Pakistan: Staff Report for the 2004 Article IV Consultation, Ninth Review Under the Three—Year Arrangement Under the Poverty Reduction and Growth Facility, and Request for Waiver of Performance Criteria

This paper focuses on Pakistan’s 2004 Article IV Consultation, Ninth Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility (PRGF), and Request for Waiver of Performance Criteria (PCs). Implementation of the PRGF program in Pakistan remains broadly on track. All quantitative PCs and indicative targets for end-June 2004 were met. Structural reforms continue to be advancing, although four structural PCs were breached. A temporary intensification of an existing and the imposition of a new exchange restriction, however, were quickly reversed, and new tax exemptions have been offset by other tax measures.

Abstract

This paper focuses on Pakistan’s 2004 Article IV Consultation, Ninth Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility (PRGF), and Request for Waiver of Performance Criteria (PCs). Implementation of the PRGF program in Pakistan remains broadly on track. All quantitative PCs and indicative targets for end-June 2004 were met. Structural reforms continue to be advancing, although four structural PCs were breached. A temporary intensification of an existing and the imposition of a new exchange restriction, however, were quickly reversed, and new tax exemptions have been offset by other tax measures.

I. Introduction

1. In the attached letter dated November 12, 2004 and the accompanying Memorandum of Economic and Financial Policies (MEFP), the government of Pakistan requests completion of the ninth and final review under the PRGF arrangement. The authorities also request waivers for the nonobservance of four structural PCs. While the tenth disbursement is conditional upon completion of this review, the authorities state in the attached letter that they will not draw the final tranche.

2. The political and security situations remain complex. A new government was announced in August 2004. Prime Minister Aziz retained the finance portfolio, which bodes well for the continuation of reforms. Pakistan’s National Assembly has approved a bill to allow President Musharraf to continue as both president and army chief, much to the ire of the opposition. Operations against militants in the border areas are ongoing and have prompted retaliation from affected groups, including an attempt on the prime minister. The dialogue with India is progressing, though differences over Kashmir remain.

II. Background

3. As part of the Article IV consultations, the staff took a fresh look at developments and reforms since the 1998/99 crisis, and particularly performance under the 2000 Stand-By Arrangement and the subsequent PRGF arrangement. By 1998/99, Pakistan had virtually run out of foreign exchange reserves and public debt obligations were not being met. Economic growth had slowed to an average of below 3 percent in 1996/97–1998/99. The Stand-By Arrangement focused therefore on restoring macroeconomic stability. The subsequent PRGF arrangement centered on further strengthening macroeconomic stability, raising growth, and reducing poverty.1 The PRGF arrangement included wide-ranging structural reforms, focusing on revenue administration, expenditure management, and the energy and financial sectors. Unlike under previous programs, quantitative targets were mostly met or exceeded, and structural reforms measures were largely followed through, though in some cases with delays.

4. The fiscal and monetary policy mix yielded quick macroeconomic stabilization (Table 1, see also Box 1). Significant fiscal consolidation was achieved largely by savings on the interest bill and increases in nontax revenues. The resulting fiscal space was used to reduce government debt while raising social- and poverty-related spending. Monetary policy was tightened immediately after the crisis, and inflation was brought down successfully. Large remittances strengthened the Pakistani rupee and helped to achieve an unprecedented accumulation of foreign exchange reserves. This allowed the SBP to reduce interest rates, stimulating growth and benefiting the budget, though very recently inflation has increased modestly. Taken together, Pakistan successfully reduced external vulnerabilities, though debt remains high.

Table 1.

Pakistan: Selected Economic Indicators, 2000/01–2004/05

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

Program as updated during the eighth review (IMF Country Report No. 04/211). Program numbers where possible recalculated using the new, rebased GDP series.

Includes public sector enterprises and changes in inventories.

Expenditures included in the Public Sector Development Program.

Including the statistical discrepancy.

Including KESC recapitalization and CBR bonds in 2001/02.

Program data for 2002/03 and 2003/04 are evaluated at program exchange rates.

Including interest on short-term debt.

Current-year interest payments devided by previous period debt stock.

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.

Pakistan’s Macroeconomic Improvement—Windfall or Homemade?

Of great interest in both Pakistan and abroad has been the question of whether the stronger macroeconomic situation stems primarily from an improved external setting in the aftermath of the September 11, 2001 events, or because of domestic adjustment. Many, sometimes complex, external factors have affected Pakistan’s economy. On the positive side, Pakistan has benefited from higher external grants and remittances, and increases in textile and clothing quota allowances. On the negative side, Pakistan has suffered from high petroleum prices, a prolonged drought (2000–02) and the perception of a worsened security situation. These factors are not easily quantified, but a decomposition of the fiscal and external accounts can shed some light on the contribution of external versus domestic factors.

