–January 2002 indicate satisfactory progress towards the program’s macroeconomic objectives, although growth prospects had to be scaled down and tax revenue was lower than targeted. All but two quantitative and structural performance criteria for end-December 2001 were met. The authorities are taking corrective measures that should deliver the revised macroeconomic targets for 2001/02 provided regional tensions ease in the near future.

Abstract

This paper evaluates Pakistan’s First Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility (PRGF) and a Request for Waiver and Modification of Performance Criteria. Developments in October 2001–January 2002 indicate satisfactory progress towards the program’s macroeconomic objectives, although growth prospects had to be scaled down and tax revenue was lower than targeted. All but two quantitative and structural performance criteria for end-December 2001 were met. The authorities are taking corrective measures that should deliver the revised macroeconomic targets for 2001/02 provided regional tensions ease in the near future.

March 26, 2002

Key Points

  • The Pakistan authorities have stayed the course and implemented their PRGF program in line with expectations;

  • A shortfall in growth performance has been more than counterbalanced by overperformance on the fiscal deficit target, inflation and the external front and structural reforms have been implemented as planned;

  • Nevertheless, challenges remain, most notably with respect to CBR, effecting a shift towards pro-poor spending, public enterprise restructuring and privatization;

  • The recent actions in the petroleum and gas pricing area and the announcement of the timetable for the elimination of sales tax exemptions on highly sensitive items bear testimony to the authorities’ on-going commitment to the program.

The Pakistani authorities thank staff for a concise and well-written report, which they consider to be a fair and balanced assessment of recent economic performance, and the challenges they face in the period ahead. They share the thrust of the staffs analysis and conclusions.

In broad terms, performance under the PRGF has been satisfactory with macroeconomic policies having been implemented in line with program expectations. The ongoing drought and the lingering effects of post-September 11 events on net exports suggest that economic growth in 2001/02 will be lower than previously expected. However, this unfortunate growth shortfall will be more than counterbalanced by the continued excellent performance on the inflation front and much better than expected external sector developments. Indeed, the tight stance of macroeconomic policies and favorable supply effects have helped keep the headline rate of inflation at a subdued level. The combination of a trade surplus, a significant pick-up in workers’ remittances through the banking system, and better performance in the capital account—reflecting higher portfolio and direct investment inflows—led to a large accumulation of external reserves. Despite aggressive purchases of foreign exchange by the State Bank of Pakistan (SBP) on the inter-bank market, the rupee strengthened while the kerb-market premium virtually disappeared.

The target for the fiscal deficit for the first six months was comfortably met as shortfalls in revenue were more than offset by lower than programmed expenditures. Central Board of Revenue (CBR) tax revenue shortfalls were attributable to the slower pace of activity and imports, a large increase in refund payments, and an appreciating exchange rate. The increase in the petroleum development levy on diesel and other oil products in early January 2002 should help recoup some of the revenue loss in the period ahead. On the expenditure side, the more appreciated exchange rate and lower fuel prices and defense imports helped keep defense outlays some Rs. 8 billion below the program. Less propitiously, there was a large shortfall in pro-poor expenditures as the newly-established local governments—which did not become fully operational before end-January 2002—were thrust into the hitherto unfamiliar and challenging task of executing their devolved budgets.

The pace of implementation of structural reforms was maintained. The CBR reform was on track, helped by a World Bank project preparation grant and significant FAD technical assistance. A new office of Controller General of Accounts (CGA), separate from the Auditor General of Accounts (AGPR), was established. The PRSP process was carried forward with a well-attended national conference on Human Development, and a new unit was created within the Ministry of Finance to guide and oversee work in this critically important area. Despite concerted efforts to improve performance, the financial situation of two large public enterprises—the Karachi Electric Supply Corporation (KESC) and the Water & Power Development Authority WAPDA)—came under strain, highlighting the importance of moving boldly ahead with key reforms in this sector.

Assuming that the worst of post-September 11 effects have subsided and export orders are also boosted by the projected upturn in global activity, the authorities are hopeful of better growth performance in the second half of the year. The modest easing of the fiscal stance implied by the revised budget deficit target should provide some stimulus to domestic demand. The targeted CBR tax revenue ratio has been lowered to reflect revenue shortfalls to date but still implies a significant pick-up in the remaining part of the year. In this regard, the recently enacted actions to remove sales tax exemptions, combined with the increase in petroleum taxation noted above, should help underpin revenue. The continued patrolling of the Afghanistan border and tensions on Pakistan’s eastern front will, unfortunately, necessitate higher defense outlays—only partly offset by savings elsewhere.

The Pakistan authorities recognize that fiscal management presents them with two major challenges. First, on the revenue side, is the challenge presented by persistent shortfalls in CBR tax revenue. While the package of measures introduced recently will help the tax effort, it will need to be complemented by sustained and vigorous pursuit of the CBR restructuring process. Implementing an action program, which strengthens the sales tax and customs duty refund system and makes it less susceptible to abuse would also help tax compliance. Second, as the staff report rightly highlights, Pakistan’s poverty reduction objectives will not be met without a sustained shift of public expenditures towards human development. With the elected local governments now in charge of their devolved budgets, the authorities believe the foundations for a meaningful increase in public spending are in place. While risks to underspending remain, the authorities are confident that the impact of training in budget execution and improved governance that is being imparted to local governments will gradually make themselves felt.

Monetary and exchange rate policy will be guided by prudence and flexibility, respectively. Monetary policy will need to be vigilant, given the uncertainties in money demand while safeguarding an enviable inflation record. The SBP will respond to exchange market pressures with a “more aggressive absorption of liquidity” should that be warranted, so as not to complicate the hoped-for recovery in exports. The planned enactment of a legal and regulatory framework for transforming moneychangers into foreign exchange companies will mark a further step towards unification of the interbank and kerb markets.

In the structural area, the authorities are committed to tighter monitoring of credit to all public sector enterprises in the light of recent experience and undertake, for a few large public enterprises, to publish quarterly performance targets and outcomes to strengthen public scrutiny of their performance. Mindful of the fact that the continued financial difficulties of KESC and WAPDA could pose a major risk for the budget, they are firmly committed to bringing KESC to the point of sale by July 2002. Concurrently, the restructuring of WAPDA will continue, in close consultation with the World Bank, with financing from a possible Structural Adjustment Credit (SAC) II. Despite a difficult regional environment, the first round of substantive privatization is expected in take place in April/May 2002. The authorities are actively discussing with MAE the elements of best-practice against money laundering and look forward to fuller discussions of all financial sector issues in the context of the up-coming FSAP mission later this year. The new gas-pricing framework, which aims at a gradual elimination of subsidies, will give renewed impetus to reforms in this sector.

The staff report notes the various risks to the program. While these risks are less stark than only a few months ago, the authorities believe that the economy is better placed to deal with these risks if they should materialize. Moreover, the government has built up a strong record of policy implementation and has shown a willingness to take tough decisions to deliver on their commitments and keep the program on track. The new gas pricing formula, the increase in petroleum prices, and the bold announcement of the timetable for the elimination of exemptions on highly sensitive items—notably pharmaceuticals and edible oils—attest to that commitment.

Pakistan: First Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility (PRGF), and Request for Waiver and Modification of Performance Criteria
Author: International Monetary Fund