Pakistan: Staff Report for the 2002 Article IV Consultation, Third Review Under the Poverty Reduction and Growth Facility Arrangement, and Request for Waivers of Performance Criteria
Author: International Monetary Fund
Publication Date:
05 Mar 2004
eISBN:
9781451830521
ISBN:
9781451830521
Language:
English
Keywords:
ISCR; CR; government; privatization agenda; September data; revenue target; PRGF loan; exchange rate; short-term debt; debt service; private sector; broad money; Privatization
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The economic outlook remains clouded by regional and domestic security concerns. Real GDP growth and inflation were broadly in line with program projections in 2001–02. The balance of payments position unproved faster than expected. The budget deficit target for 2001–02 (as set during the first review) was met, despite a shortfall in the Central Board of Revenue (CBR). Broad money increased strongly in 2001–02, despite efforts to sterilize foreign exchange inflows. Reforms in the financial sector made significant progress.

Abstract

The economic outlook remains clouded by regional and domestic security concerns. Real GDP growth and inflation were broadly in line with program projections in 2001–02. The balance of payments position unproved faster than expected. The budget deficit target for 2001–02 (as set during the first review) was met, despite a shortfall in the Central Board of Revenue (CBR). Broad money increased strongly in 2001–02, despite efforts to sterilize foreign exchange inflows. Reforms in the financial sector made significant progress.

I. Introduction and Background

1. The last Article IV consultation with Pakistan was concluded on November 29, 2000 (Country Report No. 01/24). Pakistan has accepted the obligations of Article VIII and maintains an exchange system free of restrictions on payments and transfers for current international transactions. On December 6, 2001, the Executive Board approved Pakistan’s request for a three-year arrangement under the PRGF with access of 100 percent of quota (SDR 1,033.7 million) and endorsed the country’s Interim Poverty Reduction Strategy Paper (I-PRSP). The Executive Board completed the second review of the program on July 3, 2002, thus enabling Pakistan to draw SDR 86 million.1 As of August 31, 2002, total Fund credit and loans outstanding to Pakistan amounted to SDR 1,481 million (143.3 percent of quota). Upon completion of the third review, a disbursement of SDR 86 million would become available.

2. In the attached letter dated October 16, 2002, and the attached Memorandum of Economic and Financial Policies (MEFP) (Attachment I), the government of Pakistan requests completion of the third review under the PRGF arrangement, a technical modification of the performance criterion on CBR revenue for end-December 2002, and waivers for the nonobservance of performance criteria on (a) the Central Board of Revenue (CBR) revenue through June 2002; (b) bringing KESC to the point of sale by end-July 2002; and (c) not granting any new tax exemptions.

II. Recent Economic Developments

3. The economic outlook remains clouded by regional and domestic security concerns. Tensions with India have diminished somewhat since late June, but large military forces are still deployed along the border and skirmishes remain frequent across the Line of Control. Isolated domestic terrorist acts have occurred, especially in Karachi, Pakistan’s largest city and commercial center, and in the area around Islamabad.

4. Elections for the national and provincial parliaments were held on October 10, 2002, with participation of a large number of political parties. In August 2002, the government promulgated amendments to the constitution, including extending General Musharraf’s presidency for five years and instituting a National Security Council (NSC) as a constitutional body to be consulted on strategic issues. The NSC will be chaired by the President and will include a majority of civilians, including the leader of the parliamentary opposition, as well as representatives from the armed forces. The government considered the amendments as needed to protect the reforms of the last three years.

5. Despite the security situation and the proximity of elections, the government has broadly held the course on reforms and recent macroeconomic developments have been encouraging. Continued regional tension and the associated risks may partly explain the depressed levels of private investment, but have had otherwise little visible impact on the economy up to now. As detailed below, macroeconomic performance has improved further in recent months: growth has perked up and inflation remains below 4 percent, official reserves have increased much faster than anticipated, and the budget deficit for FY 2001/02 (ending June 2002) was lower than expected, despite a significant pickup in social sector spending in the last quarter (Tables 1–6 and Figures 1–6). In July and August, exports, imports, and CBR revenue continued the recovery observed since April. Structural reforms have been pursued broadly in line with the agenda set under Pakistan’s poverty reduction strategy.

Table 1.

Pakistan: Medium-term Macroeconomic Framework, 2000/01–2006/07

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

Program underlying the quantitative performance criteria for end-June 2002 as set during the first review (EBS/02/43).

Includes public sector enterprises.

Expenditures included in the Public Sector Development Program.

Including the statistical discrepancy.

Including KESC recapitalization and CBR bonds in 2001/02.

Defined as the sum of net domestic government debt and external public- and publicly-guaranteed debt.

Gross domestic government debt, including U.S. dollar bonds, net of government deposits with the banking system.

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.

Program data for 2001/02 and revised program for 2002/03 are evaluated at program exchange rates.

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

Short-term debt is defined on the basis of remaining maturity.

Table 2.

Pakistan: Balance of Payments, 2000/01–2003/04

(In millions of U.S. dollars)

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

Includes a grant from Saudi Arabia in the form of oil that has been agreed on through 2002/03.

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 U.A.E.’s deposits with the SBP, and Bank of China’s deposits with the NBP.

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

Table 3.