Pakistan: External Performance, 1993/94–2003/04

(in millions of U.S. dollars)

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Private net income, transfers and capital flows; and commercial bank reserve accumulation.

Official income, transfers and capital flows; exceptional financing; and privatization receipts.

On the external side, domestic adjustment seems to have been the key to the macroeconomic improvement, although external factors played some role. The main element underscoring the increase in reserve accumulation was an improvement in the trade and nonfactor service accounts (see table). This was helped by higher defense receipts ($676 million) and increased access to foreign markets, but also by strong performance of Pakistan’s export-oriented industries. Higher defense receipts reflected payments to cover costs in the war against terror. Moreover, strong reserve accumulation was helped by higher remittances. The latter may partly reflect the tighter scrutiny of financial holdings of Pakistanis living in some industrialized countries, providing an extra incentive to transfer funds to Pakistan. However, it also reflects efforts to bring informal remittances into the official net, and enhanced confidence in the Pakistani rupee and in Pakistan’s financial system. By contrast, official flows have not contributed to Pakistan’s reserve build-up, as higher gross inflows merely helped to meet the increase in Pakistan’s external obligations. On the fiscal side, the improvement in the overall balance (including grants) was helped by significantly higher grants, but were facilitated also by improvements in nontax revenue (including defense receipts), along with substantial savings on domestic interest expenditure (see table). Lower domestic borrowing costs reflected improved macroeconomic policies and financial reforms.

Pakistan: Fiscal Performance, 1993/94–2003/04

(in percent of GDP)

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uA01fig01

Fiscal Adjustment

(percent of GDP)

Citation: IMF Staff Country Reports 2004, 411; 10.5089/9781451830637.002.A001

Source: Pakistani authorities.
uA01fig02

CPI Inflation, Real GDP Growth, and Reserves

Citation: IMF Staff Country Reports 2004, 411; 10.5089/9781451830637.002.A001

Source: Pakistani authorities; and Fund staff estimates and projections.1/ In months of next year’s imports of goods and nonfactor services.

5. Growth has recovered from crisis and adverse circumstances. After emerging from the financial crisis, a severe drought, and the post-September 11 environment, Pakistan’s growth performance compares well with regional peers. Initially, net external demand supported growth. However, in 2003/04, the contribution of net external demand turned negative and domestic demand has taken over as the engine of growth.

uA01fig03

U.S. Dollar GDP Growth in Regional Comparison

(in percent)

Citation: IMF Staff Country Reports 2004, 411; 10.5089/9781451830637.002.A001

Source: World Economic Outlook.
uA01fig04

Contribution to GDP growth

(in percent)

Citation: IMF Staff Country Reports 2004, 411; 10.5089/9781451830637.002.A001

Source: Pakistani authorities.
uA01fig05

Per-capita GDP

Citation: IMF Staff Country Reports 2004, 411; 10.5089/9781451830637.002.A001

Source: Pakistani authorities; Fund staff estimates and projections.

6. There is no clear evidence yet on poverty trends, reflecting a lack of comparable current data (see Box 2). Encouragingly, per capita GDP has grown significantly. Social- and poverty-related expenditures have been raised to 4.7 percent of GDP in 2003/04, from 3.8 percent of GDP in 2001/02. However, many intermediate outcome indicators for the health and education sectors have yet to show significant improvements (Table 2). This may partly reflect the still limited administrative and institutional capacity at the local government level that continues to be a constraint to rapid progress in poverty reduction. Meanwhile, real wages in the manufacturing sector have declined by 7½ percent in real terms since 2000/01. Pakistan is still ranked low in the 2004 UNDP human development index. Overall, poverty remains widespread and Pakistan faces a major challenge in trying to meet its Millennium Development Goals (Table 3).

Table 2.

Pakistan: Intermediate Outcome Indicators, 2000/01–2003/04

(In percent, unless otherwise indicated)

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Sources: Pakistani authorities; and Fund staff calculations.PRSP Secretariat, PRSP–Fourth Quarter Progress Report FY2003/04, September 2004.

Lady health workers are outreach workers providing preventive health and family planning services through house-to-house visits.

Table 3.

Pakistan: Millennium Development Goals, 1990–2015 1/

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Source: World Development Indicators.

