Pakistan: Fifth Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility and Request for Waiver and Modification of Performance Criteria

This paper examines Pakistan’s Fifth Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility (PRGF) and Request for Waiver and Modification of Performance Criteria. Although most reforms were broadly on track, there were setbacks in energy sector reforms, and to a lesser extent in privatization. Progress was made in preparing the full Poverty Reduction Strategy Paper and monitoring intermediate social outcomes. All quantitative performance criteria for end-December 2002 were met. The budget for fiscal year 2003/04 will aim at a further reduction of the fiscal deficit while raising social and poverty-related expenditures.


This paper examines Pakistan’s Fifth Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility (PRGF) and Request for Waiver and Modification of Performance Criteria. Although most reforms were broadly on track, there were setbacks in energy sector reforms, and to a lesser extent in privatization. Progress was made in preparing the full Poverty Reduction Strategy Paper and monitoring intermediate social outcomes. All quantitative performance criteria for end-December 2002 were met. The budget for fiscal year 2003/04 will aim at a further reduction of the fiscal deficit while raising social and poverty-related expenditures.

I. Introduction and Background

1. On December 6, 2001, the Executive Board approved Pakistan’s request for a three-year arrangement under the Poverty Reduction and Growth Facility (PRGF) with access to 100 percent of quota (SDR 1.03 billion) and endorsed the country’s Interim Poverty Reduction Strategy Paper (I-PRSP).1 The Executive Board completed the fourth review of the program on February 28, 2003 (IMF Country Report No. 03/54), thus enabling Pakistan to draw SDR 86 million. As of April 30, 2003, total Fund credit and loans outstanding to Pakistan amounted to SDR 1.45 billion (140.1 percent of quota).

2. In the attached letter dated May 29, 2003 and the Memorandum of Economic and Financial Policies (MEFP) (Attachment I), the government of Pakistan requests completion of the fifth review under the PRGF arrangement, a waiver for the nonobservance of the performance criterion regarding the preparation of a revised FIP for the Water and Power Development Authority (WAPDA), and modification of a performance criterion regarding privatization of Habib Bank Limited (HBL). A sixth disbursement (SDR 86 million) is conditional on the completion of this review.

II. Performance Under the Program from October 2002–April 20032

3. The formation of the new parliament was completed in late February 2003 with the Senate elections, which paved the way for completion of the cabinet. However, the opposition’s rejection of constitutional amendments made under the previous military government has so far prevented the resumption of normal parliamentary business. The situation at the Indian and Afghan borders continues to involve deployment of significant security forces, though tensions with India appear to be subsiding.

4. All quantitative performance criteria for end-December 2002 were met. Recent data on agriculture and manufacturing are consistent with a 4.5 percent real GDP growth for FY 2002/03 (July–June). Inflation further slowed to 2.2 percent year-on-year in April. Due to high remittances, strong exports, and sizeable external support, the current account and overall balance of payments overperformed relative to program targets. Since January, the SBP has significantly reduced its purchases on the foreign exchange market, thus slowing the accumulation of gross official reserves, which reached $9.1 billion (equivalent to about 7.4 months of next year imports) at end-April. The Pakistani rupee has appreciated slightly against the U.S. dollar in recent months.

5. The fiscal deficit target for end-December 2002 was met with a comfortable margin. Total revenue was higher than targeted, helped by an overperformance on CBR receipts. Nontax revenue shortfalls, mostly on account of WAPDA and lower-than-expected transfer of SBP profit (reflecting, for the latter, sterilization costs), were more than offset by unexpected large payments from some public enterprises, and from the coalition against terrorism for services rendered. Expenditure analysis is hampered by data reconciliation issues, but indicates underspending relative to program targets, most likely on account of lower interest payments. According to preliminary unreconciled data, social (I-PRSP) expenditures in the first half of 2002/03 grew by 45 percent year-on-year, close to the indicative target.

6. Broad money growth remained strong in the second quarter (+17.6 percent year-on-year), driven by NFA accumulation and a recovery in growth of credit to the private sector. Similar trends continued through February 2003. Due to lesser sterilization, reserve money growth accelerated in early 2003 to about 15 percent. Interest rates on 6-month treasury bills dropped to 1.6 percent in April 2003 and yields on 10-year bonds to 4.0 percent in March 2003.

7. The authorities made little progress in energy sector reforms. A positive development was the steadfast application of the fortnightly automatic adjustment of petroleum product prices. However, setbacks were recorded in the power sector:

  • The financial performance of both WAPDA and Karachi Electric Supply Corporation (KESC) through December 2002 was worse than targeted in their FIPs (MEFP, para. 6).

  • In May, the government implemented only part of the automatic electricity tariff adjustments determined by the National Electric Power Regulatory Authority (NEPRA) to offset the surge in fuel costs in early 2003 in the run-up to the war in Iraq. As a result, the deficit of both utilities for the current year will be higher than planned.

  • A performance criterion was missed, as the revised FIP for WAPDA provided by the authorities on April 15 (MEFP, para. 18 and 19) did not include contingency measures to be implemented if needed to achieve the financial targets; such contingencies were, however, developed subsequently in consultation with Fund and World Bank staff. The revised FIP also indicates delays in two key steps in the unbundling of WAPDA, planned for end-April and end-June 2003. Both are structural benchmarks under the program (Table 2(a)).

