2009 Article IV Consultation and First Review Under the Stand-By Arrangement: Staff Report; Staff Statement; Public Information Notice and Press Release on the Executive Board Discussion; and Statement by the Executive Director for Pakistan

Pakistan has been facing significant economic difficulties. With sharp increases in oil and food prices, and adverse security developments, Pakistan has experienced a significant widening of the fiscal deficit, owing in large part to increasing energy subsidies and major pressures on its balance of payments. As a result, inflation rose considerably and international reserves declined sharply. Executive Directors have commended the authorities for the progress achieved under the stabilization program. Directors have also welcomed the focus on social protection in the authorities’ program.


Pakistan has been facing significant economic difficulties. With sharp increases in oil and food prices, and adverse security developments, Pakistan has experienced a significant widening of the fiscal deficit, owing in large part to increasing energy subsidies and major pressures on its balance of payments. As a result, inflation rose considerably and international reserves declined sharply. Executive Directors have commended the authorities for the progress achieved under the stabilization program. Directors have also welcomed the focus on social protection in the authorities’ program.

I. Background

1. Following the successful implementation of two Fund-supported programs during 2000–04, Pakistan enjoyed a relatively robust economic performance. During 2007, the country continued to perform well in terms of growth owing to favorable global economic and financial conditions and expansionary economic policies, but inflation rose and external imbalances began to emerge. At the conclusion of the 2007 Article IV consultation, Directors encouraged the authorities to strengthen the fiscal program for 2007/081 to complement monetary tightening, particularly by reducing energy subsidies and capital spending. Looking beyond 2007/08, Directors stressed that further fiscal consolidation would be required to reduce inflation and the external current account deficit while lessening pressures on real interest rates. They noted that the tax revenue-to-GDP ratio was low by international standards, and recommended to press ahead with reforms to increase revenue and enable a reduction in the fiscal deficit while allowing for higher spending on infrastructure and poverty alleviation. The authorities have generally responded positively to Fund advice but the implementation of advice on some structural reforms has been slow (Box 1).

Effectiveness of Fund Advice

The Pakistani authorities have generally agreed with Fund advice, but implementation has been slow. In early 2008, the authorities started to adopt some of the policies recommended by the Fund to address Pakistan’s macroeconomic imbalances, including monetary tightening and a fiscal consolidation, particularly by reducing energy subsidies and capital spending. But, various considerations, including political constraints, slowed their implementation, especially on tax reforms. In the fall of 2008, the authorities developed a home-grown adjustment program, very much in line with Fund policy advice.

2. The macroeconomic situation has deteriorated significantly since 2007/08 on account of both external and domestic factors. The increase in oil and food prices, and adverse security developments exacerbated external imbalances. Growing fiscal deficits, owing in large part to increasing energy subsidies and financed by the central bank, fuelled inflation, while international reserves declined sharply and confidence waned.

3. In October 2008, the authorities embarked on a stabilization program for 2008/09–2009/10 aimed at restoring financial stability while protecting the poor. This program, supported by the SBA approved on November 24, envisages a significant tightening of fiscal and monetary policies to bring down inflation and strengthen the external position, as well as several structural measures in the fiscal and financial sectors. Strengthening the social safety net is a key priority under the program.

4. In addition to stabilizing the macroeconomic situation, the program aims at addressing some of Pakistan’s long-standing economic problems. In particular, it calls for a comprehensive tax reform to raise budgetary revenue, and create greater fiscal space for public investment and social spending. The authorities also plan to phase out electricity subsidies, and to tackle the problem of inter-corporate (circular) debt in the energy sector.

II. Recent Developments

A. Overview

5. Initial developments since the approval of the program have been generally positive.2 The exchange rate has been broadly stable, enabling the SBP to buy foreign exchange on a net basis (Figure 1). As a result, gross reserves have strengthened from $3.5 billion at end-October to $6.7 billion as of February 20. There has also been a strong positive response from the T-bill market to the 200-basis point increase in the SBP discount rate implemented in mid-November, which brought the cumulative increase since January 2008 to 500 basis points. T-bill auctions through end-February have been consistently oversubscribed, with wide participation of banks, and enabled the government to retire some of its debt to the SBP. T-bill rates came down from a peak of 14 percent (weighted average) in mid-January to just below 13 percent at end-February.

