Pakistan: Staff Report for the 2006 Article IV Consultation
Author: International Monetary Fund
Publication Date:
07 Dec 2006
eISBN:
9781451830699
Language:
English
Keywords:
ISCR; CR; government; government debt-to-GDP ratio; deficit; reform agenda; rate; monetary policy; banking system; short-term debt; interest rate; broad money; Current account deficits; Global
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The demand pressures associated with the large terms-of-trade gains are reflected in a fast real appreciation of the ruble, although more of this has come through nominal appreciation during the last year. The risks to the outlook are evenly balanced and depend mostly on oil price developments. Current policies raise medium-term risks. IMF staff welcomed the greater focus on inflation control, but cautioned that additional exchange rate flexibility would be needed to meet the end-2006 target, especially at a time when demand pressures are exacerbated by fiscal relaxation.

Abstract

The demand pressures associated with the large terms-of-trade gains are reflected in a fast real appreciation of the ruble, although more of this has come through nominal appreciation during the last year. The risks to the outlook are evenly balanced and depend mostly on oil price developments. Current policies raise medium-term risks. IMF staff welcomed the greater focus on inflation control, but cautioned that additional exchange rate flexibility would be needed to meet the end-2006 target, especially at a time when demand pressures are exacerbated by fiscal relaxation.

I. Introduction

1. Pakistan’s economic performance since 2001/02 has been impressive. Growth has accelerated, improvements in public spending and wide-ranging structural reforms have reduced the debt burden and increased efficiency, and pro-poor policies have helped lower poverty rates (Box 1). To maintain this momentum it is necessary to focus macroeconomic policies on containing domestic demand growth and reducing the possible associated vulnerabilities. Over the medium term, the challenge remains to deepen structural reforms in areas critical for raising saving and investment, improving external competitiveness and sustaining high output growth.

2. The devastating earthquake of October 8, 2005 gave rise to additional demands for government spending. The earthquake left a heavy toll in terms of human lives and physical and social infrastructure, though it had relatively minor effects on macroeconomic indicators (other than government spending) owing to weak links between the affected areas and the rest of the economy. The bulk of government spending on relief and reconstruction during 2005/06 was financed by external grants and loans, but higher-than-budgeted fiscal resources also were allocated to this end. Reconstruction-related spending is expected to decline gradually over the next four years.

3. The political and security situation remains relatively calm. There has been some domestic unrest, however, especially near the border with Afghanistan and in the Baluchistan province. Relations with India are progressing slowly, following the ratification of the South Asian Free Trade Area (SAFTA) in early 2006. Parliamentary and presidential elections are scheduled for October 2007.

4. The implementation of recent Fund advice on macroeconomic policy and structural reforms has been mixed. During 2005/06, large negative shocks, especially the earthquake, limited the scope for fiscal maneuver, and the overheating pressures that were identified during the last Article IV consultation continued. Declines in inflation and, especially, domestic demand growth were relatively small, the external current account deficit widened by more than envisaged in mid-2005, and the rupee appreciated in real terms. The import coverage of reserves, however, remained stable. Against this background, the 2006 Article IV discussions focused on the macroeconomic policies needed to moderate demand pressures and contain the external current account deficit, appropriate policy responses to adverse external shocks, and structural reforms to help sustain rapid growth and reduce poverty.

Poverty in Pakistan—New Estimates

Poverty declined during the last four years. Estimates based on the recent Household Integrated Economic Survey (HIES) show that the share of Pakistan’s population living below the poverty line (poverty headcount ratio) declined by over 10 percentage points from 2000/01 to 2004/05. The decline was more than twice the size of the increase recorded in this indicator during 1996/97–2000/01. Despite this impressive outturn, nearly one quarter of Pakistan’s population continues to live below the poverty line. Two other key measures of poverty incidence (the poverty gap and severity of poverty) also showed improvement during the last four years. Unlike the poverty headcount ratio, however, the improvement in these indicators was not sufficiently large to bring them below their 1996/97 levels.

Pakistan: Poverty Indicators

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Source: Pakistani authorities; and Fund staff estimates.

Share of the population whose average spending falls below the poverty line.

In percent. Both indicators measure the extent by which spending of poor households falls below the poverty line. The larger the value of these indicators, the larger the share of poor households that is “close” to (below) the poverty line.

In percent. Average of previous four years.

The decline in poverty coincided with a strong pick up in economic growth. This is in line with cross-country studies that find evidence of a robust inverse relationship between growth and poverty. The large decline in the poverty headcount following the pick up in growth may also be related to the high concentration of households that had fallen just below the poverty line in 2000/01.1/

1/ See “Poverty, Risk and Vulnerability in Pakistan,” Centre for Research on Poverty Reduction and Income Distribution, Karachi: Pakistan, March 2006.

