My authorities thank staff for a well-written and candid report which describes progress under the PRGF and the challenges that lie ahead of Pakistan. They also express their deep appreciation for the continuing support of staff, management, and the Executive Board in pursuit of high sustainable growth and poverty reduction.

Recent economic performance in Pakistan has been encouraging. Since the last review, economic activity appears to be gathering strength, inflation remains quiescent, the fiscal deficit for end-September has been met thanks, in part, to rising tax collections by the Central Board of Revenue (CBR). I-PRSP expenditures have risen sharply, and the external sector has overperformed, reflecting higher-than expected private inflows and strong exports. The implementation of structural reforms has been broadly on track, except for continuing financial difficulties experienced by the Water and Power Development Authority (WAPDA). Privatization has made some headway, with faster progress being constrained by limited investor interest. In other structural areas, staff note with regret government’s decision to restore some tax exemptions, amendments to the central bank act that were less strong than hoped for, and the risk of abuse from a new National Savings Scheme (NSS) instrument targeted at pensioners. The authorities assure the Board that the new exemptions are limited in nature and scope and bear virtually no fiscal impact. In one case, the exemption merely corrected an inadvertent error. The amendments to the central bank act do indeed strengthen the institution that was already widely regarded as being highly independent. In regards to the new NSS instruments targeted at pensioners, the authorities will put in place appropriate safeguards—including special documentation requirements and monitoring mechanisms—to ensure that there is no abuse.

The new civilian government, which took power following the October 2002 elections, has endorsed the main goals of the I-PRSP and supports the broad macroeconomic and structural contours of the PRGF. Staff express concern about the “dangerous view now gaining momentum” in Pakistan that a comfortable macrofmancial situation should permit some relaxation of fiscal discipline. While there may have been some risk of a drift towards macroeconomic populism in the initial days of the new government, there has since been a growing realization that adhering to the program is in Pakistan’s best interest and offers the best chance of extricating the economy from its slow growth equilibrium. The regular increases in domestic petroleum prices provide one illustration of the authorities’ commitment to the program.

The macroeconomic framework for the remainder of FY 2002/03 in terms of growth and inflation is largely unchanged. However, there are some indications that the GDP growth target of 4.5 percent may be exceeded. Revisions to the balance of payments projections arise from stronger-than-expected foreign exchange inflows. The staff report notes the two forces at work, namely, “a combination of a shift of inflows to official channels and a still ongoing portfolio reallocation.” On the assumption that the portfolio reallocation is a one-time phenomenon, the balance of payments projections assume a tapering off in 2003.

The continued high level of private inflows has presented monetary policy with a dilemma which has been well-documented in previous staff reports. In light of the large fiscal costs associated with “massive” sterilization operations, the monetary/exchange rate policy mix will be slightly modified towards lesser intervention—thereby regaining better control over monetary aggregates—and greater exchange rate flexibility. At the same time, monetary policy will remain alert to the emergence of inflationary pressures in light of the rapid growth in broad money and evidence—albeit largely anecdotal—of sharp increases in asset prices, especially real estate. Staff recommendation to exercise caution in relaxing interest rate policy further is therefore well taken. On exchange rate policy, the authorities are cognizant of the risks that reduced intervention could lead to a real appreciation of the rupee and ultimately hurt the presently strong pace of export growth. They agree with staff that the best way to safeguard external competitiveness is to accelerate the pace of structural reforms.

The combination of sterilization costs, which have sharply reduced central bank profit transfers to the budget, and the financing needs of the two power utilities (WAPDA and KESC) have placed unexpected strains on the budget. Given the importance of fiscal consolidation to macroeconomic stability and debt reduction and Pakistan’s good record of consistently meeting fiscal deficit targets, the authorities will make every effort to achieve the savings required to close the fiscal gap without affecting high-priority social and poverty-reducing expenditures.

In the structural area, tax policy and tax administration reform will continue to be given priority. The authorities are encouraged by the fact that reforms in the Central Board of Revenue (CBR) appear to be bearing fruit, as reflected in the much improved revenue performance. Further reforms will be implemented in light of the FAD report on tax and customs administration. The recently opened pilot tax offices have been well received, there is to be a sweeping reduction of income tax exemptions in the next budget, and the authorities intend to evolve a strategy to deal with the practice of “benami” accounts. Parliament is also expected to take up the draft fiscal responsibility law which, inter alia, defines a multi-year framework for reducing public debt, and it is the intention to work with the provincial governments to extend the relevant provisions of the law to provinces. Staff express concern at the involvement of members of parliament in the selection of local development projects, and fear it may lead to a setback in fiscal management. The authorities wish to reiterate that these development schemes will be subject to the same scrutiny and discipline as other projects in the development budget.

While the authorities remain strongly committed to privatization, their efforts have, in some cases, been frustrated by a lack of investor interest, forcing resort to a negotiated sale. In other cases, the privatization drive is proceeding, with Habib Bank and major public enterprises in the oil and gas sector expected to be privatized in the coming months. A privatization strategy for the national airline (PIA) is also expected to be in place by next year.

The authorities fully share staffs concerns regarding the poor operational and financial performance of WAPDA and the need to address its problems more forcefully. Box 1 of the staff report brings out WAPDA’s problems succinctly. Timely and adequate adjustments in tariffs, redoubled efforts to reduce line losses, proceeding with the unbundling of WAPDA, and enforcing bill collection, especially in the Federally Administered Tribal Area (FATA), will be key to improving financial performance.

After a slow start, reflecting capacity constraints, I-PRSP expenditures have risen sharply, especially in regards to education, health, and rural development suggesting that a major expenditure shift towards the social sectors is taking place. Nevertheless, the authorities recognize that the task of capacity building of local elected governments is an on-going process requiring continued commitment. The Poverty Reduction Strategy Paper Preparation Status Report prepared by the Government of Pakistan and the Joint Staff Assessment chart a road map of development of the full-PRSP and describe the challenges ahead, especially in the area of independent monitoring of outcomes and intermediate indicators. However, as the papers note, good progress is being made in this important area.