Statement by Abbas Mirakhor, Executive Director for Pakistan and Iqbal Zaidi, Senior Advisor to Executive Director

This 2005 Article IV Consultation for Pakistan reports that macroeconomic performance continues to be strong, but inflation and external pressures are evident. High growth, including in agriculture, is estimated to have raised disposable incomes. The authorities’ ambitious growth objectives require substantial increases in investment, including from the private sector. Public investment has been increased to ease bottlenecks in transportation, irrigation, and energy. In the short term, macroeconomic policies need to be tightened somewhat to counter inflation and external pressures.

Abstract

This 2005 Article IV Consultation for Pakistan reports that macroeconomic performance continues to be strong, but inflation and external pressures are evident. High growth, including in agriculture, is estimated to have raised disposable incomes. The authorities’ ambitious growth objectives require substantial increases in investment, including from the private sector. Public investment has been increased to ease bottlenecks in transportation, irrigation, and energy. In the short term, macroeconomic policies need to be tightened somewhat to counter inflation and external pressures.

Key Points:

  • Steadfast implementation of prudent financial policies and bold structural reforms has led to a remarkable turnaround in the economy, which went from the brink of financial crisis to one of the highest growth rates in the world;

  • The authorities have taken welcome steps to protect their fiscal deficit target in the wake of recent international oil price hikes, including significant increases in domestic petroleum retail prices. The CBR reform project should enhance revenue collection significantly. Various indicators point to progress toward poverty reduction;

  • The overriding objective in the conduct of monetary policy is to contain inflation, and the SBP has tightened monetary policy in recent months to combat inflation;

  • Considerable progress has been made in strengthening the financial sector, and banks’ financial soundness indicators have improved;

  • The authorities scaled new heights in their ambitious privatization program, with the completion of the largest privatization transaction in Pakistan’s history;

  • The main findings of the ex post assessment are that Pakistan’s Fund-supported programs during 2000–04 were successful because of the authorities’ strong ownership. Considerable progress was made in most areas, including some difficult structural reforms, such as financial sector and public enterprise reforms; and

  • In answering the question whether structural conditionality was appropriate, staff have noted that the “conditionality in the 2000 SBA clearly did not meet the test of parsimony.” Although recent experience with Fund-supported programs has shown that judicious streamlining of conditionality provides the welcome result that ‘less is more,’ unfortunately, this valuable lesson was not applied to Pakistan.

The Pakistan authorities express their sincere appreciation and gratitude for the compassionate response by the international community in the aftermath of the devastating earthquake, measuring 7.6 on the Richter scale. The earthquake has caused untold suffering and unprecedented damage, taking 80,000 lives, severely injuring over 70,000, and breaking up hundreds of thousands of homes and families. The infrastructure damage will take billions of dollars and five to ten years to rebuild, according to the UN relief mission. But even with many countries responding in a timely and significant way to provide material help in the wake of this calamity, it is clear that this is a devastating humanitarian disaster that requires a scaled-up response from the international community. Medical relief teams have predicted that thousands of earthquake victims could die from the effects of cold weather as winter approaches and as illnesses and infections go untreated. The biggest problem is that 3.3 million have become homeless, and thousands of survivors face death from exposure; entire villages have been living outdoors in increasingly harsh conditions, with many, including children, lacking warm clothing or blankets. The authorities and volunteers from all over Pakistan are doing their utmost, but they need help.

I. Staff Report for the 2005 Article IV Consultation

The authorities wish to convey to Fund management and staff their appreciation for the continued support to Pakistan through policy dialogue and technical advice over the years, and, until recently, Fund-supported programs. This relationship, based on mutual trust and respect, has been of considerable value to the authorities in implementation of their “homemade” policies—supported by a strong commitment from all segments of the society—that has led to a remarkable turnaround in the economy, which went in the short spate of five years from the brink of financial crisis to one of the highest growth rates in the world.

As noted in Chapter II of the Selected Issues paper, economic growth reached 8.4 percent in 2004/05 and is expected to remain high despite the deterioration in the terms of trade. Economic growth has averaged 5½ percent per year since 1960, meaning that real per capita GDP has been growing at about 2¾ percent per year, or that real incomes have more than tripled during this period. It is noteworthy that the recent growth acceleration has come largely from an increase in total factor productivity (TFP). The robust TFP growth may be attributed, in part, to the growing contribution of the services sector to growth, and that there was not much need for new investments due to the slump of the late 1990s and the excess capacity in the economy. However, it should be stressed that structural reforms aimed at fostering both productivity gains and higher investment, including in the domain of infrastructure and governance, were major factors behind this growth performance. Furthermore, many indicators show that investment rose last year and new capacity will come on stream during 2005/06, even though the national accounts data appear to understate private investment because of incomplete coverage of firms.

