I. Overview

1. Pakistan needs to continue its recent record of strong policy implementation to realize its development objectives outlined in the Poverty Reduction Strategy Paper (IMF Country Report No. 04/24). Sustaining high growth while maintaining macroeconomic stability and reducing fiscal as well as external vulnerabilities can be achieved if macroeconomic policies and structural reforms are fully coordinated. The following six chapters analyze some important policy areas that are crucial in this regard. Growth will require increased physical as well as human capital investment in addition to macroeconomic stability including through price stability. Fiscal policy needs to be geared toward generating the resources to finance the government’s share of social expenditure and investment. Containing the drain from public sector enterprises and interest costs on the budget will contribute to this. Further trade liberalization and integration would also support growth in the medium to long term.

2. Raising investment and improving institutions are key to raising Pakistan’s potential growth. Chapter II presents cross-country regression results that identify investment in physical capital and improvements in institutional quality as having the largest pay-off in terms of increased growth. In addition, better education and health care also boost growth. Therefore, Pakistan needs to raise its investment rate, institutional quality, as well as health and education indicators to levels achieved by South-East Asian countries such as Malaysia, Singapore, and Thailand, if it wants to emulate the stellar growth performance achieved by these countries.

3. Quantitative inflation forecasts can assist monetary policy in achieving its inflation target. Chapter III employs three approaches to forecast inflation in Pakistan. A leading indicator model outperforms an univariate autoregressive moving average model as well as a vector autoregressive model in terms of forecast quality. The leading indicators model would have anticipated the rapid acceleration of inflation over the last fiscal year and thus provided early cues that monetary tightening was required. For the remainder of this fiscal year, the model forecasts a further acceleration, supporting staffs advice that a more forceful tightening is needed. The chapter also finds that Pakistan could adopt inflation targeting if it were to make a medium-term inflation target the primary objective of monetary policy.

4. Ongoing reforms and continued economic growth are expected to raise Pakistan’s tax revenue yield by at least 1 percent of GDP over the next five years. Fiscal revenues need to be strengthened to provide the space needed for social and development spending while reducing the still high debt to GDP ratio. Chapter IV finds that Pakistan has a low revenue-to-GDP ratio compared to countries in the same per capita GDP range. Recent tax policy measures have made the tax system more efficient, though some of them may have been revenue-reducing. Looking ahead, Pakistan’s revenue take should be lifted through administrative reforms of the Central Board of Revenue and base broadening including through further extending the sales tax into the service sector and better taxation of agriculture income. In fact, these reform efforts, if implemented steadfastly, could yield more than the 1 percent of GDP increase in revenues currently targeted by the government.

5. Financial performance of public sector enterprises (PSEs) can be substantially strengthened through management reforms. Chapter V presents three case studies of Pakistani PSEs that have recently witnessed strong improvements in their financial performance. All three PSEs were plagued by poor governance and imposed a significant burden on the budget. In two cases, new management teams were successful in fundamentally turning their businesses around by focusing on service delivery, downsizing overstaffed workforces, and controlling costs in general. Prepayment of expensive debt as well as debt write-offs by the government also contributed in this regard.

6. Comprehensive public debt management is still at an early stage, though much progress has recently been made. Chapter VI takes stock of current debt management policies and identifies vulnerabilities and policy challenges. Domestic financing is presently cheaper than financing through international capital markets. Nevertheless, developing a presence in international capital markets and—to a lesser extent—establishing a sovereign curve, are arguments for modest and cautious tapping of international capital markets. The government has started to hedge currency and interest rate risk. However, the government has also exposed itself somewhat to the risk of rising interest rates by relying heavily on short-term domestic financing and engaging in an interest rate swap on its recent Eurobond issue.

7. The potential benefits of expanding trade between Pakistan and India from the current low levels are large. Chapter VII takes stock of existing trade barriers and finds that the reduction of tariff and nontariff barriers, including through the prospective South Asian Free Trade Area, holds the potential for large benefits for Pakistan. Existing trade barriers span the full spectrum of tariff and non-tariff barriers. In addition, foreign direct investment which is typically associated with trade is also low between the two countries. Benefits of well-implemented trade liberalization can include lower prices and more choice for consumers, increased efficiency and larger markets for exporters, an increase in economic growth, and support to the broader process of regional integration.