  • In line with the gas pricing framework, which has been published by the Oil and Gas Regulatory Authority (OGRA), wellhead prices were adjusted on January 1, 2003, leading OGRA to increase the prescribed prices for the two gas distribution companies. However, the government has so far delayed the pass-through of this increase to consumers.

8. Other structural reforms were broadly on track (MEFP, Table 2(a)). In addition, the performances of the three other large public enterprises3 during the first half of 2002/03 were broadly in line with their respective FIP targets. Work on the Core Welfare Indicators Questionnaire (CWIQ) has been initiated, and further progress has been made toward the preparation of the full PRSP. The draft fiscal responsibility law was sent to the cabinet for approval, and a strategy to reduce the scope for abuse of the Benami practice was prepared in March 2003 (Box 1). Privatization however made little progress. Considering that a negotiated sale of HBL to the only qualified investor could be viewed as insufficiently transparent, the authorities have re-invited expressions of interest, making the actual sale by end-June 2003—as planned under the program—unlikely. The authorities now expect privatization to take place by end-2003, and therefore request modification of the related performance criterion.

III. Report on the Discussions

9. The discussions focused on the fiscal framework for 2003/04 and the power sector reforms. The I-PRSP called for a further reduction of the deficit next fiscal year to reduce high public debt, while creating room for increasing human development expenditures to address Pakistan’s large social gap. The mission therefore discussed with the authorities the scope for further enhancing revenues by broadening the tax base and for reducing subsidies to public enterprises. Since power utilities are getting most of these subsidies, discussions centered on how to reduce WAPDA and KESC’s drain on the budget. Program conditionality in the power sector has been strengthened in recognition of its critical importance for the attainment of the program targets. The discussions highlighted that consensus building within parliament and the coalition government on carrying on with the reform agenda will be a challenging task, especially in a context where strong macroeconomic results fuel populist pressures.

A. Macroeconomic Framework for the Remainder of 2002/03 and for 2003/04

10. The economic growth projections and inflation targets for the current and next fiscal years were kept unchanged, with real GDP growth accelerating to 5 percent and consumer price inflation to be kept below 4 percent. The external position is expected to further improve in 2003/04. The current account excluding official transfers, after a large surplus this year, is projected to return close to balance. This mainly reflects the assumptions that remittances would gradually taper off, and of lower reimbursements from the coalition against terrorism. The capital account, net of exceptional financing, would record a lower surplus, mostly because of the expected repayment of foreign central bank deposits with the SBP. Gross official reserves would further increase—though much less than in 2002/03—to $10.6 billion in June 2004 (about eight months of imports).

Strategy to Reduce Abuse of “Benami” Practice

1. The expression “Benami” refers to the practice of holding property/assets in the name of one person for the benefit of another. Historically, the practice was widespread in parts of South Asia, reflecting deep-rooted cultural traditions. However, Benami is often aimed at concealing ownership of assets acquired through illegal means, defrauding creditors, and/or evading payment of government fees, charges, or taxes. Pakistani courts have recognized this concept as a custom and enforced the intention of the parties. Nonetheless, under the existing law, if the real owner is a defaulter or a creditor, the government can have recourse against the real owner’s property held Benami.

2. In order to curb abuse of the Benami practice, a task force1/ will organize consultations with the provinces (which may legislate in this area) to secure their concurrence for reform. The provinces may consult relevant stakeholders such as Bar Associations, Chambers of Commerce/Industry, Trade Associations, Agricultural Associations, real estate sector, etc. The task force will submit a report to the cabinet not later than end-October 2003, with recommendations to reform legislation. Following approval of the cabinet, in accordance with the constitutional requirements, the provincial governments’ concurrence will be sought before a draft law is submitted to parliament (by end-2003).

3. Ideas for possible legislation emanating from a work force headed by MoF and SBP and partly based on other countries’ experience envisage to deal separately with the two different aspects of Benami: (a) property held in another person’s name (Benami property in accordance with common usage); and (b) property held in the name of a fictitious person (ownerless property). These ideas include:

  • With respect to both Benami and ownerless property, the law may allow the existing holders a period of one year from the date of its promulgation to transfer the said property into their own names.

  • After expiration of the immunity period, all property should vest in the person in whose name the property is held (the Benamidar). The “real” owner of the Benami property will no longer have the legal right to claim the property from the Benamidar.

  • Regarding Benami property, the loss of legal right to the property would be the only deterrent the proposed law shall place on a holder of Benami property. However, regarding ownerless property, penal sanctions (imprisonment and/or fines) may be imposed in addition to existing laws.

  • The property that is declared ownerless will vest in the government. The High Court may be given the jurisdiction to determine whether a property is ownerless.

1/ The task force includes representatives of the Ministry of Finance (MoF), provincial governments, CBR, SBP, Securities and Exchange Commission of Pakistan (SECP), and National Accountability Bureau (NAB).