Figure 1.
Figure 1.

Pakistan: Financial Market Indicators

(August 2008–February 2009, unless otherwise indicated)

Citation: IMF Staff Country Reports 2009, 123; 10.5089/9781451830743.002.A001

Sources: Pakistani authorities; and Bloomberg.

6. Domestic activity has weakened while inflation has been falling more rapidly than expected, and the external current account deficit has been narrowing. A combination of domestic factors (energy shortages, high interest rates) and external factors (weakening global demand for textiles) resulted in a decline of nearly 6 percent in large-scale manufacturing output during the first half of 2008/09 (Figure 2) and a sharp drop in exports in recent months. On the positive side, agricultural output will benefit from a bumper wheat crop in 2008/09, and significant increases in the rice and cotton crops should more than compensate for the decline in sugar cane production. With falling food and energy prices and lower economic activity, headline inflation has dropped faster than expected. In January, headline CPI inflation declined to 20.5 percent (year-on-year), its lowest point since May 2008. Although core inflation is still around 19 percent (year-on-year), monthly core inflation dropped from a peak of 2.3 percent in July to 1.1 percent in January.3 Despite the decline in international oil spot prices, the external current account through December did not show a decisive improvement because of deferred payments for oil contracted at higher prices, but the trend in imports pointed to an underlying improvement in the current account, notwithstanding lower exports. Also, inflows of remittances have thus far proven resilient, and capital outflows have been lower than projected.

Figure 2.
Figure 2.

Pakistan: Monthly Macroeconomic Indicators

Citation: IMF Staff Country Reports 2009, 123; 10.5089/9781451830743.002.A001

Source: Pakistani authorites.1/ Through January 24, 2009.

7. In mid-December, the authorities removed the stock market price floor which had been in place for 3½ months. The feared massive capital outflows did not materialize.4 After the initial sharp drop, the Karachi Stock Exchange (KSE) 100 Index bottomed out in late January, following a cumulative decline of nearly 70 percent from its April 2008 peak. The stock market has since rebounded by about 20 percent but, like most other capital markets, is volatile. The recovery was supported only to a small extent by the National Investment Trust’s State Enterprise Fund (NITSEF) of Rs. 20 billion (0.15 percent of GDP), which was created to buy shares in eight public enterprises. The NITSEF, which is funded through borrowing from domestic banks with government guarantee, has been active since early January, and as of mid-February it had invested Rs. 7 billion.

8. The global economic and financial environment has deteriorated significantly since the SBA approval. To date, the global crisis has had mixed effects on Pakistan. As noted earlier, the decline in fuel and food prices has had a moderating impact on inflation and has helped strengthen the external current account. It has also contributed to the reduction of energy and food subsidies, but it has had an adverse impact on output, exports, fiscal revenue base, and current transfers. And, higher risk aversion will reduce foreign investment in Pakistan: privatization receipts of $1.7 billion projected in the 2008/09 budget (a major component of projected foreign financing) are unlikely to materialize, and market access remains constrained (Box 2).

B. Program Implementation

9. All quantitative performance criteria through December 2008 were met. The authorities demonstrated an impressive degree of program ownership. Despite downward pressures on the revenue side, they maintained a tight fiscal policy stance to fend off the risk of resurging inflation and set the stage for a sustainable easing of interest rates down the road. At the same time, the SBP capitalized on the upward pressure on the rupee to build a cushion above the program net foreign assets (NFA) targets (SMEFP, Table 1).

Table 1.

Pakistan: Selected Economic Indicators, 2007/08–2009/10 1/

(Population: 160.9 million (2007/08))

(Per capita GDP: US$1,042 (2007/08))

(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.

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

Expenditure on social assistance in 2008/09 is budgeted at 0.5 percent of GDP. The program will target an additional 0.3–0.5 percent of GDP.

2008/09: average for June–December 2008.

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

Excluding gold and foreign deposits of commercial banks held with the State Bank of Pakistan.