Targets 12–15 and indicators 32–44 are excluded because they can not be measured on a country specific basis. These are related to official development assistance, market access, and the HIPC initiative.

uA01fig06

Social Spending

(real per-capita growth in percent)

Citation: IMF Staff Country Reports 2004, 411; 10.5089/9781451830637.002.A001

Source: Pakistani authorities; Fund staff calculations.

Poverty Trends

A government survey conducted in early 2004 suggests that poverty has fallen over the last three years. The survey showed a decline by 4 percentage points in the poverty rate, to 23 percent. However, the results of this survey are not fully comparable with those from earlier household surveys, as its sample size was much smaller and the poverty line may have been underestimated. But even taking this into account, the recent survey does seem to indicate a positive trend. Other, more comprehensive surveys have been launched recently (MEFP, paragraph 25), but their results will only become available in the second half of 2005. A firm assessment of poverty trends cannot be made until the results of these surveys are known. Reports from nongovernmental organizations and labor unions meanwhile claim that the poor have yet to benefit from the recovery and that inequality has been rising in recent years.

7. Structural reforms aimed at establishing a modern economy were successful in many areas. The banking sector is more competitive and efficient following restructuring and privatization, as well as the strengthening of supervision and prudential regulations.2 Foreign exchange transactions have been further liberalized, including through allowing banks to purchase foreign exchange from money changers. Finally, Pakistan has liberalized its trade regime substantially in recent years, reducing tariffs and removing most nontariff barriers.

8. Fiscal reforms also made progress. The revenue system has been strengthened through administrative reforms, the introduction of universal self-assessment, as well as reductions and rationalizations of customs tariffs and tax rates. However, despite these reforms, revenue collection has strengthened only modestly in recent years, and Pakistan’s revenue-to-GDP ratio remains low in international comparison.3 Improvements have been made in expenditure releases and fiscal reporting, but systems still have to catch up with the devolution process. In a few areas, the legislative agenda still has to be completed, including the implementation of the fiscal responsibility, benami,4 and anti-money laundering laws.

9. The role of the state in the economy has diminished and governance improved. Governance in fiscal and financial management has been strengthened, but weaknesses remain in the energy sector, tax and local administration, and the police. Regulatory agencies to protect the consumer and ensure stability have been established in many areas, while the Water and Power Development Authority (WAPDA) has been split into smaller companies to improve governance and facilitate privatization. However, government intervention continues to be evident in the wheat and cotton markets and in the pricing of petroleum products and electricity, which has undermined the budget. Political devolution has laid the groundwork for improving social service delivery, but full administrative and financial empowerment of local governments is still lacking.

III. Recent Performance Under the PRGF Arrangement

10. The PRGF program is broadly on track. All quantitative PCs and indicative targets for end-June 2004 have been met (see MEFP, Table 1a). Moreover, all but four structural PCs have been met (see MEFP, Table 2, and Box 3).

Structural Conditionality

1. Coverage of structural conditionality for the last review under the PRGF program

The focus of structural conditionality for the last review has been on broadening the tax base, strengthening tax and customs administration, and advancing electricity sector reforms (MEFP, Table 2). The large number of energy sector measures reflects the importance of this sector for the achievement of macroeconomic objectives, notably fiscal consolidation, as well as frequent delays in implementing reforms in this sector.

2. Status of structural conditionality from earlier reviews

Despite some delays, all of the structural conditionality has been largely met. Some tax exemptions that should have expired were extended, while some new exemptions were introduced. The impact on the budget, however, has been negligible.

3. Structural areas and conditionality covered by World Bank lending

The World Bank approved in September the first of three Poverty Reduction Support Credits. Conditionality aims predominantly at (a) maintaining macroeconomic stability; (b) accelerating power and gas sector reforms; (c) increasing fiscal space for health and education expenditures; and (d) improving governance through (i) reforms in financial management, procurement, and other anti-corruption and accountability institutions; (ii) civil service reform; and (iii) devolution, through the transfer of increased resources to lower levels of government.