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

(In billions of Pakistani rupees)

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Source: Pakistani authorities; and Fund staff estimates and projections.

Program as agreed during the second review.

Revised program including PRs 20 billion in additional spending on KESC, ADBP, PIA, and WAPDA, partly offset by savings on foreign interest payments.

Accrued payments. Excludes interest expenditure by the military which is included in the defense allocation.

KESC recapitalization was PRs 32 billion. Bonds for PRs 20 billion were issued for the settlement of excess taxes paid by banks to the CBR on unrealized profits through 2000.

Table 4.

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

(In percent of GDP; unless otherwise indicated)

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Source: Pakistani authorities; and Fund staff estimates and projections.

Program as agreed during the second review.

Revised program including PRs 20 billion in additional spending on KESC, ADBP, PIA, and WAPDA, partly offset by savings on foreign interest payments.

Accrued payments. Excludes interest expenditure by the military which is included in the defense allocation.

KESC recapitalization was PRs 32 billion. Bonds for PRs 20 billion were issued for the settlement of excess taxes paid by banks to the CBR on unrealized profits through 2000.

Table 5.

Pakistan: Monetary Survey, 1999/2000–2002/03

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

At indicative program exchange rate.

Stocks as reported in EBS/02/43.

Revised projection based on: (a) program flows set during the second review for variables subject to performance criteria; and (b) revised assumptions.

Table 6.

Pakistan: Accounts of the State Bank of Pakistan, 1999/2000–2002/03

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

At indicative program exchange rates.

Stocks as reported in EBS/02/43.

Revised projection based on: (a) program flows set during the second review for variables subject to performance criteria; and (b) revised assumptions.

Starting in April 2000/01, reserve money includes special reserves on foreign currency deposits.

For the purpose of calculating the 12-month growth rate, reserve money is considered net of the special reserves and corrected for the transformation of the special deposits accounts into treasury bills in December 2000 and March 2001.

Figure 1.
Figure 1.

Pakistan: Output and Inflation, 1995/96–2002/03

Citation: IMF Staff Country Reports 2002, 246; 10.5089/9781451830521.002.A001

Sources: Data provided by the Pakistani authorities.1/ Last observation: projection for 2002/03.2/ Last observation: May 2002.3/ Last observation: August 2002.
Figure 2.
Figure 2.

Pakistan: External Sector Developments, 1994/95–2002/03

Citation: IMF Staff Country Reports 2002, 246; 10.5089/9781451830521.002.A001

Sources: Data provided by the Pakistani authorities.1/ Customs basis. Last observation: August 2002.2/ Excluding official transfers. Last observation: projection for 2002/03.3/ Excluding gold, foreign deposits held with SBP, short-term swap and forward commitments. Last observation: September 11, 2002.
Figure 3.
Figure 3.

Pakistan: Exchange Rate and Stock Market Developments, 1995–2002

Citation: IMF Staff Country Reports 2002, 246; 10.5089/9781451830521.002.A001

Sources: Data provided by Pakistani authorities; and Fund staff estimates.1/ Last observation: September 11, 2002.2/ Last observation: June 2002.
Figure 4.
Figure 4.

Pakistan: Monetary Developments, 1996–2002

Citation: IMF Staff Country Reports 2002, 246; 10.5089/9781451830521.002.A001

Sources: Data provided by the Pakistani authorities.1/ Last observation: July 2002.2/ Last observation: June 2002.
Figure 5.
Figure 5.

Pakistan: Fiscal Developments, 1993/94–2002/03 1/

Citation: IMF Staff Country Reports 2002, 246; 10.5089/9781451830521.002.A001

Sources: Data provided by the Pakistani authorities.1/ Last observation: projection for 2002/03.2/ Net public debt is the sum of net domestic government debt and external public- and publicly-guaranteed debt.
Figure 6.
Figure 6.

Pakistan: Recent Financial Market Developments 2001–2002 1/

Citation: IMF Staff Country Reports 2002, 246; 10.5089/9781451830521.002.A001

Sources: Data provided by Pakistani authorities; and Data stream.1/ First observation; June 1, 2001; last observation: September 11, 2002.2/ Calculated for Pakistan Islamic Republic 10 percent bond maturing on December 13, 2005.

6. Real GDP growth and inflation were broadly in line with program projections in 2001/02. As detailed in the MEFP (paras. 2-3), preliminary official estimates indicate that real GDP (at factor costs) grew by 3.6 percent, slightly higher than programmed. Average inflation in 2001/02 was 2.7 percent, one of the lowest in Pakistan’s history. However, inflation picked up in the first half of 2002, with the 12-month CPI increase almost doubling from December 2001 to 4 percent in July 2002, before slowing to 3.7 percent in August 2002.

7. The balance of payments position improved faster than expected. The current account, excluding grants, recorded a small surplus in 2001/02 on account of a better-than-expected trade balance and continued strong worker remittances. Combined with substantial exceptional financing in the form of debt rescheduling and program financing from international financial institutions (IFIs), this allowed the State Bank of Pakistan (SBP) to build up foreign exchange reserves in the course of the year much faster than expected, to US$4.3 billion at end-June 2002, equivalent to four months of next year’s imports of goods and nonfactor services. Since late 2001, the Pakistani rupee has remained virtually stable against the U.S. dollar, with large foreign exchange purchases by the SBP, exclusively in the interbank market after June 2002, preventing a further appreciation.