11. The planned monetary/exchange rate policy mix (MEFP, para. 8) should help curb money supply growth and avoid the emergence of inflationary pressures. Given some evidence of asset price inflation, negative real treasury bill rates, and the recent strong money growth, the authorities and staff concurred on the heightened need to carefully monitor inflation developments and to progressively bring the growth rates of monetary aggregates in line with nominal GDP growth. The expected slowdown in remittances/private capital inflows should help in this regard. The mission noted that although the SBP considerably reduced its intervention on the foreign exchange market in March/April 2003, the Pakistani rupee appreciated only slightly against the U.S. dollar, suggesting that the pace of foreign exchange inflows might be easing already.

12. The authorities plan to prepay some expensive foreign debt, and to involve outside expertise in managing official reserves. The mission strongly encouraged the authorities to quickly implement these plans, stressing that early repayments, to be financed by issuing treasury bills and bonds, would improve the debt profile and allow the SBP to build up its dwindling stock of treasury bills, thereby enhancing its profitability and facilitating open market operations. The authorities recognized that sterilization costs of past foreign exchange inflows would still affect next year’s SBP profit, and stood ready to recapitalize the central bank if needed.

13. Meeting the end-June 2003 fiscal deficit and CBR collection targets will be a close call, and requires firm expenditure control and continued strong tax performance. Reimbursement from the coalition against terrorism should cover much of the higher-than-projected defense expenditures on account of the fight against terrorism. Overall, overperformance on some nontax revenue items has provided an offset to the additional financing needs of some public enterprises (mostly WAPDA and KESC), and higher-than-expected subsidies. The latter reflect in the main that the General Sales Tax (GST) subsidy on electricity consumption has not been reduced as envisaged in the budget, along with the higher subsidies for wheat exports.

14. The 2003/04 fiscal framework’s goals are to further reduce the public debt-to-GDP ratio while increasing social expenditures. The draft federal budget to be submitted to parliament in early June will aim at a consolidated deficit of 4.0 percent of GDP (excluding possible bank restructuring outlays, see below). While higher than the initial I-PRSP target (3.5 percent of GDP), the authorities believe that, given the setbacks in power sector reforms and sterilization costs, a lower deficit would have required lower social or development expenditure. They felt that many infrastructure needs already were not being met, and that low public investment partly explained low levels of private investment (see Box 2 on some quantitative evidence in this respect). CBR revenue is projected to increase by about 11 percent, reflecting a buoyant economy, some broadening of the tax base (below), and further improvement in administrative efficiency. While staff had argued for a stronger increase in the CBR revenue ratio, the authorities preferred to be cautious about assuming rapid gains from administrative reforms, pointed to possible teething problems with the introduction of universal self-assessment, and indicated that a substantial expansion of the GST to services was possible only for 2004/05 as it would require considerable preparatory work and consent of the provinces. On the expenditure side, social spending would increase from 4.0 percent to 4.2 percent of GDP. Budgetary support to public enterprises is expected to decline, reflecting the planned improvement in the financial situation of the two power utilities (see below). Specifically, budgetary support for KESC/WAPDA (including debt service arrears) will decline from 1.6 percent of GDP this year to 0.7 percent in FY 2003/04 (see text table). To improve transparency, this budgetary support will be explicitly budgeted as subsidies rather than netted against debt repayments due, as in the current year. Interest payments as a percent of GDP are expected to decline, owing to lower interest rates and a strong Pakistani rupee. Overall, non-I-PRSP expenditures would barely increase, reflecting further rationalization of nonpriority spending. The deficit ceiling for program monitoring purposes will be adjusted upward (up to 0.5 percent of GDP) for expenditures incurred for the restructuring of two public banks (Industrial Development Bank of Pakistan (IDBP) and Allied Bank Limited (ABL)), conditional on actual transfer of ownership (or liquidation), as well as for additional I-PRSP expenditure financed by additional grants. The mission welcomed the projected reduction of the debt-to-GDP ratio (to 83.7 percent of GDP by mid-2004), as well as the efforts to increase social expenditures, but maintained that a more forceful attempt at reducing subsidies could have been made (in particular for the poorly targeted subsidies on the GST on electricity).

Budget Support to WAPDA and KESC, 2002/03–2003/04

(In billions of Pakistani rupees)

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Sources: Pakistani authorities; and Fund staff calculations.

Private Investment Determinants in Pakistan 1/

The share of private investment in Pakistan has been growing steadily during 1974–92 from 4.8 percent to 11.2 percent of GDP, but both public and private investment have been declining since then, with total investment down to 14.4 percent of GDP in 2001.


Pakistan: Real Public and Private Fixed Capital Formation, 1969–2001

(In percent of GDP)

Citation: IMF Staff Country Reports 2003, 180; 10.5089/9781451830576.002.A001

The following econometric model makes an attempt to assess and measure the factors determining private investment in Pakistan from 1973–2001.2/ Variables for which the initial model produced implausible or insignificant coefficient estimates (such as foreign exchange levels, export price shocks, CPI variance, workers remittances) were excluded to determine the general equation in the Table. The specific equation was estimated by performing F-tests on redundant variables.

