Introduction

My authorities express their appreciation to the staff, management, and the Executive Board for their advice and continued support, and concur with the thrust of the balanced staff report. Their firm commitment to the implementation of sound policies, aided by robust capital inflows and external assistance, has resulted in continued strong performance under their PRGF-supported program despite ongoing regional security problems and high international oil prices. All quantitative performance criteria for end-December 2003 were met as well as most indicative targets for end-September 2003, end-December 2003, and end-March 2004. The authorities seek waivers for the non-observance of structural performance criteria relating to: a) effective transfer of ownership of Habib Bank Limited by end-December 2003; b) preparation of an action plan by end-October 2003 for establishing a transparent regulatory framework for regional electricity tariff setting by end-December 2003; c) notification of electricity tariff adjustments within 30 days of determination by the National Electric Power Regulatory Agency (NEPRA); and d) non-implementation of downward electricity tariff adjustment determined by NEPRA unless the respective utility met its accrual balance target in the previous quarter.

The effective transfer of ownership of Habib Bank Limited was delayed until February 2004 to accommodate the investor. The tariff setting framework was announced in early-June 2004. The downward tariff adjustment for the Karachi Electric Supply Company (KESC), determined by NEPRA in mid-January 2004, was implemented in mid-April after confirming that the accrual balance of the preceding quarter was met and allowing time for discussions on the overall subsidy policy. Finally, the downward electricity tariff adjustment for the Water and Power Development Authority (WAPDA) in November 2003 was implemented only after the authorities were assured that WAPDA would meet its cumulative end-December 2003 accrual balance target, which it did by a comfortable margin. The authorities also request modification of the performance criterion on contracting nonconcessional loans to accommodate a larger-than-expected guarantee for external borrowing by Pakistan International Airlines, which the company will service out of its own resources. The airlines has recently performed quite strongly.

Recent economic developments

As indicated in the staff paper, macroeconomic performance in 2003/04 continues to be very strong. Growth is accelerating and broad-based, and is expected to reach 6.4 percent, substantially higher than projected, suggesting that reforms are starting to bear fruit. Moreover, as announced by the Finance Minister in his Budget Speech for 2004/05, a recent survey shows that sustained growth has also resulted in a tangible reduction of poverty and improvement in living standards over the last three years. Inflation has edged up modestly, driven by oil and wheat prices, and the authorities have appropriately begun to tighten monetary policies to ensure that inflation targets are met. The central bank will respond to contain inflationary pressures in a measured way that does not disrupt the momentum of the incipient growth which has set in this year. The external situation has been consolidated with a continued current account surplus, excluding official transfers, a strong reserve position, and a broadly stable Pakistani rupee, reflecting buoyant export performance and private transfers. This has allowed Pakistan to pre-pay expensive external debt to the Asian Development Bank, thus reducing external vulnerabilities and future debt servicing requirements. The higher-than-projected imports, increase in oil prices, and repayments of external debt by private and public sector borrowers has led to effective depreciation of the rupee in the recent months and the pressures for appreciation have subsided.

The overall fiscal deficit in the first half of 2003/04 was much lower than targeted, reflecting improved revenue collection and lower spending. Nonetheless, social- and poverty-related expenditures (under the program definition) are well on track to reach their annual target of 4.2 percent of GDP. The higher-than-projected growth of monetary aggregates originated mainly from higher net credit to the private sector, which is an encouraging sign that financial intermediation is strengthening and supporting economic growth across all sectors. Of particular note is the successful return of Pakistan to the international capital markets with a Eurobond issue which was hugely oversubscribed, thus taking the first step of a smooth transition from PRGF to market financing as the current arrangement expires.

Solid progress was made in implementing structural reforms. Except for some technical delays, all structural performance criteria and benchmarks under the program were met. Habib Bank Limited was privatized, and more than 75 percent of the banking sector is now in private hands. Returns on National Savings Schemes certificates were adjusted in line with Pakistan Investment Bond yields in January 2004, and a simplified and more transparent alignment formula has been prepared to become effective as of July 2004. A medium-term budget framework is being developed, with pilot costing and projection exercises in the health and the population welfare ministries. The new accounting model will be used for the 2004/05 federal budget. KESC and WAPDA are well on track to meet their respective financial improvement plan targets, and NEPRA determined electricity tariffs have been implemented. Progress has been made towards the unbundling of WAPDA, and a regional electricity tariff framework has been announced. A report on the benami practice was prepared, and the authorities are now in the process of drafting a law that would limit the enforceability of benami transactions and holdings. The PRSP, which was published in December 2003 after a widespread consultation process, has outlined the future reform agenda envisioned to achieve high and sustained growth and substantially reduce poverty over the medium term.

