I. Overview

1. The Pakistani government that took power in October 1999 faced a difficult and deteriorating economic situation, including persistent high rates of poverty and low growth. Expansionary fiscal policies had saddled the country with a heavy public debt that constrained the investments in both physical and human capital needed to address Pakistan’s lagging social indicators (its “social gap”). The external situation was highly vulnerable, and was managed through a complex web of exchange controls (including a freeze on foreign currency deposits in the banking system). Governance problems were pervasive, with Pakistan ranking as one of the most corrupt countries in the world.

2. The new government quickly launched a macroeconomic stabilization program, supported by a stand-by arrangement from the Fund. A first in Pakistan’s recent history, all reviews under this arrangement were completed on time. While this program already included a substantive component of structural reforms, a more comprehensive medium-term strategy was elaborated during 2000/01 aimed at putting the economy on a sustainable high-growth path while ensuring that growth would translate into meaningful improvements in living standards, including for the poor and most vulnerable. The strategy was detailed in an interim poverty reduction strategy paper¹ endorsed by the Fund’s and the World Bank’s Boards in late 2001. The strategy is currently supported by various multilateral and bilateral institutions, including by the Fund through an arrangement under the Poverty and Reduction Growth Facility. The following notes look at some of the core issues of this strategy. As a new parliamentary government is about to assume its functions, it is hoped that the various notes could assist in identifying the key challenges ahead, in formulating policies that address the obstacles that stand in the way of high and equitable growth in Pakistan, and in explaining their rationale to a broader public.

3. A central issue for Pakistan is a worrisome trend of declining growth. Chapter II looks at this trend from a growth-accounting point of view. While data weaknesses counsel a cautious interpretation of the results, the exercise does indicate that a combination of lower total factor productivity growth and declining investment in human and physical capital explains this growth outcome. While the causes of declining private investment rates are complex, and beyond the analysis of this paper, relevant factors likely include the uncertainties arising from a turbulent domestic and regional political environment,² the “social gap”, and the decline of public investment. The latter two are partly explained by the squeezing of fiscal space for human capital and infrastructure investments by high public debt service and defense outlays.

4. Chapter III provides considerable evidence that Pakistan’s striking “social gap” in education and health is indeed a main culprit for a weakening growth performance. This section, beyond documenting the social gap, also looks at the underlying causes and identifies challenges in this area that need to be addressed, if Pakistan is to develop its human potential and reduce poverty and social vulnerability. To a large extent this task will fall to the local governments that were elected in 2001, but certain issues may require intervention by the central government.

5. Chapter IV looks at the financial sector as another area that is central for growth and governance, and where reforms are well advanced. The focus is on the banking system. A strong prudential framework is being put in place, and privatization of commercial banks is well underway. Better governance seems to have already curbed the growth in nonperforming loans, although working out the existing stock will require continued efforts. The main challenges for the future include the reform of nonbank financial institutions (insurance, pension funds, public development banks), as well as reform of the national saving schemes that continue to feature distortions that adversely affect financial intermediation and imply high costs for the budget.

6. Finally, chapter V adds to the current discussion in Pakistan on how to ensure a continuation of prudent fiscal policies that would reduce public debt to more substainable levels. The starting point is a draft fiscal responsibility law that was recently published for public comment. The law would codify recent gains in fiscal reporting and require the government to further improve on these gains. The law also contains a target to reduce public debt to 60 percent of GDP by 2011/12 as well as fiscal rules that ensure this debt reduction to be achieved in a balanced and orderly fashion.