Background

As described well by staff, Pakistan has come a long way since the 1998/99 crisis when only moderate rates of growth could be achieved, international reserves had been depleted, and sustained macroeconomic stability was difficult to attain. Prudent economic management in the context of a Fund-supported arrangement has turned the economy around. The country is now positioned to achieve sustained high growth, accelerate poverty reduction, be able to compete with its regional peers, and to exit from Fund financial support.

Since then, progress continues to permeate all areas of the economy. As a priority, macroeconomic situation has been stabilized. While strong external support contributed to this outcome, as illustrated in Box 1 of the staff report, to a large extent, policies that led to stability were “homemade” and the result of a strong domestic commitment and adjustment effort. Fiscal consolidation has taken hold through revenue and expenditure reforms, contributing to entrenched macroeconomic stability. The strengthened fiscal position was also helped by higher grants as well as improved non-tax revenue and lower borrowing costs, resulting from improved macroeconomic policies and financial reforms, thus creating space for private sector activity. Despite two years of severe drought and the September 11 shock, the economy attained growth rates that compare favorably with earlier years. The external position improved significantly with strong donor support and large inflow of remittances—a reflection of enhanced confidence in the economy—while the rupee strengthened and reserves rose substantially.

Wide-ranging reforms have increased resilience of the economy. In the financial sector, reforms allowed the flow of private capital and expertise into the sector, and reinforced supervision enhanced competition and efficiency. The trade and exchange system has been liberalized further to minimize distortions, improve allocative efficiency, and reduce incentives for corruption and rent seeking. State intervention in the economy was reduced to allow the private sector to spearhead growth, while the regulatory framework for parastatals has been reinforced to improve their efficiency and protect consumers. Governance reforms are aimed at strengthening transparency and accountability in public resource management, including at decentralized level of government. Social- and poverty-related spending has increased. The Prime Minister’s retention of his erstwhile finance portfolio is evidence of the authorities’ commitment to financial discipline as well as to policy and reform continuity.

Recent economic developments

Implementation of the PRGF-supported program remains on course, with quantitative performance criteria and indicative targets for end-June observed. Most structural performance criteria were met, while action has been taken to correct those that were missed, or to mitigate their negative effects, and, on that score, the authorities request their waiver. Real GDP growth accelerated to 6.4 percent in 2003/04. However, propelled by higher wheat and energy prices and rapid expansion of credit to support growth, inflation exceeded the target. The current account surplus was also lower than projected as higher imports more than offset larger private transfers. The increase in imports that has widened the trade deficit and narrowed current account surplus in FY 2004 is primarily due to 45 percent growth in imports of capital goods and 41 percent expansion in imports of raw materials for capital goods. This contributed to 17 percent growth in large scale manufacturing that in turn led to 6.4 percent of GDP growth rate. The authorities believe that this is a virtuous cycle that was needed by Pakistan to get back on the high growth path. Despite a somewhat weaker capital account, reserves increased to $10.6 billion at end-June, equivalent to six months of import cover.

An improving fiscal performance was better than projected, driven by strong revenue collection—reflecting the buoyant economy and improved efficiency—and lower spending. As a result, domestic debt fell below 70 percent of GDP from its peak of 89 percent in 2000/01. Social- and poverty-related spending as well as development expenditure exceeded projections. In response to rising inflation and strong monetary growth, the State Bank of Pakistan has recently tightened policy by increasing short-term interest rates. It is worth noting that, after a long period of stagnation, Pakistan recorded an increase in investment rate by 22 percent. This was possible because of the expansion in private sector credit from the banking system which was broad-based and shared by corporate sector, SMEs, agriculture and household sector for consumer financing. The backward and forward linkages to production and services were quite strong and the growth rate would have been stifled in absence of this domestic demand stimulated by the private sector credit. Inflationary consequences of this rapid private sector credit growth have been contained as the demand for credit by the public sector has been curtailed in the last two years through reduction in fiscal deficit and net retirement of debt by the public sector enterprises. The government borrowing in FY 2004 has risen for a one off prepayment of ADB loan of US$1.17 billion.