Fiscal Policy

Staff have noted that the government has taken welcome steps to protect their fiscal deficit target of 3.8 percent of GDP in the wake of recent international oil price hikes, including significant increases in petroleum retail prices in September and October. The authorities are well aware that tax buoyancy has been low, and Central Board of Revenue (CBR) tax collection declined when measured as a percent of GDP in 2004/05. The decline reflected mainly the transition costs of streamlining the tax system to improve the business climate, but they are taking corrective measures to bolster tax collection. Recent work done at CBR has shown that two-thirds of corporate tax filers had reported declining or unchanged income in 2004/05 even though overall growth had accelerated. While some of this inconsistency may be explained by differential growth rates and varying tax coverage across sectors, the authorities are confident that additional efforts should lead to higher collections from existing taxpayers. The authorities recognize that medium-term fiscal objectives can only be met with a marked improvement in revenue performance, and they have taken important steps toward that goal. In particular, the CBR reform project, supported by the World Bank, should enhance revenue collection, and the move to a greater reliance on self-assessment and risk-based auditing should make the tax machinery more efficient and taxpayer-friendly; taxpayer disgruntlement with the heavy tax machinery and low tax compliance have been perennial problems. The need for further extending the tax net into the service and agriculture sectors in a meaningful way has been recognized by the authorities, but this has been a laborious process that has required the cooperation of the provincial governments; past strenuous efforts at the federal level have resulted in only limited gains.

The government is targeting higher social and development spending, while further reducing the debt-to-GDP ratio. The authorities and staff agreed that it was crucial to increase the quality and effectiveness of social spending, including through the implementation of a medium-term budget framework, and enhancing administrative and financial capacity at the district level. To build up on the progress in poverty reduction, the authorities have planned further increases in social spending, particularly on health and education. Debt dynamics are distinctly favorable over the medium term: staff projects domestic and external debt to continue on their downward path, and international reserves to remain at adequate levels. The recently approved Fiscal Responsibility Law should provide additional confidence to official donors and private investors because it mandates continued debt reduction by at least 2½ percent of GDP per year.

Poverty Reduction

Although various indicators point to progress toward poverty reduction, the authorities have reiterated their commitment to make further inroads in this top priority issue. In particular, they are determined to increase spending in health and education because that is a sine qua non for achieving the Millennium Development Goals. It is comforting to note that results from the Pakistan Social and Living Standards Measurement Survey show improvements in various health and education outcomes. Recently, there has also been significant increases in indicators for wages and employment, while the high growth in agriculture is estimated to have raised disposable incomes in rural areas. Pakistan has further improved its ranking in the 2005 United Nation’s Human Development Index.

Monetary Policy

The overriding objective in the conduct of monetary policy is to contain inflation. The authorities have tightened monetary policy significantly, which, combined with measures to increase domestic food supply, should be sufficient to achieve the 8 percent inflation target in 2005/06. Since the beginning of 2005, the SBP has raised the six-month treasury bill (T-bill) rate by more than 4 percentage points to 8 percent in May. Nevertheless, as stated in the July 2005 monetary policy statement, the SBP stood ready to raise T-bill rates further, if necessary.

Exchange rate policy has served Pakistan well in recent years, contributing to strong export growth and reduced external vulnerabilities. The SBP is committed to exchange rate flexibility; intervention in the foreign exchange market is limited to preventing excess volatility. The sharp increase in international reserves since 2001 has allowed Pakistan to catch up with levels maintained by similarly-placed countries, and a further increase in reserves should be realized in 2005/06.

External competitiveness has been enhanced, as the real effective exchange rate has been on a depreciating trend for the last five years. The modest appreciation in the first half of 2005 and the shift of the current account into deficit should not raise concerns about the appropriateness of the real exchange rate. The strong performance of Pakistan’s exports, including the shift toward manufactured exports and the increase in market share, is an important, if not definitive indicator, of competitiveness. Furthermore, the widening trade deficit has been partly financed by a significant increase in private transfers, and the recent surge in imports has been mainly due to imports of machinery, which suggests that once the equipment is installed, there should be a major boost in the export-oriented industries.

Financial Sector

Considerable progress has been made in strengthening the financial sector. The banking system has become more competitive, banks’ financial soundness indicators have improved, and the sector shows resilience in standard stress tests performed by Fund and SBP staff. Although the high rate of credit growth may raise concerns about prudential standards because of a rebound in corporate indebtedness, the stress tests show that, in general, corporate vulnerabilities were declining and in line with comparator countries. Even though the authorities were confident that banks had strengthened substantially their risk management, SBP has again demonstrated its willingness to err on the side of caution, and recently mandated special provisioning requirements for secured and unsecured consumer financing of 1.5 percent and 5 percent, respectively.

Investment Climate and Governance

The authorities have pursued their structural reform agenda forcefully: staff have noted that the overall business climate and governance in key macroeconomic institutions have clearly improved, as attested to the data on fiscal transparency and various financial ROSCs. Also, according to the 2005 Doing Business survey of the World Bank, Pakistan has made progress in enhancing the business climate and compares well within the region. Notwithstanding this progress, the authorities have stressed that improving governance in all public institutions remains a high priority, and they are determined to create an environment conducive to investment.