Pakistan: Private Investment Function 1/

(OLS dependent variable grass fixed private investment/GDP, constant prices, in logs)

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T-statistics (***=1%, **=5%, *=10%) were computed using heteroscedasticity and autocorrelation consistent standard errors. There are 29 observations.

The results of the specific model show that private investment is mainly influenced by debt overhang effects (an increase of 10 percent in the external debt-to-GDP ratio would reduce private investment to GDP ratio by 3.08 percent) and changes in REER (10 percent would raise private investment by 3.05 percent). The estimates also indicate significant complementarity between public and private investment in Pakistan. Bank credit to private sector and demand effect also were highly significant but had a much lower effect on private investment. Recursive estimates indicated substantial stability in coefficients at two-standard error confidence level.3/ Coefficient standard errors declined as observations for the 1980s and 1990s were included in the sample, confirming the robustness of the results.

1/Data sources: Pakistani authorities; World Bank Development Indicators; and Fund staff estimates.2/The initial set of possible determinants included (a) demand (lagged GDP growth) and debt overhang (external debt and debt service ratios) effect variables; (b) real interest rate proxied by the weighted average of scheduled banks’ advances rates to the private sector; (c) real growth of bank credit to the private sector; (d) levels of foreign exchange reserves and worker remittances; (e) variables measuring macroeconomic uncertainty (CPI variance and real effective exchange rate (REER)); (f) terms-of-trade effects measured by the income effects of export and import price shocks; (g) ratio of public investment to GDP; and (h) lagged private investment to GDP ratio. Series’ stationarity was evaluated using Kwiatkowski, Phillips, Schmidt, and Shin test: there were no rejections of the null hypothesis of stationarity at any reasonable level of significance. Public investment is the sum of investment by general government and by autonomous and semi-autonomous public organizations. Models were also estimated using these two types of public investment individually: both produced positive coefficient estimates significant at 10 percent level; however, the model in the table yielded the best fit and diagnostic tests.3/Forward recursion based on an initial sample 1973–81; annual observations added until the complete sample was reached.

15. The authorities are committed to continued streamlining of the tax system and broadening of the tax base with the 2003/04 budget. The number of remaining income tax exemptions will be further reduced (MEFP, para. 9) and the remaining withholding tax exemptions on interest income—including from National Saving Schemes (NSS) instruments—will be abolished. These measures will not generate substantial revenue in the short term, but should reduce distortions and the potential for corruption. In the medium term, tax revenue should also benefit from efforts to limit the enforceability by courts of Benami transactions (see Box 1).

B. Structural Issues

Energy sector

16. The mission expressed strong concern about the recent setbacks in the electricity and gas sectors. The authorities argued that the high oil prices in the run-up to the war in Iraq were clearly exceptional and temporary, and that passing them on to consumers and industry through the periodic automatic tariff adjustment for gas and electricity could well be disruptive to social and economic stability. While acknowledging these arguments, the mission stressed that, to smooth price movements, NEPRA-determined tariff increases were already capped at 3 percent in any one quarter, and that the partial and delayed implementation of the latest determination would risk to re-politicize energy pricing issues, endangering a hard-won achievement of recent years. This might undermine the willingness of the private sector to invest in the gas and electricity sectors. The mission also expressed concern that this decision may adversely affect income distribution since middle and upper class consumers are likely to benefit most from subsidized utility tariffs as the poor have little access to gas, and lifeline electricity tariffs were not to be increased in any case. The cost of this policy, if it led to a higher debt burden or the crowding out of pro-poor expenditure, may well affect the poor disproportionally. To give credibility to the new gas pricing framework, the mission recommended early implementation of the envisaged modest consumer price increase.

17. The power sector problems need to be tackled forcefully, as they have proven to be the main risk to the budget. The financial situation of WAPDA is likely to improve in the medium term, given the lower forthcoming contractual payments to independent power producers and the coming on stream of a major hydropower project. However, the mission stressed that these factors should not distract the authorities from protecting the budget in the short term. It therefore welcomed the revised, more realistic FIP for WAPDA, as well as the commitment to make notification of tariff decreases conditional on the utilities meeting their quarterly accrual deficit targets. A substantial increase in debt-service payments to the government, and a base effect arising from the one-time payment of KESC’s arrears in 2002/03, explain the modest planned reduction in the accrual deficit. The mission urged the authorities to implement steadfastly the FIP, including a workable mechanism for collection of bills from the Federally Administered Tribal Areas (FATA) and the timely payment of bills by the public sector. While the FIP includes specific measures (gradual metering of FATA users, subcontracting collection to private operators, and others), additional steps should be developed if needed to achieve at least PRs 2 billion of payments on FATA bills. WAPDA itself needs to be made more accountable for achieving the targeted reduction to line losses (from 25 percent this year to 24 percent in FY 2003/04), and should explore the scope for specific measures to reduce administrative costs. Given WAPDA’s resource constraints, it needs to prioritize investments, and the FIP commits to refrain from launching any new projects. Completing the unbundling and corporatization process will be an important prerequisite for involving the private sector, and the mission urged the authorities to more forcefully tackle the administrative difficulties that are delaying the assignment of WAPDA’s assets and liabilities to successor companies. The authorities plan to work out, in consultation with the World Bank, a medium-term action plan addressing weaknesses in the power sector’s regulatory framework, notably to make government notification of tariff determinations by NEPRA more automatic, and with clear guidance to NEPRA on the tariff policies for the various WAPDA successors.