Financial System Stability Assessment (FSSA)

My authorities appreciate the open and constructive discussions during the Financial Sector Assessment Program mission that finally took place after several delays. The FSSA documents the many reform achievements in the financial sector, in particular the successful transformation of a state-dominated and weak banking system into one that is predominantly privately owned and characterized by significantly improved financial soundness indicators. As a result of the reforms, the financial system shows improved resilience to risks. Many of the issues raised in the FSSA to consolidate reform gains are being addressed in the authorities’ reform program.

The outlook for FY 2004/05

The authorities intend to continue fiscal prudence and envisage some further modest tightening of monetary policy to maintain the low inflation environment. Against this background and with increasing private and public investment, they are more optimistic than staff and expect the current growth momentum to continue in 2004/05 and accelerate over the medium term.

Fiscal policy will be geared towards further debt reduction, while raising social and poverty-related spending as well as public investment to remove infrastructure bottlenecks, which is crucial for sustained high growth. Central Board of Revenue collection is being strengthened through base broadening, elimination of additional income and sales tax exemptions, and further improvement in administrative efficiency. Falling interest expenditures would provide additional fiscal space. The authorities decided to buffer the impact of the recent dramatic increase in oil prices through a temporary reduction in petroleum tax rates. This became necessary to safeguard growth and to insulate vulnerable groups from dramatic cost of living increases. With oil prices falling somewhat from their peak, tax rates have been increased again and will eventually be restored. Any possible revenue loss will be offset within the budget envelope, while social and poverty related expenditures will be protected.

Monetary policy will aim at maintaining low inflation. Weak import prices of most nonenergy products, the strong Pakistani rupee, and the positive outlook for agricultural products are expected to limit further increases in inflation. Nevertheless, in light of the rapid pace of monetary expansion, the low level of short-term interest rates, and average inflation close to target, the authorities will continue to closely monitor inflation developments. The process of gradual and modest tightening will continue for some time and will be accelerated in case inflationary pressures do not subside. The authorities will limit foreign exchange interventions to smoothing short-term fluctuations and will not resist exchange rate appreciation which should reduce the rate of monetary expansion from NFA accumulation.

The authorities remain committed to pursuing their structural reform agenda in order to strengthen the economy’s growth potential and resilience to shocks. Several public enterprises, including KESC, are slated for privatization in light of growing investor interest as security concerns subside. The authorities are working closely with the World Bank to draw up a medium-term financial recovery plan for WAPDA that will curb demands on the budget while improving service delivery at competitive tariff rates. WAPDA’s unbundling and the regional tariff framework will significantly contribute to this process.

In the financial sector, the FSSA recommendations will be taken up in the authorities’ reform strategy. In particular, anti-money laundering legislation will be submitted to parliament soon. The authorities are also preparing the broad parameters of a private pension scheme. Over the medium term, the National Savings Schemes will be transformed into a modern savings institution, probably in the form of a mutual fund.

Conclusion

Pakistan has come a long way in a short time. Some five years after a debt crisis and a serious slowdown in economic growth, the country is emerging under the PRGF-supported program with a stronger economy, set for continued high and sustained growth that will translate into durable reduction of poverty. Macroeconomic performance has improved markedly, external vulnerabilities have been reduced, and Pakistan has regained access to private capital markets. Fund’s advice and financial assistance have been important and highly valued inputs in the reform process.

As announced during the discussions under the sixth and seventh reviews, and as reiterated during the Budget Speech, the authorities remain strongly committed to exiting from Fund-supported programs once the current arrangement expires. However, they have repeatedly stated that exit from Fund arrangements does not mean abandoning the orderly and disciplined economic management painfully achieved. Indeed, they see that inconsistency and disruptive policy changes in the past were the major factors hindering Pakistan’s ability to exploit its full potential. My authorities are grateful for the Fund’s support and hope that they could continue to draw on its advice through regular consultation and technical assistance. They look forward to the Board discussion and advice as well as support for their request for waiver of non-observance of structural performance criteria, modification of one performance criterion, and completion of the eighth review under the PRGF arrangement.