8. The budget deficit target for 2001/02 (as set during the first review) was met, despite a shortfall in CBR revenue. The overall deficit (excluding grants) decreased to 5.1 percent of GDP, from 5.3 percent in 2000/01,2 and compared to a program target of 5.7 percent. Lower than expected spending, in particular interest payments, more than offset shortfalls in CBR revenue collection from the (revised) annual program target by about 0.3 percent of GDP. Most of the shortfall was incurred in January-March 2002, mainly due to lower than expected imports.3 Revenue collection improved substantially in the quarter to June 2002 (in fact by more than assumed in the projection underlying the FY 2002/03 targets) as imports and economic activity strengthened, but also because GST and customs refunds were somewhat slowed. Nontax revenue was higher than expected due to strong dividend receipts from public sector enterprises (PSEs), broadly offsetting shortfalls in the petroleum surcharge and provincial tax collection. According to (as yet unreconciled) accounting data, social- and poverty-related I-PRSP expenditure picked up significantly during the fourth quarter, so that the indicative annual target (of 3.7 percent of GDP) was almost met.

9. As detailed in the June 2002 MEFP, the 2002/03 budget adopted in late June 2002 aims to contain the deficit (excluding grants) at 4.4 percent of GDP, consistent with program objectives. It includes a major tax reform package and provides an explicit commitment to the I-PRSP expenditure target for 2002/03 (4 percent of GDP). The deficit may be increased for higher social expenditure (up to 0.5 percent of GDP) if financed by additional grants, and for payment to KESC to settle arrears as part of the privatization strategy (up to 0.3 percent of GDP). The drive toward broadening the tax base ran into some difficulties following the extension of the sales tax to pharmaceuticals in March 2002. The tax had provoked widespread opposition and hostility, undermining the support for the program in general and the credibility of its anti-poverty focus in particular. In April 2002, the authorities attempted to diffuse such hostility by exempting life-saving drugs, consistent with program commitments. However, the large number of exemptions made administration of the tax nearly impossible, and public opposition did not subside. Thus, the authorities decided in August 2002 to eliminate the tax and take measures in the form of increased petroleum product taxation to offset the estimated annual revenue loss of PRs 2 billion. Since this offsetting measure is made outside CBR revenue, the quarterly CBR targets from December 2002 onward were reduced accordingly.

10. Broad money increased strongly in 2001/02, despite efforts to sterilize foreign exchange inflows. The SBP contained reserve money growth through an aggressive sterilization of its foreign exchange purchases during the second half of the fiscal year, which led to a sharp contraction of its net domestic assets (NDA). However, the banking system’s NDA recorded a slight increase partly on account of a moderate rise in credit to the private sector. As a consequence, the very large accumulation of net foreign assets (NFA) by the banking system led to an almost 16 percent annual increase in broad money through end-June 2002. Interest rates have remained relatively stable since early 2002, with the yield on six-month treasury bills hovering about 6.5 percent. The main stock market index rose by 57 percent in the year to August 31, 2002.

11. The structural reform agenda is broadly on track (MEFP, para. 2). Significant tax policy and administration measures were taken in the past months, and a customs administration reform plan has been prepared (with technical assistance requested from the Fund for finalizing the plan). Steps toward better monitoring of large public enterprises include the adoption of performance plans and monitoring frameworks for the Water and Power Development Authority (WAPDA), Pakistan International Airlines (PIA), Pakistan Steel Mills (PSM), and Pakistan Railways (PR). Somewhat later than expected, the National Electric Power Regulatory Authority (NEPRA), the power sector’s regulator, granted WAPDA a structural tariff increase of 9.2 percent, lower than initially expected under WAPDA’s financial improvement plan (FIP), especially for the low-consumption “lifeline” slab, to protect poor consumers. The privatization program is experiencing delays in some of the more difficult cases, largely reflecting turmoil in global equity markets and security concerns (MEFP, para. 6 and 17). Nonetheless, a final bidding for United Bank Limited (UBL) took place in early September and a majority stake in UBL was sold to a foreign group. The sale of minority interests in various companies was also concluded.

12. In the run-up to the elections and confronted with surging international oil prices, the government has delayed or weakened the adjustment of energy prices. In September 2002, the authorities decided to postpone the increase in consumer gas prices scheduled for September under the medium-term gas pricing framework agreed to with the World Bank; a weaker-than-expected structural tariff increase was granted to KESC (NEPRA granted a 6.5 percent increase, whereas KESC had filed for 16 percent); and some petroleum surcharges were lowered mid-September and early October to cushion the impact of surging world oil prices on consumers. As indicated in the MEFP, the authorities committed to raising the petroleum surcharges by end-October 2002 to the levels consistent with program revenue projections. A first step was taken on October 15, 2002 with increases in the surcharges across all products; the authorities plan the remaining adjustment with the next fortnightly petroleum price adjustment on October 31, 2002.