Further progress was made in implementing structural reforms. In the important energy sector, the restructuring plan was completed with the unbundling of the Water and Power Development Authority (WAPDA) into separate generation, transmission, and distribution companies. Encouragingly, the two power utilities exceeded their projected financial performance for 2003/04. Broad principles were issued for the determination of regional electricity tariffs in June, although the final cost-recovery structural tariff remains to be completed. The Financial Recovery Plans (FRPs) for the distribution companies were delayed pending determination of the structural tariffs. The government announced an electricity subsidy policy in November aimed at ensuring cost recovery while providing consumer protection. A timetable has been set for phasing out subsidies by 2010.

Significant steps were taken in the 2004/05 Budget to remove income and sales tax exemptions and broaden the tax base, although some new exemptions with minor budgetary impact were introduced aimed at addressing anomalies and discriminatory practices. To further strengthen governance, discussions are held among stakeholders on the drafting of the Benami legislation, which is expected to be submitted to Cabinet in 2005. In the financial sector, the restructuring and privatization agenda has been almost completed following the sale of Habbib Bank Limited (HBL) in August and the transfer of Allied Bank Limited (ABL) into private ownership through the sale of additional shares, leaving only the National Bank of Pakistan under major government ownership. The authorities are taking anti-money laundering measures seriously and have issued regulations that require reporting of suspicious transactions and set out minimum records-keeping standards.

Policies going forward

Building on the steady progress made in the past several years, the strategy going forward aims at sustaining macroeconomic stability, further accelerating growth, and reducing poverty. A steadfast implementation of sound financial policies and market-oriented structural reforms is considered critical to fulfilling these tasks. In 2004/05, growth is projected to reach 6.5 percent, building on the current momentum and assuming favorable weather conditions. Over the medium term, it will be necessary to reach growth rates of around 8.0 percent in order to achieve the desired trend in poverty reduction. Average inflation is expected to increase to 7.0 percent mainly reflecting food, particularly wheat price increases in 2004/05, before dropping to 4.0 percent over the medium term as tighter monetary policy and measures to regularize conditions in the wheat market take hold. Available evidence suggests that efforts at containing inflation through government successive importation of wheat and tightening monetary policy have been successful in reducing the momentum of CPI increases.

The analysis in the Selected Issues paper (SIP) demonstrates that achieving higher rates of growth that would match the performance of South-East Asian countries would require, as a priority, higher investment, including in human capital. In that regard, the authorities intend to attract higher foreign savings, preferably in the form of FDI, to supplement domestic savings and investment. Spending on education and health will increase in order to enhance human capital and labor productivity. The importance of improving the quality of the country’s institutional framework, which the SIP confirms to be an important driver of growth, is well recognized. In that connection, governance and the legal and regulatory framework will be strengthened. A sizable improvement in productivity in the agricultural sector is also crucial to accelerated growth and poverty reduction, given the size of the sector and the higher poverty incidence in the rural areas. On that score, the sector is receiving strong attention, including through improvement of water availability, in order to address a key constraint to agricultural growth. The development of physical infrastructure is also receiving large budgetary allocations, given its importance for growth.

The fiscal strategy for 2004/05 and the medium term aims to balance the need for increased social and development spending with a further reduction in the debt burden in line with the path set out in the PRSP and the draft Fiscal Responsibility Law (FRL). The overall fiscal deficit will be limited to around 3.0 percent of GDP over the medium term, while the public debt-to-GDP ratio will decline to about 50 percent by 2008/09. The Central Board of Revenue (CBR) reform project, supported by the World Bank, aims to move to a functional organization that relies on self-assessment and risk-based auditing in order to render revenue collection more efficient and taxpayer-friendly.

