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

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.


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.

As noted in the well-written staff report, economic performance during 2005/06 was strong, despite the impact of negative shocks, including the tragic earthquake of October 2005, a sharp rise in international oil prices, and unfavorable weather conditions. Reflecting prudent financial policies and a further broadening of the structural reform efforts, economic growth remained buoyant, inflation declined, and record-high capital inflows more than covered the larger external current account deficit and allowed for an increase of nearly US$1 billion in gross official reserves. 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, while pro-poor policies helped lower poverty rates. The authorities and staff agree that over the medium term, the main challenges to sustaining high output growth are to deepen structural reforms in areas critical for raising saving and investment, and improving external competitiveness. There was also broad agreement with the inflation and international reserves objectives, as well as with the medium-term balance of payments outlook.

Fiscal and monetary policies

Staff have noted that domestic demand pressures have not subsided and that the current account deficit has increased, driven by rapid import growth. However, real domestic demand growth slowed to 8.1 percent during FY06 from 11.5 percent. Despite the increase in the government's consumption due to earthquake related expenditures, total consumption showed a relatively small increase of 7.8 percent compared to 11.9 percent in the previous year. The authorities are firm in their determination to maintain external sustainability and stand ready to implement policy measures if needed. They expect import growth to decelerate sharply during the year as the effects of transitory and nonrecurring factors that pushed up imports in 2005/06 (e.g., oil price spike, unforeseen imports of sugar) unwind. Furthermore, monetary conditions were tightened in July 2006, which together with continued exchange rate stability, gives comfort that the inflation rate will decline further. During FY06, the State Bank of Pakistan (SBP) policy of keeping the overnight money market rate close to its policy lending rate has proved to be very effective in reducing the growth of private sector credit. Yearly average overnight rate in FY06 was 7.9 percent compared to 3.8 percent in FY05. The authorities are determined to follow prudent fiscal and monetary policies, reinforced by a flexible exchange rate. Whereas fiscal discipline is essential to achieve the authorities' objectives, and they have demonstrated fiscal restraint by keeping the underlying budget deficit (the overall deficit excluding grants and earthquake-related expenditures) at the level of 2005/06, the authorities have also noted that monetary policy will be tightened further if inflation remains above the government's 6½ percent target. Over the next couple of years, fiscal policy formulation will take account of the additional demands on government spending created by the earthquake and reconcile them with macroeconomic stability and poverty-reduction objectives.

The authorities have made progress in their efforts to raise the tax revenue to GDP ratio, and moreover, have been laying the groundwork for additional reforms to broaden the tax base, which, because of their complexity and the need for institutional development, will necessarily take some time. Staff have recognized that efforts to increase the efficiency of tax collection have continued by streamlining income tax rates, but it should also be stressed that revenue collection will be enhanced by the considerable progress in other areas. Recent reforms in improving the documentation of the economy and the move to a greater reliance on self-assessment and risk-based auditing will make the tax machinery more efficient and taxpayer-friendly. The authorities have been focusing on further extending the tax net into the service and agriculture sectors in a meaningful way, and increasing the provinces' contribution to overall revenue collection remains an area of continuing attention.

Structural reforms

In addition to tax reforms aimed at broadening the income tax base and reducing rates, major steps were also taken in other areas such as strengthening the legal framework for investor protection. The authorities' reform agenda has attached importance to the financial sector, including strenuous efforts to improve competition and supervision, which have played a crucial role in improving efficiency and maintaining the soundness of the sector. The banking system continued to strengthen, as banks have not only 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 have moved to near the top of the ranking in terms of profitability from a position near the bottom in 2001. The authorities will focus on encouraging higher return on deposits to promote financial savings. Staff have stressed that new issues of long-term government securities—e.g., Pakistani Investment Bonds (PIBs)—were essential for the development of a local bond market, and have encouraged the authorities to substantially increase reliance on this means of deficit financing during 2006/07. On October 13, 2006, government raised Rs. 15.03 billion through the placement of 3,5,10,15 and 20 year PIBs at weighted average yields of 9.78 percent, 9.93 percent, 10.39 percent, 10.85 percent and 11.17 percent, respectively. The sale of the Karachi Electric Supply Company and the partial sale and transfer of management control of Pakistan Telecommunication Company Limited were instrumental in revitalizing the privatization process.