Tax administration, trade reform, public expenditure management, and fiscal transparency

18. The CBR reform is on track, and the authorities plan to implement many FAD recommendations on tax and customs administration reform (MEFP, para. 13). The mission welcomed progress made in implementing the Accountable Fiscal Management Framework (MEFP, para. 16), but expressed concern about the quality of reporting on provincial and local government spending (see the relatively large statistical discrepancy for the provincial accounts at end-December). Improving fiscal reporting at the local government level will require further capacity building and some institutional changes, notably to ensure better enforcement of existing accounting procedures.

Trade liberalization

19. The mission welcomed the commitment to prepare a road map for the gradual reduction in the very high effective protection granted to certain industries (mostly motor vehicles). It noted the authorities’ view that this policy has helped to create a fast-growing industry, but felt that a better balance needed to be struck between incentives for investment in the sector and the interest of consumers in having access to vehicles at affordable prices.

Social sector issues

20. Progress is being made in preparing a full PRSP and in strengthening social outcome monitoring. The first report on intermediate social outcomes, which defines the monitoring framework, provides baseline estimates, and sets annual targets for the next three fiscal years, was recently published ( The implementation of this framework and of the annual core welfare indicators survey (with World Bank assistance) will provide essential inputs for the design of the local, provincial, and federal budgets starting in 2004/05. Progress has also been made in finalizing the PRSP, including through broad-based consultation with provincial and local governments and civil society, and outreach efforts to record the concerns of the poor.

Privatization and public enterprise reform

21. Despite the authorities’ strong commitment, privatization has been hampered by limited investor interest. The mission stressed that, in the current weak global economic environment, negotiated sales might have to be seriously considered in cases where only one well-qualified investor has expressed interest. While acknowledging that the reopening of the invitation for expressions of interest was motivated by the greater transparency of a competitive bidding process, the mission regretted that HBL’s privatization will now likely be delayed beyond June 2003. The restructuring of the balance sheets of IDBP and ABL as planned is part of a clear exit strategy (transfer of ownership or liquidation). The mission was encouraged by the satisfactory implementation of their FIPs by PIA, PR, and PSM, and progress in KESC’s collection performance, but emphasized that more efforts were needed to reduce KESC’s line losses. The increased investment by KESC, which explains the small increase in the accrual deficit in FY 2003/04, should go with high priority to equipment needed to reduce line losses and theft.

Financial sector

22. The authorities recognize the importance of reforming the NSS to reduce the costs to the budget (Box 3), improve debt management, reduce distortions, and foster the development of capital markets, and have requested from the Asian Development Bank (AsDB) technical assistance on this issue. However, the mission felt that more rapid reform would be preferable, in particular to close the on-tap issue of NSS instruments which was crowding out less expensive domestic financing. The mission encouraged the authorities to complement their comprehensive approach to money laundering issues (MEFP, para. 21) by submitting to parliament a related draft law as soon as possible.

IV. Other Issues

Statistical issues

23. The mission welcomed recent progress toward subscribing to the Special Data Dissemination Standard (SDDS) (MEFP, para. 24), as well as the renewed commitment to meet essential SDDS requirements by end-2003. Participation in the General Data Dissemination System (GDDS) will be soon within reach, following World Bank assistance with drafting the missing socio-demographic metadata.

Program financing

24. The program remains fully financed in the current and next fiscal years, with most bilateral agreements implementing the Paris Club Agreed Minutes of December 2001 now signed. The recent cancellation by the U.S. of about $1 billion of debt will contribute substantially to improve external debt sustainability.

Program monitoring

25. Proposed prior actions, quantitative and structural performance criteria and indicative targets, and structural benchmarks are specified in the MEFP (see also Box 4). A new Technical Memorandum of Understanding (TMU), effective as of July 1, 2003, incorporates amendments made in the course of 2002/03, simplifies the treatment of some adjusters, defines a monitorable deficit for the power utilities, introduces a new adjuster related to the cost of restructuring IDBP and ABL, and sets the baseline assumptions for external program financing and external grants in 2003/04. In view of the uncertainties surrounding Pakistan’s economic outlook, the program will continue to be monitored through quarterly reviews. The authorities requested that discussions for the sixth review, including assessment of the end-March 2003 quantitative performance criteria (which has not been finalized yet), be held only after completion of the fifth review. The discussions with staff for the sixth review and assessment of the end-March 2003 quantitative performance criteria are expected to take place in August 2003, and the authorities plan to request to combine the seventh and eighth disbursements at that time. The ninth and tenth disbursements (and eighth and ninth review, respectively) are scheduled for December 20, 2003 and March 20, 2004, respectively (with end-September 2003 and end-December 2003 test dates).