10. The end-December fiscal deficit target, which proved challenging, was achieved through a combination of revenue and expenditure measures. Additional revenue from the Petroleum Development Levy (PDL) largely compensated for the shortfall in revenue from direct taxes, excises, and the sales tax on imports collected by the Federal Board of Revenue (FBR).5 More recently, the authorities have also introduced regulatory duties (10–25 percent) on several imported luxury and nonessential goods. In addition, the authorities maintained spending below the program’s projections, particularly on development projects.

Pakistan and International Financial Markets

Investor perceptions of Pakistan’s sovereign debt improved following the SBA approval, but the subsequent changes, while positive, have been modest. Secondary markets are relatively illiquid and primary debt markets remain virtually closed for countries rated below investment grade, making it difficult for Pakistan to reestablish its market access. There has been some recovery in the sovereign credit risk indicators as perceptions of liquidity risk have improved, but concerns about political uncertainty, the public finances, and external sustainability have not subsided. The adoption of the program and the broadly positive developments thus far have significantly reduced implementation risk, but the underlying risks to the economic and financial outlook remain high, and Pakistan’s economic policies are expected to remain resource-constrained. Moreover, tail risks, including those related to the global economic environment, have increased significantly.

  • The Pakistan’s EMBIG spread moderated from the peak of 2222 bps in December to 1914 bps at end-February, but remain volatile (an average for February was 1964 bps).

  • Five-year credit-default swaps (CDS) premium moderated from 3886 bps in mid-October to 2850 bps in early February but still indicates high default risk. However, the CDS market is relatively illiquid and does not reflect subtle changes in risk perception.

  • Pakistan’s sovereign debt rating by Moody’s/S&P is B3/CCC+ (as of end-2008). Moody’s rating, which puts Pakistan in the same category as Lebanon, was cut from B2 to B3 in October, and has been reconfirmed in December, but the outlook was changed to negative. S&P raised Pakistan’s rating to CCC+ in December; this upgrade incorporated the first purchase under the SBA as a factor alleviating the prospects of near-term debt service stress.

  • The amortization of the Eurobond in February ($500 million) was widely anticipated and any residual positive impact that could have occurred in its aftermath has been offset by recent political uncertainties, which sent the KSE into a temporary decline after several weeks of recovery.

11. Despite the somewhat improved confidence, credit and broad money demand growth have been slower than originally envisaged (Figure 3). Although reserve money grew faster than projected (reflecting a strong build-up of NFA that offset a contraction in the net domestic assets (NDA) of the SBP due to fiscal consolidation), broad money and private sector credit growth were below program projections.6 Specifically, private sector credit growth was just below 13 percent (year-on-year), compared with 17 percent in the program. Weak private sector growth reflects lower credit demand owing to the slowdown in economic activity, increased risk aversion by banks, and a flight to quality (a shift in lending to government and public enterprises) which has helped banks remain in a generally good financial condition (Box 3).

Figure 3.
Figure 3.

Pakistan: Monetary and Credit Indicators

Citation: IMF Staff Country Reports 2009, 123; 10.5089/9781451830743.002.A001

Sources: Pakistani authorities; and Fund staff projections.1/ Lending and Deposit rates are weighted averages for all banks.

12. Measures taken to improve liquidity management and monetary policy implementation fostered demand for T-bills and ensured orderly market conditions. The Ministry of Finance (MoF) and the SBP now issue a calendar of T-bill auctions with indicative volumes on a quarterly basis. Despite large oversubscription, the volumes of T-bills sold in primary auctions do not exceed significantly the announced volumes. Cut-off rates and allocation of T-bills among the 3-month, 6-month, and 12-month maturities (now being decided solely by the MoF) have been geared toward managing cost, minimizing the rollover risk, and building a yield curve. Open-market operations (OMOs) have been conducted mainly with a view to smoothing liquidity conditions, and the overnight repo rates have been markedly more volatile since September. Banks have accessed the SBP discount window for liquidity needs with increased frequency in recent weeks. In general, however, bank liquidity has been comfortable since October and, on a net basis, OMOs have recently been conducted to absorb excess liquidity.

C. Structural Reforms under the Program

13. All structural benchmarks for the first program review have been met (SMEFP, Table 2). The authorities also observed the World Bank’s upfront conditionality for the proposed Poverty Reduction and Economic Support Operation (PRESO) loan, which raises expectations of an improved follow-through on structural reforms in general.7

Table 2.