13. Reforms in the financial sector made significant progress in the past three months. The Supreme Court’s ruling in late June 2002 (MEFP, para. 20) has cleared the way for implementation of the authorities’ evolutionary approach, developing Islamic banking alongside conventional banking and leaving market participants the choice between these institutions. Recent amendments to the SBP Act have increased the SBP’s independence, in line with the Fund’s Safeguards Assessment recommendations. A draft Anti-money Laundering Law is expected to be promulgated in the near future. It includes provisions to criminalize money laundering, set up a financial intelligence unit, and allow freezing and forfeiture of assets as well as international cooperation. With the support of the Asian Development Bank (AsDB), the authorities have started reforming the Agricultural Development Bank of Pakistan (ADBP), notably through preparing the separation of half of ADBP’s staff through a “golden handshake” and partial restructuring of its balance sheet (MEFP, para. 19). In July 2002, the SBP eliminated administrative restrictions on the setting of interest rates on foreign currency deposits (FCDs), and set a deadline of two years for moneychangers to transform into regulated foreign exchange companies (FECs). To better link the interbank foreign exchange market to the free (“kerb”) market, banks have been allowed to buy foreign exchange from moneychangers at freely negotiated rates since January 2002.

III. Report on the Discussions

14. The discussions were held against the background of the near-completion of the three-year rule of the military government and the imminent return of parliamentary government. The authorities reminded the staff of the economic situation they had inherited in late 1999: after several failed attempts at addressing deteriorating public debt dynamics in the 1990s,4 increasing external vulnerability eventually had resulted in a balance of payments crisis in 1998. The government, in office since October 1999, therefore put at the heart of its initial economic strategy a program of macroeconomic adjustment. Following the successful completion of a stabilization program supported by an IMF Stand-By Arrangement, a more comprehensive medium-term reform strategy was set forth in Pakistan’s I-PRSP that aimed to (a) improve the investment climate in the country; (b) reduce the economy’s vulnerability to external or internal shocks; and (c) put the economy on a sustainable growth path, and ensure that growth translates into palpable improvements in living standards for the population at large, and the poor in particular. The policy package to achieve these objectives centered on fiscal adjustment to bring debt to sustainable levels while raising social and poverty-related expenditure, and a wide range of governance reforms to stimulate private sector growth and improve social service delivery.

15. The 2002 Article IV consultation discussions focused on the effectiveness of this economic policy strategy to date. The authorities and staff also reassessed growth prospects, in particular in light of the relatively disappointing growth performance over the last decade. In the context of the third review under the PRGF arrangement, the authorities and staff more specifically (a) reviewed economic developments and policy implementation in the quarter to June 2002; (b) assessed the prospects for achieving the program targets for end-September 2002; and (c) formulated proposals for the end-March 2003 quantitative targets, as well as additional structural measures on KESC and WAPDA reform. Discussion of other structural targets for 2003 was postponed to the next review, to be held with the new government, as critical input will be needed from the planned review of progress in tax and customs administration reform (with FAD technical assistance); the translation of the draft anti-corruption strategy into a specific action plan (Box 1); and the formulation of an alternative strategy regarding KESC should privatization in the near future prove impossible. This approach will also allow the new government emerging from the election to take full ownership of the future structural reform agenda.

A. Achievements over the Last Two Years and Main Challenges Ahead

16. The authorities’ policies, combined with strong international financial and economic support, have been successful in restoring and consolidating macroeconomic stability over the past two years, despite several adverse shocks. A slowdown in the world economy, high oil prices, protracted drought, trade disruption in the wake of September 11, and regional and domestic security problems have increased uncertainty for businesses and hampered growth. In this unfavorable context, the overall economic performance has been quite encouraging: real GDP growth averaged about 3.5 percent over the past two years (and thus was modestly positive in per capita terms), and inflation remained subdued. The external accounts recorded a dramatic turnaround, allowing the SBP to build up reserves to levels unprecedented in Pakistan’s history.

National Anti-Corruption Strategy

To improve upon existing mechanisms to fight corruption the new government established the National Accountability Bureau (NAB) in 1999.1/ The authorizing ordinance updated the Prevention of Corruption Act of 1947 by providing the government with extensive powers to investigate alleged corrupt behavior both by holders of public office and by members of the public, including for the first time legislators and willful defaulters. It permitted the presumption of guilt based on the accumulation of wealth and shifted the burden of proof to the accused.

Despite these efforts, corruption in Pakistan remains “pervasive and deeply entrenched”, as acknowledged by a recent report by the NAB. While the NAB has had some successes in tackling “grand” corruption cases, little progress has been made in fighting low-level corruption.2/ The annual Corruption Perceptions Index published by Transparency International (TI)–an international nongovernmental organization devoted towards combating corruption—ranked Pakistan 77th out of 102 countries surveyed in 2002.3/ This ranking indicates an improvement of Pakistan’s relative position, as the proportion of countries ranked below Pakistan doubled from 12 percent of the total sample in 1999 to 25 percent in 2002, although it is in part due to an increase in the number of countries included in the survey. Pakistan’s score on the index improved marginally from 2.2 to 2.6 during the same period, broadly in line with other South Asian countries. In September 2002, TI is expected to publish a survey of 3000 respondents’ experience of corruption in Pakistan, providing some indication of the extent of corruption in government departments, among grades/posts within those departments, and the average bribe paid.