Implicit Subsidy in the National Savings Schemes

The National Savings Schemes (NSS) comprise a list of saving certificates intended to mobilize and promote private saving. NSS certificates finance the federal government budget and are available on tap from National Savings Centers, post offices, and commercial banks. Since December 2000, the rates of return on NSS certificates have been loosely tied to those of Pakistan Investment Bonds (PIBs) of same maturity with a premium (semi-annual adjustment). The formula was designed to make commercial banks neutral between holding NSS certificates or PIBs even though banks cannot hold NSS certificates and PIBs are available only to institutional investors.

The rates of return on NSS certificates are higher than those on deposits with commercial banks of similar maturity. The difference can be viewed as an implicit subsidy which reflects the government’s intention to promote private saving, and to give support to pensioners and others who rely on income from NSS savings. Given that the very poor do not command sufficient resources to invest in NSS, the implicit subsidy does not appear targeted to those most in need of government assistance. In the fiscal accounts, the implicit subsidy is included in the interest bill; subsidies are thus understated while interest costs are overstated.

An estimated lower bound for the implicit subsidy is 0.7 percent of GDP in 2002/03 (16 percent of domestic interest payments).1/ The highest implicit subsidy over the full maturity is paid on three-year Special Saving Certificates with a rate of return almost twice that on three-year deposits. For Regular Income Certificates, the implicit subsidy is 26 percent of the nominal return, and for Defense Saving Certificates, the implicit subsidy varies between 6 percent and 50 percent of the nominal return, depending on the time of encashment.

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Sources: Pakistani authorities; and Fund staff calculations and estimates.

As of June 30, 2002. Table does not include some smaller instruments.

As of January 1, 2003, if held over full maturity.

Comparators: Deposits with scheduled banks with similar maturity.

Several aspects of the NSS merit reform. First, NSS certificates should not be available on tap, so that the government regains full control over nonbank financing. Second, the rates of return should be tied closer to comparable instruments. At a minimum, the premium over PIBs should be eliminated. Third, any subsidy for a particular group should be well targeted and explicit.

1/ Calculating the implicit subsidy requires a number of assumptions, given the paucity of detailed data on NSS. The approach taken estimates a lower bound for the implicit subsidy based on current rates. Given that the implicit subsidy on past issues (before linking NSS rates to PIBs) was higher than today’s, the actual subsidy on the outstanding NSS stock is likely to be higher. The average annual rate of return is calculated as the geometric average of the actual rates of return effective July 1, 2002. The implicit subsidy is calculated by comparing the average annual rate of return to the rate of return on deposits with similar maturities offered by commercial banks. The total subsidy included in the interest bill is calculated from average subsidies per instrument and the respective interest payments.

Structural Conditionality 1/

1. Coverage of structural conditionality in the PRGF program for FY 2002/03

Most of the structural conditionality has been met so far. Structural conditionality for the remainder of the 2002/03 and for 2003/04 is detailed in Tables 2(a) and 2(b) of the MEFP. The focus remains on tax policy and tax administration reforms, public expenditure management reforms, and fiscal transparency. Particular emphasis is also given to the reform of WAPDA and KESC, whose financial situation weighs considerably on public finances. This extension of Fund conditionality to an area usually covered by the World Bank reflects its critical relevance for the macroeconomic framework. The privatization of a nationalized bank is a structural performance criterion, as privatization is critical to create a sound and efficient financial sector that contributes to growth, and is less vulnerable to government interference.

2. Status of structural conditionality from earlier programs

Virtually all structural measures included in the Stand-By Arrangement, which expired in September 2001, were implemented. A benchmark on the establishment of best practice anti-money laundering rules was missed because of a postponement in the scheduled FSAP mission, that was expected to provide technical advice. The benchmark on the reconciliation of provincial expenditure was only partially met because of limited institutional capacity in managing both the devolution initiative and revising accounting procedures to include the newly created district administrations. Expenditure reconciliation has further improved since the start of the current PRGF program.

3. Structural areas covered by World Bank and other donors’ lending and conditionality

World Bank program lending for FY 2001/02, as for the previous fiscal year, was delivered under a one-tranche Structural Adjustment Credit (SAC). The IDA-financed $500 million SAC II disbursement (in June 2002) was conditional on (a) accelerating power sector reforms with a view to restoring the sector’s financial viability; (b) revamping the tax administration system to improve governance and increase revenues; (c) improving the policy framework in the oil and gas sectors to attract domestic and foreign investment; (d) improving the effectiveness in the delivery of social services through civil service reforms, and enhanced transparency and accountability in the use of public resources; (e) accelerating the implementation of the Education Sector Reforms Action Plan and the National Health Policy; and (f) establishing monitoring and evaluation systems to assess progress in the implementation of the poverty reduction strategy. Overall, conditionality has proven relatively ineffective in the power sector, with the implementation of WAPDA’s initial FIP largely off-track and limited progress in the utility’s corporatization/unbundling process. The World Bank approved in July 2002 SACs for two provinces (Sindh and North West Frontier Province) totaling $190 million supporting provincial reform strategies to improve fiscal transparency, resource management, and strengthen provision of public services by local governments and communities. Conditionality related to the restructuring of three nationalized banks is part of a banking sector project loan approved in October 2001. Successful implementation of reforms have facilitated the privatization of United Bank Limited and should help privatize HBL.