While monetary policy will be directed to achieve the inflation targets in the PRSP, supporting growth and stemming excessive exchange rate fluctuation are important objectives and, as staff suggest, the SBP will strive to achieve an appropriate balance between them. Analysis of the SIP on inflation forecasting and the prospect of inflation targeting in Pakistan provide useful policy guidance. The authorities also take note of and intend to take appropriate action regarding the role of private sector credit growth in inflation trends as well as the potential risks for banks’ balance sheets. Financial sector reforms have significantly increased private sector participation and improved efficiency and resilience of the banking system as well as financial intermediation, as confirmed by the recent FSSA. The authorities will ensure that banking supervision remains in compliance with international standards. As noted in the staff report, Pakistan’s exchange rate policy has served it well, contributing to strong export growth, high reserves, and increased confidence in the rupee. The authorities will limit intervention to smoothing excessive exchange rate fluctuations and will ensure that the exchange rate continues to be market-determined and to safeguard Pakistan’s external competitiveness.

Structural reforms aim at fostering growth, long-term macroeconomic sustainability, and accelerated poverty reduction. Building on the strong improvements in the financial performance of major public sector enterprises (PSEs), as confirmed by the SIP study, reform and divestiture of PSEs, particularly in the power sector, will continue. The goal is to gradually transfer the sector into private ownership and, in that connection, major companies will be offered for sale in 2004/05. Furthermore, majority stakes will be sold in Pakistan State Oil and National Refinery Limited. Work on its medium-term adjustment program, supported by the World Bank, will aim at increasing efficiency and reducing the drain on the budget.

Pakistan continues to liberalize its trade regime—including lowering tariff rates and customs duties and reducing tariff bands—in furtherance of regional trade integration, increased efficiency, larger export markets, and expanding consumer choices. Pakistan needs to position itself to offset possible loss of preferential status for clothing and textiles to the EU in early-2005. The SIP highlights potential benefits of increasing trade with India, which is receiving attention in the context of a prospective South-Asian Free Trade Area.

The authorities recognize the need to deepen the poverty and social impact analysis of their policies. In this context, comprehensive surveys have been launched recently, which are expected to provide greater insight into poverty incidence, geographical distribution, and trends to assist in better targeting and enhancing effectiveness of poverty-related spending and other social interventions. The strategy to continue to reduce poverty with greater social inclusion, notably through devolution of political and economic power. In this regard, provincial and local governments will have the responsibility of provision of key social services. Efforts to strengthen political empowerment will be buttressed by administrative and financial devolution to enable the lower levels of government to carry out their increased responsibilities more effectively.

The authorities acknowledge the potential risks highlighted by staff and consider the best mitigating response is to remain firmly committed to policy continuity and to implement sound policies that sustain stability and achieve high growth, while strengthening the economy’s resilience. Staffs analysis confirms that the public debt declines substantially under alternative growth scenarios, while stress tests indicate robustness to a number of downside risks. Nevertheless, the authorities intend to remain vigilant and take whatever steps necessary to stay the course. Noting staff suggestions in the SIP, the authorities intend to pursue a prudent debt management policy, including through balancing the costs of borrowing from domestic and international debt markets. They will also finalize the remaining rescheduling agreements with Paris Club and non-Paris Club bilateral creditors, while continuing to seek grant financing from other official creditors.

Conclusion

Considering Pakistan’s improved external position and the need to free concessional resources for the benefit of more needy countries, the authorities have decided not to draw the final tranche of the PRGF arrangement. In the period ahead, they intend to access domestic and international markets, complemented by support from official creditors, to meet Pakistan’s financing needs. Already, Pakistan successfully re-entered the international capital markets. While exiting from the PRGF arrangement, the authorities remain committed to implementing sound policies and strong reforms in line with the PRSP to ensure sustained high growth, job creation, and poverty reduction. Close collaboration and dialogue with the Fund will be maintained in the context of the surveillance mechanism, vital to sustaining the quality of policies and programs and in signaling to donors and financial markets. Pakistan continues to count on the international community to support its economic development efforts and progress toward the MDGs.

As always, my authorities look forward to the Board discussion of this review and express their gratitude for the hard work of the staff as well as for the advice and support of management and the Executive Board.