In an effort to accelerate the pace of reform, the NAB is formulating a National Anti-Corruption Strategy (NACS),4/ based on a broad review and assessment of the causes and extent of corruption. According to a preliminary report, the strategy focuses on prevention to complement the existing enforcement approach. The preliminary report, which is to be finalized in September 2002, calls for strengthening accountability and transparency in government and civil society by:

  • Creating the political will for reform by building a broad coalition of stakeholders through participatory mechanisms.

  • Ensuring a wide adoption of anti-corruption policies by assigning responsibility for their implementation to a broad based Steering Committee consisting of stakeholder institutions.

  • Downsizing the public sector to reduce opportunities for corruption through privatization, reduction of the number and level of selected taxes, and lowering the staff-to-officers ratio.

  • Strengthening public sector management through decentralization, simplification, standardization and transparency of procedures, including procurement, introduction of “whistleblower” protection, and through introducing greater accountability (e.g. passage of Freedom of Information Act).

  • Enhancing human resources in the public sector by increasing remuneration, providing an adequate and secure work environment for public employees, simplifying the code of conduct, and introducing merit-based recruitment procedures.

  • Strengthening public watchdog bodies by giving them greater autonomy (Auditor General’s Department), appointing chairmen from the opposition (Public Accounts Committee), and building capacity (Ombudsman offices).

  • Promoting social change by empowering civil society through increased access to government, enhancing consumer rights legislation, and improving regulation of nongovernmental organizations.

  • Ensuring fair and efficient legal processes by vigorously implementing the Access to Justice Program, abolishing the ability to acquire assets under another person’s name (“Benami” practice), and simplifying laws and procedures.

1/ The provincial Anti-Corruption Establishments and the Federal Investigation Agency continue to pursue their anti-corruption tasks in parallel.2/ The NAB has so far recovered PRs 80 billion and held 154 inquiries against politicians, including a former prime minister, former federal ministers, 290 inquiries against bureaucrats, 38 against businessmen, and seven against officials of the armed forces.3/ The Corruption Perceptions Index score reflects the perception of the degree of corruption as seen by business people, academics, and risk analysts, and ranges between 10 (highly clean) and 0 (highly corrupt). It is a composite index using surveys from different sources.4/ A Preliminary report, discussed at a National Anti-Corruption seminar in Islamabad in July 2002.

17. Though revenue collection has not improved as much as needed, progress in fiscal consolidation has been significant. Staff stressed that revenue collection has remained a weak spot in Pakistan’s public finances, with CBR having repeatedly missed tax collection targets. The overall tax effort remains insufficient to extricate Pakistan from its debt trap, while simultaneously ensuring the needed significant increase in social expenditures. The authorities emphasized that, nonetheless, the overall fiscal situation has improved. The budget deficit (including grants) decreased from 5.5 percent of GDP in 1999/2000 to 4.2 percent of GDP last fiscal year. As highlighted in the public debt sustainability exercise (Annex II), this contributed—together with the appreciation of the Pakistani rupee and the use of government deposits to retire a large amount of treasury bills—to the significant decline in the gross public debt ratio last fiscal year (to 98 percent of GDP). However, the burden of public debt (with debt service absorbing nearly one-third of government revenue) remained heavy and constrained government spending on development. The authorities pointed to their (published) debt management strategy that endorsed continued fiscal adjustment to reduce public debt, along with policies to reduce the cost of borrowing. Specifically, nonconcessional external borrowing was to be kept within tight limits and the cost of borrowing under the National Saving Scheme (NSS) brought closer to market levels. The authorities recently published for public comment a draft Fiscal Responsibility Law (Box 2) that aims to enshrine the debt strategy in the law.

18. The authorities pointed to the steadfast implementation of their comprehensive structural reform agenda, focusing on improved governance. Staff recognized that tangible progress has been made in broadening the tax base through elimination of a wide range of sales tax and income tax exemptions, and in preparing the basis for an efficient and accountable tax administration through a modernization of CBR’s procedures, including the ongoing move to self-assessment and functional integration of tax administration across taxes. Fiscal accountability and transparency have drastically improved with faster and more comprehensive reconciliation of federal and, to a lesser extent, provincial expenditure data, and regular publication of fiscal accounts including, more recently, progress reports on I-PRSP spending (see the fiscal ROSC update in Attachment III). Trade and exchange system reforms (Annex I) have substantially reduced protection and anti-export bias, and established an exchange system that is free of restrictions on current payments and transfers.5 The reduction of the number of special regulatory orders and adoption of a streamlined Foreign Exchange Manual have substantially increased transparency and reduced scope for rent-seeking in this area. In the financial sector, the restructuring and privatization of the nationalized banks is advancing well (Box 3), and important reforms of prudential regulations and steps to tackle nonperforming loans have been undertaken. The authorities recognized that several important weaknesses of the financial sector had yet to be forcefully addressed, notably reform of the NSS and of various nonbank financial institutions. Reform of social service delivery is also underway, with an ambitious devolution plan aimed at empowering local communities to take charge of basic social services. Staff felt that significant challenges still loom in the public enterprise sector, where privatization and restructuring have made only limited progress.