4. The AsDB is supporting Pakistan’s adjustment effort through various program loans: an Energy Sector Restructuring Program loan (including conditionality leading to the privatization of KESC and two of the corporatized WAPDA entities), whose disbursement has been delayed due to limited reform progress; a Small and Medium Enterprise Trade Enhancement Finance loan; a Trade, Export Promotion and Industry program; an agricultural policy reform loan, aimed at reducing the government’s intervention in agriculture and raising agricultural productivity; and a loan to enhance access to justice, raise the accountability of justice and law enforcement agents, and strengthen the rule of law. In December 2002, the AsDB approved two new program loans: one aimed at improving governance and operational efficiency in financial markets; the other to develop the rural finance sector, including through the restructuring of the Agricultural Development Bank of Pakistan.

1/ Updated from IMF Country Report No. 03/54.

V. Staff Appraisal

26. Pakistan’s macroeconomic performance through May 2003 remained strong. Economic growth of 4.5 percent in 2002/03 remains within reach, despite global economic weaknesses and a difficult regional security environment. Inflation remains lower than expected, and official reserves continue to grow faster than programmed. These outcomes reflect solid macroeconomic policies, capitalizing on favorable exogenous factors such as good rains, strong external support, and persistent high private capital inflows.

27. Structural reforms in many areas progressed well, but setbacks in power sector reform, and to a lesser extent in privatization, were disappointing. Revenue collection is on track and CBR reform is being carried out as planned. The authorities deserve credit for adhering to the rules-based adjustments for petroleum product prices to reflect world oil prices even during the spike in the run-up to the Iraq war and in the face of strong political pressure. Little progress on privatization reflects mostly investor concerns during the recent period of Iraq-related regional and global uncertainties. However, the recent delay in notifying utility tariff adjustments has further damaged the credibility of the rules-based pricing mechanism for the gas and power utilities, and worsened financial imbalances. Staff appreciates the strong socio-political pressures leading to these decisions, but urges the authorities to keep a rules-based pricing mechanism that minimizes government interference with the application of the determinations of the sector’s regulator.

28. Looking ahead, staff welcomes the authorities’ plan to persevere with the current macroeconomic policy mix. Within a flexible exchange rate system, monetary policy will aim to maintain low inflation. Anecdotal evidence of asset price inflation and continued high growth of monetary aggregates highlight the need to continue to monitor inflation carefully. To be able to absorb liquidity aggressively, if needed, the SBP needs to replenish its stock of government paper usable in open market operations. This highlights the need to shift domestic budget financing from (nonmarketable) NSS instruments to treasury bills and treasury bonds, which would also reduce interest costs. The planned repayment of relatively expensive external debt to improve the public debt profile and enhance the profitability of the SBP would also be helpful in this regard, if financed by the issuance of treasury bills and bonds. Staff welcomes SBP plans to use outside professional expertise in investing part of the reserves and to seek greater currency diversification to limit the vulnerability to bilateral exchange rate movements.

29. The planned reduction in the fiscal deficit for 2003/04 remains the cornerstone of Pakistan’s efforts to reduce the burden of public debt which deters private investment and constrains productive expenditure. Staff had argued for a more ambitious reduction of the deficit, while recognizing that the setbacks in the power sector, the cost of past sterilization, and the budgetary burden of continued regional tensions have made the original PRGF target virtually unattainable. Staff concurs that the restructuring of the balance sheets of two insolvent banks should not be delayed, even if it adds to the headline deficit. Nonetheless, the budget could have made a stronger effort to reduce subsidies (for wheat exports, for GST on electricity for certain classes of households, and most important for various public enterprises) and staff encourages the authorities to move ahead in this area in the near future. On the revenue side, staff concurs with the budget’s emphasis on tax administration reforms and base broadening, but urges the authorities to speed up work with provincial governments on a further extension of the GST on services for FY 2004/05. The revenue targets appear realistic, but make timely implementation of these reforms critical for achieving the fiscal objectives.

30. Fundamental reform of WAPDA remains essential for addressing the main risk to the fiscal objectives, and for laying the foundations for higher growth. In recognition of this, program conditionality in the power sector has been strengthened. The authorities rightly emphasize that part of WAPDA’s current woes reflect temporary factors such as the frontloading of payments to the independent power producers and high investments to get the Ghazi-Barotha hydropower plant on stream. This should not deter, however, the forceful implementation of the revised FIPs. WAPDA needs to be held accountable for achieving the programmed improvements in line losses and in collecting bills from the private sector. The government needs to address the law-and-order issues hampering bill collection in FATA, improve the timely verification and payment of public sector bills, and allow full and timely implementation of tariff increases determined by the sector regulator. In this regard, staff welcomes the proposed contingency measure of making downward tariff adjustments conditional on WAPDA and KESC meeting their quarterly deficit targets. Staff urges the authorities to make stronger efforts toward completion of the unbundling and corporatization of WAPDA, as it will be essential to better localize WAPDA’s problems, reduce the government’s role through corporatization, and clear the way for gradual privatization.