II. Recent Economic Developments

5. Economic developments during 2005/06 were broadly favorable, but the external current account deficit widened. Real GDP growth remained buoyant at 6.6 percent, and average inflation (12-month rate) declined from 9.3 percent to 7.9 percent. Domestic demand and import growth remained high, and the current account deficit increased to US$5 billion (3.9 percent of GDP), from US$1.5 billion (1.4 percent of GDP) a year earlier. Record-high net capital inflows (including from FDI and privatization) more than covered the larger deficit and allowed an increase of nearly US$1 billion in gross official reserves. As of end-June 2006, gross international reserves stood at US$10.8 billion (3.6 months of next year’s imports of goods and services), and the interbank market exchange rate was broadly unchanged from end-June 2005.

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Growth and Inflation

Citation: IMF Staff Country Reports 2006, 426; 10.5089/9781451830699.002.A001

Sources: Pakistani authorities; and Fund staff estimates.
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Balance of Payments Developments

Citation: IMF Staff Country Reports 2006, 426; 10.5089/9781451830699.002.A001

Sources: Pakistani authorities; and Fund staff estimates.1/ Foreign direct investment; including privatization.2/ Defined as the overall balance minus the current account balance.

6. The fiscal deficit exceeded the original budget target for 2005/06 owing to earthquake-related spending. Excluding the latter (0.9 percent of GDP), revenues and expenditures both rose slightly (by roughly the same amounts) compared to the outturn in 2004/05. Strong corporate profits, higher petroleum taxes, and continued improvements in tax administration more than offset lower nontax revenue. The increase in total expenditure was mainly driven by development spending. The government debt-to-GDP ratio fell to 56 percent by end-June 2006, below the 60 percent ceiling stipulated in the 2005 Fiscal Responsibility Law.1 The budget for 2006/07, approved in early June, targets a deficit of 4.2 percent of GDP (excluding grants), unchanged from the estimated outturn for 2005/06. The underlying fiscal deficit (defined as the overall deficit excluding grants and earthquake-related spending) is budgeted to increase by about 0.3 percent of GDP.

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Fiscal Balance and Public Debt

Citation: IMF Staff Country Reports 2006, 426; 10.5089/9781451830699.002.A001

Sources: Pakistani authorities; and Fund staff estimates.1/ Authorities’ target based on the budget for 2006/07

7. Domestic credit was, for the third year in a row, the main source of monetary expansion. The growth of broad money and bank credit to the private sector decelerated, but private sector credit still grew at the relatively high rate of 23 percent (Box 2). Bank lending rates became increasingly positive in real terms as inflation declined, but the real return on bank deposits remained negative. SBP claims on the government increased by more than total government borrowing from banks (as commercial banks continued reducing their holdings of government paper), and was the main factor behind the 10.2 percent increase in reserve money. Interest rates on 6-month treasury bills remained stable at 8.2 percent throughout 2005/06, and the discount rate was kept at its May 2005 level (9 percent) until end-June.

Banking System Update

Pakistan’s banking system continued to strengthen since the last Article IV consultation. From December 2004 to June 2006 most financial soundness indicators (FSI) improved. The rise in earning and profitability indicators was particularly noteworthy, partly reflecting the high spread between deposit and lending rates (700 basis points). Pakistan’s banks maintained their ranking among the top half in a group of 44 emerging market countries in terms of indicators of capital adequacy and asset quality, but moved to near the top of the ranking in terms of profitability—from a position near the bottom in 2001.

Pakistan: Selected Financial Soundness Indicators, Banking System, 1997–2006

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Source: Pakistani authorities.

End-December for 1997–2004; end-June for 2006.

Banking Profitability in Selected Emerging Markets 1/

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Source: Fund staff estimates.

Banking profitability is defined as the percentage return on assets after tax.

Banks’ FSIs have improved, though this could be partly due to continued rapid credit growth. The expansion in bank credit to the private sector slowed to 23 percent in 2005/06 (from an average of 31 percent in the previous two years) but remained on the high side. The slowdown in credit during 2005/06 was broad-based, affecting all types of borrowers—including households. The growing deposit base remained the primary source for credit expansion; banks’ foreign borrowing, other than for trade credit, remained negligible.

Concentration of the banking system remains high. As of March 2006, Pakistan’s five largest banks held 53 percent of the system’s assets and 51 percent of its loans—somewhat less than at end-2004. Public banks still account for about 20 percent of total assets of the banking system (excluding the SBP). Mergers and acquisitions are on the rise, partly as a result of mandated increases in minimum required capital (from PRs 1.5 billion at end-2004, to PRs 3 billion at end-2006, and further to PRs 6 billion in 2009). Foreign banks’ interest in Pakistani banks is also on the rise, partly in response to the government’s plans to divest most of its shares in several domestic banks.