Draft Fiscal Responsibility and Debt Limitation Ordinance1/

  • In June 2002, the government published a draft federal fiscal responsibility and debt limitation ordinance, inviting public comment.2/ The draft ordinance is intended to achieve an ambitious debt reduction strategy over the coming decade. First, reporting requirements would inform the National Parliament and the public on fiscal developments, fiscal policy, and progress towards the debt target. Second, quantitative fiscal rules would constrain annual federal budgets. Successful debt reduction will reduce fiscal vulnerabilities and create room for additional non-interest expenditures in the areas of social and development spending.

  • The draft ordinance requires the government to report regularly on fiscal policy and developments. The reports would nest the annual budget in a three-year medium-term budget framework and explain how the budget relates to the debt target. The reports would also provide background information on vulnerabilities, contingent liabilities, and underlying assumptions. Moreover, the reports would assess fiscal outcomes and progress on debt reduction. Staff considers that the reporting requirements are sound, but will require that additional administrative capacity to be built in the areas of medium-term budgeting, costing, and asset and debt reporting. Staff recommends that the ordinance set out a timetable for capacity building and phase in reporting requirements accordingly.

  • The draft ordinance contains three quantitative rules (a) public debt is to be reduced to 60 percent of GDP by 2011/12; (b) public debt is to be reduced by at least 2½ percent of GDP each year; and (c) the current balance must be in surplus by 2006/07. In case social and poverty-related expenditure falls below 4 percent of GDP or in case of a national emergency or a natural disaster, fiscal policy can deviate from the rules. The draft ordinance also limits issuing new guarantees to 2 percent of GDP per fiscal year.

  • Staff believes that the draft ordinance could be simplified by setting a debt target as the overarching objective and having a fiscal rule that determines an overall balance floor or an expenditure ceiling consistent with that target. An overall balance floor would be calculated based on the difference between the debt target and the actual debt stock, taking into account the GDP growth. An expenditure ceiling would be calculated from the overall balance floor and revenue projections. Both rules would directly feed into the budget process. The expenditure ceiling would allow for automatic stabilizers on the revenue side and thus be somewhat more flexible than the overall balance floor. The current balance rule (“golden rule”) would not be needed for debt reduction, but could be useful in the budget process. The escape clause for social and poverty expenditure could be restated as an overarching objective, which would feed into the process of prioritizing expenditures. The escape clause for national emergencies or natural disasters should be more clearly specified as an ex-post adjuster.

  • The draft ordinance could be extended to provincial and local governments. As devolution proceeds, a larger share of fiscal policy is carried out at the subnational level and should be subject to the same debate and scrutiny as fiscal policy at the federal level. Moreover, devolution will reduce the federal government’s control over macro fiscal policy and public debt, which could potentially threaten the debt reduction strategy. A balanced budget requirement for provincial and local governments could address such concerns.

1/ For a more detailed assessment, see the forthcoming Selected Issues and Statistical Appendix paper.2/ Available at www.finance.gov.pk/law/main.html.

Banks’ Financial Soundness Indicators: Recent Results, Impact of Ongoing Reforms, and Challenges Ahead

Pakistan initiated in-depth structural reforms in the banking sector in the early 1990s to reverse the previous trend of bank nationalizations, state control, and directed credit. Later, confronted with increasing credit risks and governance issues, the authorities accelerated banks’ modernization, including the privatization of three major commercial banks, including UBL in September 2002, an overhaul of the legal and accounting framework, a strengthening of financial supervision, and a shift to market-oriented policies. A recent SBP study suggests a yet modest impact of these reforms on the soundness of the banking sector.1/ As of end-December 2001:

  • The capital adequacy ratio was on average equal to 11.4 percent; four commercial banks were below the prudential minimum of 8 percent.2/

  • Credit risks remain high but limited to state-owned banks. The ratio of nonperforming over total loans stabilized to 19.6 percent, from 19.5 percent in 2000, and 22 percent in 1999. Stricter classification rules enforced by the SBP pushed this ratio up, largely offsetting a stepped-up drive to loan recovery, and initial transfers of bad loans from state-owned banks to the Corporate and Industrial Restructuring Corporation (CIRC).3/

  • The lack of profitability of commercial banks, both in terms of return on assets and return on equity, is mainly caused by the state-owned banks’ situation. In spite of high spreads between lending and deposit rates (close to 6 percent), private banks’ profitability has declined and also remains low by international standards. The decline reflects in part the impact of the freeze of FCDs in 1998 and the related elimination of schemes that provided safe and high returns to banks.

  • Commercial banks’ liquidity risk is limited. Cash reserve requirements and statutory liquidity requirements constrain banks to keep 5 percent and 15 percent of their deposits in cash and government bonds that are eligible to SBP refinancing, respectively. Banks’ liquidity has also been enhanced in 2001 by a low economic growth and the lack of opportunities to lend to the private sector.

  • Available data do not permit a clear assessment of banks’ exposure to risks of macroeconomic shocks. The dollarization of bank deposits has been considerably reversed (14.5 percent in June 2002, from 19.6 percent a year earlier, and more than 40 percent in 1998) but continues to expose banks to significant foreign exchange risks, since capital mobility is relatively high in Pakistan, although several prudential regulations imposed by the central bank limit these risks.4/ Maturity mismatch for some banks that hold large amounts of long-term government bonds and the high concentration of loans in the textile industry are two possible risks which warrant attention.