31. Staff is encouraged by available evidence of progress on social sector issues. Social sector (I-PRSP) spending, as reported by the authorities, continues to grow and preparation of a full PRSP seems well advanced. The authorities have made progress in developing a better system to monitor intermediate social outcomes, which should provide inputs in the next budget. Staff remains concerned about the quality of reporting on provincial and local government spending, where progress needs to accelerate, both in terms of moving to computer-based systems and better enforcement of existing accounting procedures.

32. Pakistan’s track record over the last three years indicates that the government will hold the program broadly on course, although the risk of delay for certain structural reforms has risen. Strong reserves and a flexible exchange rate should help cushion unexpected external shocks, and quarterly reviews provide some assurance that an adequate response to unforeseen events will be developed quickly. The government will have to make a strong effort for maintaining a consensus on fiscal consolidation and reform, given its small majority in parliament and in the face of strong and vocal interest groups. The adoption of WAPDA contingency measures and the planned reform of the power sector tariff mechanism, as outlined in the MEFP, corrected for the factors that led to the nonobservance of a performance criterion. On this basis, staff recommends Executive Board approval of the requested waiver and modification of performance criteria, and completion of the fifth review.

Figure 1.
Figure 1.

Pakistan: Output and Inflation, 1997/98–2003/04

Citation: IMF Staff Country Reports 2003, 180; 10.5089/9781451830576.002.A001

Source: Data provided by the Pakistani authorities.1/ Last observation: projection for 2003/04.2/ Last observation: November 2002.3/ Last observation: April 2003.
Figure 2.
Figure 2.

Pakistan: External Sector Developments, 1997/98–2003/04

Citation: IMF Staff Country Reports 2003, 180; 10.5089/9781451830576.002.A001

Source: Data provided by the Pakistani authorities.1/ Customs basis, in U.S. dollar terms. Last observation: April 2003.2/ Excluding official transfers. Last data point: projection for 2003/04.3/ Excluding gold, foreign deposits held with SBP, short-term swap and forward commitments. Last data point: May 29, 2003.
Figure 3.
Figure 3.

Pakistan: Exchange Rate and Stock Market Developments, 1998–2003

Citation: IMF Staff Country Reports 2003, 180; 10.5089/9781451830576.002.A001

Sources: Data provided by Pakistani authorities; and Fund staff estimates.1/ Last observation: May 29, 2003.2/ Last observation: March 2003.
Figure 4.
Figure 4.

Pakistan: Monetary Developments, 1998–2003

Citation: IMF Staff Country Reports 2003, 180; 10.5089/9781451830576.002.A001

Source: Data provided by the Pakistani authorities.1/ Last observation: March 2003.2/ Last observation: February 2003.
Figure 5.
Figure 5.

Pakistan: Fiscal Developments, 1997/98–2003/04 1/

Citation: IMF Staff Country Reports 2003, 180; 10.5089/9781451830576.002.A001

Source: Data provided by the Pakistani authorities.1/ Last data point: projection for 2003/04.2/ 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, 2001–03 1/

Citation: IMF Staff Country Reports 2003, 180; 10.5089/9781451830576.002.A001

Sources: Data provided by Pakistani authorities; and Datastream.1/ First observation: June 1, 2001; last observation: May 29, 2003.2/ Calculated for Pakistan Islamic Republic 10 percent bond maturing on December 13, 2005.
Table 1.

Pakistan: Medium-Term Macroeconomic Framework, 2000/01–2003/04

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

As published in IMF Country Report No. 03/54.

Includes public sector enterprises.

Expenditures included in the Public Sector Development Program.

Including the statistical discrepancy.

Including one-off expenditures: KESC recapitalization and CBR bonds in 2001/02, and IDBP and ABL restructuring in 2003/04.

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 government debt is calculated as interest payments in percent of the end-of-period debt stock of the previous year.

Program data for 2002/03 and 2003/04 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, 2001/02–2003/04

(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 accelerated repayment of $1 billion USDA loan.

Includes $1 billion capital grant to finance the accelerated repayment of the USDA loan.

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, cash reserve requirement, and net of and outstanding short-term swap and forward contracts and the sinking fund.

Table 3.

Pakistan: Consolidated Government Budget, 1999/2000–2003/2004

(In billions of Pakistani rupees)

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

Program as agreed during the fourth review.

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

In 2002/03, subsidies include arrears settlement on behalf of KESC amouting to PRs 11 billion in the initial program and PRs 8 billion in the revised projections.

2001/02: KESC recapitalization (PRs 32 billion) and CBR bonds (PRs 20 billion). 2003/04: IDBP restructuring (PRs 12 billion) and ABL restructuring (PRs 8 billion).

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 fourth review.

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

In 2002/03, subsidies include arrears settlement on behalf of KESC amouting to PRs 11 billion in the initial program and PRs 8 billion in the revised projections.

2001/02: KESC recapitalization (PRs 32 billion) and CBR bonds (PRs 20 billion). 2003/04:IDBP restructuring (PRs 12 billion) and ABL restructuring (PRs 8 billion).