Monetary policy was tightened in July 2006; reserve requirements on bank deposits were raised for the first time since end-2000 and, two weeks later, the discount rate was increased to 9.5 percent.2

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Money Growth and Interest Rates

Citation: IMF Staff Country Reports 2006, 426; 10.5089/9781451830699.002.A001

Sources: Pakistani authorities; and Fund staff estimates.

8. Foreign investors’ interest in Pakistan increased significantly in 2005/06. The sale of the Karachi Electric Supply Company (KESC) and the partial sale and transfer of management control of Pakistan Telecommunication Company Limited (PTCL) generated large foreign exchange inflows and revitalized the privatization process.3 Foreign direct investment inflows, excluding privatization, rose by 70 percent. The successful March 2006 placement of US$800 million of 10-year and 30-year government bonds at very favorable terms was also indicative of strong foreign demand for Pakistani paper.

9. Progress on structural reforms was mixed. Reforms to broaden the income tax base and reduce rates continued, and the legal framework for investor protection was strengthened. However, reform of the power sector has stalled, and the schedule of higher regional electricity tariffs has not yet been implemented. Progress on trade liberalization slowed.

III. Report on the Discussions

10. Discussions on the near-term macroeconomic outlook focused on steps to strengthen the balance of payments and lower inflation, and on policy responses to possible adverse external shocks. On structural reforms, discussions focused on key areas to sustain high growth and reduce poverty over the medium term.

A. Economic Outlook and Key Challenges

11. The outlook for sustained growth is favorable, provided inflation falls further. In addition, there is a need to strengthen the balance of payments to reduce external vulnerabilities by:

  • a. containing the external current account deficit;

  • b. obtaining foreign financing consistent with external debt sustainability; and

  • c. achieving a higher stock of international reserves.

Discussions on these issues were illustrated by quantitative scenarios. The focus was mainly on: (i) the level and trajectory of the external current account deficit; (ii) the prospects for external financing (particularly for non-debt-creating capital flows); and (iii) the role of macroeconomic policies in reducing external risks.

12. The authorities and staff had broadly similar views on the medium-term path for the external current account deficit, the prospects for external financing, and the targets for international reserves. The external current account deficit has reached relatively high levels—by both historical and cross-country standards—and a further widening could, at some point, compromise external sustainability. However, Pakistan’s increased attractiveness to foreign investors (including from oil-exporting countries in the Gulf region) has led to a notable rise in the supply of non-debt-creating capital flows (in search of both profitable new projects and purchase of entities slated for privatization). At the same time, the country’s ability to borrow from international and regional capital markets at relatively low spreads and long maturities has also improved. With this change in the supply of capital flows, external financing prospects can remain favorable for several years. During this period, Pakistan could sustain external current account deficits in the range of US$5-6 billion (consistent with a steady decline in the current account deficit-to-GDP ratio), and strengthen gradually its international reserves position (chart).

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Medium-Term Balance of Payments

Citation: IMF Staff Country Reports 2006, 426; 10.5089/9781451830699.002.A001

Source: See Table 3.1/ Defined as the overall balance minus the current account balance. Net capital flows in 2004/05 were lower than FDI flows.2/ Foreign direct investment, including privatization.

13. There were, however, differences of views on the policies needed to achieve those outcomes. In the authorities’ view, the macroeconomic policy stance envisaged for 2006/07 will keep the external current account deficit at levels broadly similar to last year’s outturn, and reduce headline CPI inflation to about 6½ percent. The current policy stance was also seen by the authorities as consistent with the government’s target of real GDP growth of at least 7 percent in 2006/07. The authorities expected import growth to decelerate sharply during the year as the effects of transitory, nonrecurrent factors that pushed up imports in 2005/06 (e.g., oil price spike, unforeseen imports of sugar) unwind. They were also confident that the July 2006 tightening of monetary conditions, supported by continued exchange rate stability, would accelerate the pace of disinflation. The authorities thought that the recent tightening of monetary policy would not have adverse effects on bank lending to the private sector.4 Moreover, they indicated that they were prepared to tighten monetary policy further if inflation continued above the government’s 6½ percent target. On the fiscal side, the authorities saw some scope for overperforming on their budget deficit target for 2006/07, including by saving higher-than-projected revenue.