The impact of the ongoing reforms

The authorities are pursuing policies that should bring more decisive improvements in the banks’ financial soundness in the medium term:

  • The SBP is progressively increasing banks’ minimum capital requirements, from PRs 500 million to PRs 750 million by January 1, 2002 and to PRs 1 billion by January 1, 2003. This is expected to trigger mergers between or acquisition of undercapitalized banks.

  • The ongoing privatization of state-owned banks, which still account for the majority of assets of the banking sector, and the restructuring measures prior to their privatization are expected to improve banks’ overall capital-adequacy, asset quality, and profitability indicators. Measures include (a) the SBP’s recapitalization of UBL (PRs 8 billion); (b) the consolidation of banks’ outstanding tax refund claims on CBR (PRs 22 billion) and claims on KESC (another PRs 22 billion) into treasury bonds; (c) CIRC’s purchases at a market-based discount of state-owned banks’ assets (above PRs 30 million) in arrears for at least one year (as of August 2002, some PRs 26.5 billion of such assets had been sold for a market price of PRs 5.1 billion); and (d) cost-saving measures initiated in 2001, including the closure of nonprofitable branches and government-financed golden handshake programs (about 7,000 staff since June 2001, for a total cost of PRs 7 billion).

Remaining Challenges

The SBP has identified four directions for further reforms (a) further restructuring/privatization of specialized banks and nonbank financial institutions; (b) enhanced judicial/regulatory/supervision framework; (c) improved monetary policy and market mechanisms for interest rates; and (d) improved supply of financial instruments. While broadly agreeing with this strategy, staff insisted on the need to rely more on market forces to reshape a modem financial system. In addition, staff stressed the need to improve the SBP’s monitoring of the banks’ resilience to macroeconomic shocks, and raised three additional challenges.5/

  • The financial system remains too fragmented by tax distortions, including discriminatory income tax rates against banks. Tax rates have been reduced from 58 percent to 50 percent but are still well above the standard corporate tax rate of 35 percent, which applies for other financial institutions such as leasing companies and investment banks. Banks’ specific provisions against nonperforming loans should be tax deductible. Tax distortions also discourage mergers between banks, as well investment in pension funds.

  • Distortions affecting deposit collection or credit allocations prevent banks’ fair competition with other finance institutions. Although adequate regulations for the stock exchange and for the leasing industry have been in place for some years, the development of modern long-term financial intermediation instruments is still hampered by state-sponsored savings schemes, and public nonprofitable development finance institutions and insurance companies. At end-June 2002, about 40 percent of total financial savings were still channeled to the government through the National Saving Schemes. No paper except government bonds was eligible to the refinancing of the SEP, and credit to the agricultural sector was still directed.

  • The regulatory and judicial framework needs further reform. The recovery of bad loans is still excessively long and costly. The treatment of nonperforming loans is hampered by (he lack of clear guidelines for writing-off bad loans. Banks should be given more opportunities to diversify their loan portfolio and reduce their vulnerability to cyclical shocks, in particular the textiles sector, through legal steps to improve the solvable demand for credit in housing and agriculture, as well as measures to improve corporate governance and companies’ financial disclosure. The recent adoption of a regulatory framework to promote the development of sound microfinance institutions, while key for poverty reduction, could also offer new development perspectives for banks.

1/ At end-December 2001, the banking sector consisted of 39 banks (8 state-owned banks, 12 domestic private banks, and 19 foreign banks).2/ These prudential ratios, which are discussed in more details in the forthcoming Selected Issues and Statistical Appendix paper, are subject to confirmation on a bank-by-bank basis, one of the tasks that an FSAP mission is expected to perform in the coming months.3/ The CIRC was established in September 2000 as an autonomous body under the Ministry of Finance to “promote the revitalization of the economy by reviving sick industrial units.” Its main function is to recover minimum one-year overdue loans of PRs 30 million and more on behalf of the state-owned banks and development finance institutions. As of end-June 2002, some 10.2 percent of the total stock of NPLs had been transferred to CIRC at market prices, for about 19.2 percent of their face value. CIRC has at most three years to pay for the transfer (less if the bank is privatized), partly in cash (through the liquidation of the collateralized assets), partly in five-year bonds (for the residual).4/ Banks’ foreign exchange position cannot exceed 10 percent of their capital; 20 percent of FCDs need to be placed with the central bank and banks are not allowed to collect FCDs more than 20 percent of their total deposits and provide for exchange-denominated loans to enterprises, except for short-term export credits.5/ These and other issues were debated in depth during a large conference organized to discuss the results of the SBP study on the financial system in June 2002 in Karachi. Many of the planned reforms are being formulated in the context of a second capital market reform operation supported technically and financially by the AsDB.

19. Staff concurred with the authorities’ assessment that the economic strategy adopted over the past two years was broadly the right one. During the discussions, some voices within the government expressed the view, quite widespread in Pakistan’s academia and media, that fiscal policy has been overly tight in recent years, thus depressing private investment and curbing economic growth. Other officials concurred with staff that mere was no real alternative to the modest fiscal adjustment of the past few years to prevent public debt from spiraling out of control, and to avoid further undermining business confidence and private investment.