Privatization

The authorities scaled new heights this year in their ambitious privatization program when the largest privatization transaction in Pakistan’s history took place, with the sale, together with management control of 26 percent of the telecommunication company. The winning bid amounted to $2.6 billion (2¼ percent of GDP). The sale of other major companies—large and strategic companies, such as Pakistan Steel and Pakistan Petroleum—is underway.

II. Ex Post Assessment of Pakistan’s Longer-Term Program Engagement

The main findings of the ex post assessment are that Pakistan’s Fund-supported programs during 2000–04 had been successful because of the authorities’ strong ownership. Recognizing that the previous programs had suffered from substantial policy slippages, the new government addressed the economic difficulties with a new commitment to break away from past trends. Considerable progress was made in most areas, including some difficult structural reforms, such as financial sector and public enterprise reforms. The economy not only recovered, but entered a high growth with low inflation phase. The 2000 Stand-by Arrangement (SBA) and the 2001 three-year arrangement under the Poverty Reduction and Growth Facility (PRGF) were successfully completed without extensions.

Notwithstanding the noteworthy progress made in most areas under the last two Fund-supported programs, staff have noted that progress was slower in areas where broader institution building or cooperation from lower levels of government was needed. One of the objectives of the last two programs had been a significant expansion of the tax base to create room for achieving the twin goals of higher social spending and debt reduction, but tax collection remained disappointing. Another area that has been subjected to much criticism in the review by staff is conditionality in Pakistan’s Fund-supported programs, which became increasingly extensive after 1999. Structural conditionality peaked in the 2000 SBA: the total of 56 PCs, benchmarks and prior actions in this arrangement was nearly three times the Fund-wide average of 19 conditions in GRA-supported programs.

Staff note that following the 2000 SBA, structural conditionality was reduced gradually not only because of Pakistan’s improved performance, but also because of rising doubts in the Fund about the effectiveness of large policy matrices of conditions. Nevertheless, it is worth noting that, notwithstanding the overall drive in the Fund to streamline conditionality, Pakistan had remained burdened with an excessive number of structural conditions, and only in the last program year did their number approach the Fundwide average for PRGF-supported programs, but even then it was slightly higher. It is a tribute to the authorities’ dedication and steadfast adherence to program implementation in 2001–04 that their program compared favorably to the average PRGF-supported programs. For example, waiver rates were comparable to, or even lower than, those in average Fund-supported programs despite the larger number of conditions attached to the program. Furthermore, not only was the frequency of waiver requests lower than the average for all programs, but most of the waivers were needed because of delays in implementation rather than an outright lack of implementation. This was particularly true for energy sector measures, which typically required more time to overcome political or technical hurdles.

In answering the question of whether structural conditionality was appropriate, staff have noted that the “conditionality in the 2000 SBA clearly did not meet the test of parsimony. In terms of numbers, structural conditions exceeded Fundwide averages by a wide margin. Moreover, conditions were not limited to just those areas that were macrorelevant and critical to the success of the program.” Staff are correct in stressing that “[s]tructural conditionality focused on critical issues, but could have been more selective—individual measures subject to conditionality were often not critical.” A main conclusion of the ex post assessment is that “[o]verall, it appears that Fund structural conditionality was not well-suited for areas that require longer-term institution building and the cooperation of more than just the central government.” All in all, it would be fair to say that although the recent experience with Fund-supported programs has shown that judicious streamlining of conditionality provides the welcome result that ‘less is more,’ this valuable lesson was, unfortunately, not applied to Pakistan.

In light of staff’s criticism on the conditionality attached to the programs, one comes away from reading this review with all the more admiration for the authorities for their perseverance with program implementation. The authorities and staff are rightly satisfied that all disbursements were made available upon completion of the program reviews. In fact, the authorities decided not to draw the last tranche under the PRGF arrangement or seek a successor arrangement because of the vastly improved external situation, reflecting that growth in 2004/05 was among the highest in the world, vulnerabilities had been greatly reduced, and Pakistan had successfully re-entered the international financial markets.

That said, the authorities have expressed frustration with the frequent need for waivers of structural performance criteria, even for minor deviations or brief delays. They are correct to ask the Fund to review its procedures for deciding whether a performance criterion has been met, or not. This also leads us to today’s report on the noncomplying disbursements and recommendation for waiver of nonobservance of performance criterion, which is truly bewildering, and we discuss it in a separate statement. How could there be a misreporting in this case, even if one only juxtaposes the following two quotes from staff and the authorities? Staff note in the ex post assessment that “[m]easures to improve the tax system dominated conditionality in the 2000 SBA and the 2001 PRGF arrangements, reflecting the critical importance attached to increasing the revenue intake.” The authorities note in their letter to the Managing Director on the purported misreporting: “…it is hard to understand why there would have been no reference to SRO 207 in the communication between the Resident Representative and Central Board of Revenue (CBR) officials, because there were several use of Fund resources missions to Pakistan in 2002, and it is routine to ask for this information in advance of the arrival of the mission.”