14. The authorities’ policy stance for 2006/07 may not suffice, however, to contain domestic demand growth and stabilize the external current account deficit. In particular, a further tightening of monetary policy, including by allowing higher cutoff rates at treasury bill auctions (to increase commercial banks’ demand for government paper and reduce SBP’s direct lending to the government), would help slow the growth of private sector credit and non-oil imports, and avoid an increase in the external current account deficit-to-GDP ratio. To be effective, this tightening would have to be supported by greater exchange rate flexibility and by fiscal restraint to keep the underlying budget deficit (the overall deficit excluding grants and earthquake-related expenditures) at the level of 2005/06—i.e., some 0.3 percent of GDP lower than the outcome envisaged in the budget.

15. During the discussions, staff prepared a macroeconomic scenario encompassing monetary and fiscal tightening (Tables 2–6). In the staff’s scenario, higher real interest rates starting in 2006/07 are assumed to rein in domestic demand growth, significantly reduce non-oil imports growth, and lower inflation to 6½ percent. Over the medium term, fiscal consolidation bringing the overall fiscal deficit (excluding grants) below 2½ percent of GDP, a stable real exchange rate, and the maintenance of real interest rates at positive levels would help keep domestic demand growth in check and narrow the aggregate saving-investment imbalance. Under these policy assumptions, output growth would remain in the 6½–7 percent range (compared to growth in the 7–8 percent range expected by the government), headline and core inflation would fall further to 5 percent, and the reserve import coverage would rise moderately. The downward trend in public debt and external debt ratios would continue, even under less favorable assumptions for growth and interest rates (Tables 7–8, Figures 1–2). By 2010/11, the external current account deficit as a share of GDP (2.3 percent) would be close to Pakistan’s current account “norm” (Box 3).

Table 1.

Pakistan: Selected Economic Indicators, 2001/02–2006/07 1/

(Population: 151 million (2004))

(Per capita GDP: US$724 (2005))

(Poverty rate: 23.9 percent (2004/05))

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

Fiscal year ends June 30.

Staff projections; assume monetary and fiscal tightening during 2006/07.

Including changes in inventories. Investment data recorded by the Federal Bureau of Statistics are said to underreport true activity.

Calculated as interest payments in percent of the end-of-period debt stock of the previous year.

Excluding gold, foreign deposits held with the State Bank of Pakistan, and net of outstanding short-term foreign currency swap and forward contracts.

An increase is a real appreciation.

Table 2.

Pakistan: Medium-Term Macroeconomic Framework, 2003/04–2010/11

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Sources: Pakistani authorities and IMF staff estimates for historical data. Projections based on a staff scenario of monetary and fiscal tightening.

Difference between the overall balance and the current account balance.

Including privatization.

Ratio of gross official reserves to next year’s imports of goods and services (divided by twelve).

Including grants and earthquake-related expenditures.

Excluding grants and earthquake-related expenditures.

Table 3.

Pakistan: Balance of Payments, 2001/02–2010/11

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

Projections are based on a staff scenario of monetary and fiscal tightening.

Includes U.S. capital grants to finance accelerated repayment of U.S. debt in 2002/03 ($1 billion) and in 2004/05 ($495 million).

Includes accelerated repayments to the U.S. ($1 billion in 2002/03 and $495 million in 2004/05) and to the AsDB ($1.1 billion in 2003/04).

Including IMF, military debt, commercial loans, and short-term debt.

Defined as current account balance plus amortization of medium- and long-term debt.

Excluding foreign currency deposits held with the State Bank of Pakistan (cash reserve requirements), gold, and net of outstanding short-term swap and forward contracts.

Table 4.

Pakistan: Monetary Survey and Analytical Balance Sheet of the State Bank of Pakistan, 2001/02–2006/07

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

Staff projections; assume monetary and fiscal tightening during 2006/07.

Denominator is the stock of broad (reserve) money at the end of the previous year.

Table 5a.

Pakistan: Consolidated Government Budget, 2001/02–2006/07

(In billions of Pakistani rupees)

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

Staff projections based on the budget for 2006/07 plus additional monetary and fiscal tightening.

Excludes spending related to the 2005 earthquake.

The statistical discrepancy is believed to arise mainly from double-counting of spending at the provincial level.

Includes statistical discrepancy and spending related to the 2005 earthquake.

Social- and poverty-related expenditure as defined in the government’s Poverty Reduction Strategy Paper (2003).

Excludes military debt, commercial loans, and short-term debt.

Table 5b.

Pakistan: Consolidated Government Budget, 2001/02–2006/07

(In percent of GDP; unless otherwise indicated)

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

Staff projections based on the budget for 2006/07 plus additional monetary and fiscal tightening.

Excludes spending related to the 2005 earthquake.

The statistical discrepancy is believed to arise mainly from double-counting of spending at the provincial level.

Includes statistical discrepancy and spending related to the 2005 earthquake.

Social- and poverty-related expenditure as defined in the government’s Poverty Reduction Strategy Paper (2003).

Excludes military debt, commercial loans, and short-term debt.