20. While firm quantitative evidence is not (yet) available, the authorities concurred with staff that it was unlikely that much progress has been made in recent years in reducing poverty, although without the reforms poverty might have risen quite dramatically. The lack of progress on poverty reduction mostly reflects continued low levels of private investment and growth, the impact of drought on the rural regions, and inadequate provision of basic social services as public spending on human development remains too low (0.5 percent of GDP on health and 1.8 percent on education in 2001/02, about half of the ratio in the average low income country). Staff pointed to World Bank analysis indicating that some of the main institutional causes of poverty (ownership of land and other assets, lack of a functioning judicial system, deep-rooted gender issues, etc.) have yet to be fully addressed. In finalizing the PRSP, even greater emphasis and specificity needs to be given to such issues. Another urgent task in the context of finalizing the PRSP will be a realistic costing of achieving the authorities’ social targets, to ascertain more firmly the level of human development expenditure required to rapidly improve Pakistan’s poor social indicators. Staff welcomed the strong increase in 2001/02 in education and health spending over the preceding year (by 17 percent and 34 percent, respectively), and the planned further increase in 2002/03 (by 18 percent and 10 percent, respectively), which would put I-PRSP spending ahead of defense spending. Staff sympathized with the authorities’ view that, concomitant with stepping up such expenditure, better expenditure and outcome controls have to be put in place, but expressed concern that implementation of systems to monitor (intermediate) outcomes has been too slow. Staff urged the authorities to put in place quickly practical monitoring systems so as to get at least preliminary indications on which social programs work and which do not. In this way, the authorities would have an important input for formulating the next budgets at the district and provincial levels. At least as important, timely accounting of all expenditure at the local government levels needs to be fully assured, without which I-PRSP spending cannot not be meaningfully assessed. Led by the World Bank’s Social Development Unit, social impact analysis is currently underway to assess the (a) devolution and its impact on the quality of service delivery, especially to the poor, and (b) the impact of tariff reforms in the gas and power sectors.

B. Development Strategy for the Medium Term

21. In light of these achievements and challenges, the authorities and staff reviewed the development strategy for the medium term. Discussions focused on macroeconomic policies, the structural reform agenda, sustainability and vulnerability issues, and political economy considerations regarding reform ownership and acceptance by the population.

22. The authorities believe that current macroeconomic policies remain appropriate to foster high growth, reduce vulnerability, and ensure public debt sustainability. They underscored that these policies have already brought significant macroeconomic stability gains and increased the economy’s resilience to shocks. With time, and in a less disruptive economic context than last year’s, these policies should help create an enabling environment for private investment and activity as the driving force for growth and poverty reduction. The authorities recognized the need to diversify the export base, especially in light of the prospective expiration of the multi-fibre agreement. They hoped to achieve this diversification through removing anti-export biases in trade policies and maintaining a competitive exchange rate, in certain cases complemented through sector-specific strategies. The authorities were encouraged by the results of the public debt sustainability exercises: debt to GDP ratios are expected to decrease steadily, assuming that current reforms will continue to be implemented and have the intended impact within a relatively short time. Shocks of magnitudes similar to those experienced in the 1990s seem unlikely to trigger unsustainable debt dynamics. Staff stressed that a combination of such shocks could still result in instability, and that the most important danger, which had so often materialized in Pakistan’s history, was that the reform effort was not sustained over a sufficiently long period.

23. The authorities stressed their commitment to pursue the implementation of their structural reform agenda, centered on improving governance at all levels of government and the further liberalization of the economy. The most urgent task was reform of the public enterprise sector, as it accounts for a significant share in GDP and employment. Within this sector of about 50 enterprises, many were on track for privatization (banks, oil and gas enterprises, telecommunications, cement) and others currently required only limited budgetary support (steel and airline), within the context of ongoing restructuring operations that involved in some cases partial privatization. The bulk of direct budgetary support went to WAPDA and KESC (about 1 percent of GDP in 2001/02), and staff stressed that for the two utilities the need to implement greater efficiency and accountability was largest. The authorities shared with staff a comprehensive draft anti-corruption strategy, to be discussed by the cabinet shortly. In the context of preparing the PRSP, which is expected to be finalized by the new government, the authorities stressed their willingness to deepen participation through consultation at provincial and district levels, strengthen mechanisms to measure and monitor poverty-related data and intermediate outcome indicators, and improve the costing of reaching the social targets in the context of a medium-term budgeting framework. The authorities regretted that repeated postponement of the planned FSAP mission (for security reasons) has deprived them of important input for their financial sector reform strategy.

24. Staff broadly concurred with the reform agenda but cautioned the authorities about the risk of being overly optimistic regarding expected outcomes, and highlighted the vulnerability of the outlook to various risks. In particular, staff argued that, given the modest growth performance of the late 1990s (Box 4), medium-term projections should be based on cautious growth assumptions. The baseline projections imply a pronounced structural break in economic and financial outcomes compared to the 1990s, in particular a significantly higher growth rate (about 5 percent on average, compared to 3.4 percent during the preceding 10 years). Such a break could be achieved through governance and other reforms resulting in an acceleration of total factor productivity (TFP) growth by about 1 percentage point, and a modest increase in investment. To the extent that reforms would accelerate human