Exchange rate

The SBP is committed to exchange rate flexibility, and intervention in the foreign exchange market is limited to preventing excess volatility; a flexible exchange rate regime has been in effect since May 19, 1999. The current level of the real exchange rate is broadly appropriate: the real exchange rate was significantly more depreciated than its level during the 1990s. Regarding the staff's classification of Pakistan's exchange rate regime as a conventional peg, the methodology used is essentially centered on the variability of the nominal exchange rate, and gives very little weight to other considerations such as foreign exchange intervention and judgmental elements. The authorities have noted that the movement of the exchange rate within a narrow band, particularly when this is due to effective policy measures, should not be treated at par with the exchange rate regime that has been classified as de jure (announced) peg. In the recent Board meeting on review of exchange rate arrangements, several chairs had stressed that greater exchange rate stability per se is not sufficient evidence of less flexibility in the exchange rate regime, since it may just as well reflect a different pattern of shocks to the foreign exchange market. In particular, a country that experiences a decrease in the intensity and number of shocks (e.g., terms of trade, cost of borrowing, policy induced) could easily see a stable exchange rate over a 12-month period. A country should not be encouraged to have a greater fluctuation in the exchange rate so that it may be categorized as following a de facto floating exchange rate regime. As regards the intervention in the interbank foreign exchange market, especially in providing support to meet lumpy payments for petroleum imports, the authorities have pointed out that a recent study done at the SBP has shown that the effects of intervention on dampening volatility of the exchange rate are more pronounced compared to the effects on the level of the exchange rate.

Payments restriction

Regarding the 50 percent limit on advance payments for some imports, the authorities have pointed out that payments of over 50 percent are not prohibited but require SBP's approval and that genuine requests receive blanket approval to effect 100 percent advance payment. They note that 50 percent advance payment against some imports is an adjustment in the mode of payment, which is aimed at curbing speculative activity in the market. It has no effect on meeting the genuine needs of businesses and does not impede any bona fide transactions. Also, importers have been given blanket approvals to effect 100 percent advance payment where it was either a supplier's requirement or global corporate policies, which necessitated such settlements with companies. Staff agree that the regulation states that requests shall be considered for approval by the SBP on the basis of evidence of the bona fide nature of the underlying transaction and a bank guarantee, and all bona fide transactions have been allowed. However, there is an exchange restriction that could be removed by clarifying the regulations. It is a restriction only insofar as the authorities have not yet issued the circular that would clarify that despite the various limits on advance import payments, foreign exchange will be provided without limitations for advance import payments upon verification of the bona fide nature of the underlying transactions. In short, there is no payment restriction in the sense of having any real world effects, that is, affecting current account transactions in a material way that would classify as a payment restriction. This is entirely a legal issue, with no economic effects, and the authorities are looking into the exact wording of the regulation that would lead to the removal of this restriction.

Poverty reduction

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. Two other key measures of poverty incidence (the poverty gap and severity of poverty) also showed improvement during the last four years. Despite this impressive outturn, the authorities are deeply concerned that nearly one quarter of Pakistan's population lives below the poverty line. They have reiterated their commitment to make further inroads in this top priority item, and are determined to increase spending in health and education because that is a sine qua non for achieving the Millennium Development Goals.

Investment climate, anti-money laundering, and trade policy

The overall business climate and governance in key macroeconomic institutions have clearly improved, as attested by the data on fiscal transparency and Doing Business survey of the World Bank. Notwithstanding this progress, the authorities have stressed that they are determined to create an environment conducive to investment and improving governance in all public institutions. Priorities in this area will be to bolster reforms to increase efficiency, transparency, and accountability in the use of public resources. The anti-money laundering/combating the financing of terrorism (AML/CFT) framework has been strengthened. In July 2006, the SBP issued prudential regulations recommended by the Financial Action Task Force. In addition, an AML/CFT unit has been established in the SBP under the direct supervision of the Governor. On trade policy, the authorities would like to give the assurance that the progress in bilateral and regional trade agreements has not compromised Pakistan's commitment to maintaining a liberal trade regime and to contribute to multilateral trade negotiations, including their support for a successful Doha round of trade talks.

Medium-term outlook

The authorities and staff are in broad agreement on the medium-term path for the external current account deficit, the prospects for external financing, and the targets for international reserves. Staff have noted that the external current account deficit has reached relatively high levels and a further widening could compromise external sustainability. The authorities recognize that the medium-term outlook is subject to various risks, but they note the country's increased attractiveness to foreign investors has led to a notable rise in the supply of non-debt-creating capital flows, as well as relatively low spreads and long maturities in the recent borrowings from international and regional capital markets. The authorities anticipate that growth would be somewhat higher than assumed by staff, mainly due to the rapid increases in foreign direct investment and domestic private investment. The growth in national savings would outpace the increase in domestic investment, both on account of a gradual rise of real return to financial savings (as a result of the lower inflation), as well as a decline in the fiscal deficit below 3 percent of GDP over the medium term. The Fiscal Responsibility Law will serve as a key anchor for sound macroeconomic policies, and the authorities are resolute in their focus on fiscal and external sustainability, including an ambitious program to increase domestic revenue.

The authorities value highly their close relationship with the Fund, gratefully acknowledge the support they have received over the years from the Board, management, and staff and look forward to the Board discussion.