11. Macroeconomic performance is strong, but inflation is edging up. Real GDP growth accelerated to 6½ percent in 2003/04 (July–June), driven by large-scale manufacturing (see also Box 4 on recent revisions to the national accounts). On the demand side, there was an encouraging pickup in private and public investment, as well as consumption—in particular consumer durables. Inflation accelerated throughout 2003/04, reflecting pressures emanating from the partial liberalization of the wheat market, rising oil prices, as well as domestic demand supported by easy monetary conditions. Twelve-month consumer price inflation reached 9 percent in September 2004, with nonfood, nonenergy (core) inflation at 6.8 percent.

uA01fig07

Inflation

(year-on-year, in percent) 1

Citation: IMF Staff Country Reports 2004, 411; 10.5089/9781451830637.002.A001

Source: Pakistani authorities.1/ Last observation refers to September 2004.
uA01fig08

Economic Activity

(growth in percent)

Citation: IMF Staff Country Reports 2004, 411; 10.5089/9781451830637.002.A001

Source: Pakistani authorities; Fund staff estimates and projections.
uA01fig09

Investment and Saving

(in percent of GDP)

Citation: IMF Staff Country Reports 2004, 411; 10.5089/9781451830637.002.A001

Source: Pakistani authorities; Fund staff estimates and projections.

12. The budget overperformed in 2003/04. Strong Central Board of Revenue (CBR) collection and possible underspending at the provincial level contributed to an overall deficit (excluding grants) of 2.4 percent of GDP, some 0.8 percent of GDP better than programmed (Tables 4 and 5).5 CBR collection reflected the buoyant economy and administrative efficiency gains, which offset some revenue-reducing measures in the 2003/04 budget. Encouragingly, the target for social spending was met (Table 6). Support to public enterprises, and particularly power utilities, was reduced, reflecting better financial performance by these entities.

Table 4.

Pakistan: Consolidated Government Budget, 2000/01–2004/05

(In billions of Pakistani rupees)

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

Program as agreed during the eighth review (IMF Country Report No. 04/211).

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).

Figures for 2004/05 incorporate an expanded definition, in line with the full PRSP, including items such as law and order, justice, low cost housing, and village electrification, adding nearly 1 percent of GDP.

Table 5.

Pakistan: Consolidated Government Budget, 2000/01–2004/05

(In percent of GDP; unless otherwise indicated)

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

Program as agreed during the eighth review (IMF Country Report No. 04/211).

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).

Figures for 2004/05 incorporate an expanded definition, in line with the full PRSP, including items such as law and order, justice, low cost housing, and village electrification, adding nearly 1 percent of GDP.

Table 6.

Social- and Poverty-Related Expenditure (PRSP Expenditure), Cumulative 1/

2000/01–2003/04

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Source: Pakistani authorities; World Bank; and Fund staff estimates and calculations.

In 2003/04, the authorities have extended their definition of social- and poverty-related expenditure by law and order, justice, low cost housing, village electrification, and Tawana Pakistan. Data revisions have been made as of 2001/02.

uA01fig10

Fiscal Deficit and Government Debt

(percent of GDP)

Citation: IMF Staff Country Reports 2004, 411; 10.5089/9781451830637.002.A001

Source: Pakistani authorities; Fund staff estimates and projections.

Rebasing of National Accounts Statistics

In the spring of 2004, the Federal Bureau of Statistics completed a revision of Pakistan’s national accounts statistics. The objective was to bring Pakistan’s national accounts closer in line with the 1993 UN System of National Accounts. As part of the exercise, the base year was moved from 1980/81 to 1999/2000. The new statistics capture better the changes that have occurred in the Pakistani economy in the past 20 years, as several areas of economic activity had been either seriously underestimated or not captured at all.

The rebasing exercise resulted in GDP estimates for 1999/2000 and following years that were almost 20 percent higher compared to the old base estimates. This, however, leaves the fundamental policy assessment largely unchanged. Per capita income, while improved, remains low. The debt-to-GDP ratio is lower, but is still relatively high. Revenue collection and social spending now appear even lower in the relation to the new GDP, underscoring the need for continued policy efforts.

Pakistan: Effects of the Rebasing of National Accounts

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Sources: Pakistani authorities; and Fund staff estimates.

13. The SBP has started to tighten monetary policy. Rapid growth of broad money has been driven predominantly by strong private sector credit growth, fueled by low interest rates and ample bank liquidity (Tables 7 and 8). The SBP has raised treasury bill (TB) cut-off rates in recent months; the six-month TB rate was increased by around 100 basis points between January and August 2004, and by another 39 basis points in September 2004. Policy makers resisted market pressures to tighten more quickly in an effort to balance inflation and growth objectives. Real interest rates for maturities up to three years remain negative.

Table 7.

Pakistan: Monetary Survey, 2000/01–2004/05

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

At indicative program exchange rate.

Program column is the revised projection published in IMF Country Report No. 04/211.