Pakistan: Balance of Payments, 2007/08–2009/10

(In millions of U.S. dollars; unless otherwise indicated)

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

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

Excluding foreign currency deposits held with the State Bank of Pakistan (cash reserve requirements) and gold.

  • The authorities adopted a tax policy and tax administration action plan. The plan envisages the integration of the income tax and sales tax departments and the replacement of the current general sales tax with a broad-based Value-Added Tax (VAT). A technical assistance mission from the Fund (scheduled for April) will help with the design of the VAT law, the revisions in the income tax legislation, and the possible introduction of a carbon tax (SMEFP, ¶13–14).

  • The authorities reached understandings with World Bank staff regarding the elimination of tariff differential subsidies by end-June 2009. Electricity tariffs were increased by 1 percent effective February 1, and will be raised further by a cumulative 4 percent by end-June (SMEFP, ¶17).

  • The SBP has prepared a contingency plan for handling problem banks. As required, the plan sets out criteria for liquidity support, assessment of problem banks, and intervention procedures. The SBP has actively encouraged the owners of the few problem banks to proceed with mergers or fresh capital injections (SMEFP, ¶22–24).

  • The provision of foreign exchange by SBP for imports of furnace oil ceased on February 1. These transactions were moved back to the interbank market.8

Pakistan—Banking System Stability Assessment

Based on the recently conducted Financial Sector Assessment Program (FSAP) update, the banking system appears to be generally well-capitalized and liquid. Aggregate financial soundness indicators improved since the 2004 FSAP. However, the worsening macroeconomic environment affected adversely bank profitability and asset quality in 2008. Tighter provisioning requirements reduced profits in 2007, and interest margins in 2008 were squeezed by increases in the policy rate and the minimum deposit rate for savings accounts. Gross nonperforming loans (NPLs) rose from 7.7 percent of total loans in June 2008 to 9.1 percent in December 2008, mainly on account of growing non-performing consumer and textile sector loans. The ratio of net NPLs to net loans increased from 1.3 to 2.5 percent in the same period, and provisioning has remained generally adequate. This level of NPLs is manageable given the improved capital position of the banking system, with capital adequacy ratios (CARs) having risen from 12.1 to 12.2 percent of risk-weighted assets over the same period. The improvement in CARs reflected mainly the increased share of T-bills and other low-risk assets in bank portfolios. A few banks representing less than 10 percent of system assets face financial pressures, which are to be addressed through mergers or fresh injection of equity. Progress by these banks in resolving their problems is monitored closely by the SBP.

Stress tests conducted by the IMF/World Bank staffs with June 2008 data indicated that most banks—including all large banks—would remain solvent in severe crisis scenario. However, some small and mid-sized banks would face insolvency under these simulated crisis conditions. In the worst case scenario, the capital injection needed to restore the CAR of the twelve largest banks to the minimum regulatory CAR of 8 percent was 2.3 percent of GDP. This relatively benign outcome reflects the low credit-to-GDP ratio and the relatively high capital buffers prior to the simulated crisis. The main sources of risk for the vulnerable banks are a major deterioration in credit quality, mainly in the textile industry, and a sharp drop in equity prices. Default on the largest exposures puts significant strains on solvency given the large concentration of these exposures in some banks. The SBP has obtained similar results on the basis of end-September data.

Direct exposure of the banking system to currency depreciation was found to be generally small, and indirect exposures through the unhedged exposure of bank clients limited. Lending in foreign currencies is restricted to trade-related purposes by SBP regulation. Exporters have foreign currency cash flows to cover debt service, but importers may be vulnerable in the event of a sharp depreciation that depresses import demand. Residents’ foreign-currency accounts constitute less than 8 percent of total deposits in commercial banks.

14. Progress has also been made toward the end-March 2009 benchmarks:9

  • The authorities and World Bank staff have agreed on reforming the Benazir Income Support Program (BISP) by introducing a scorecard as an objective targeting mechanism for identifying poor households. The roll-out in 16 districts (pilot phase) has started, with the roll-out in all the 130 districts expected to be finalized between December 2009 and June 2010. BISP disbursements will start shortly, but delays in the BISP roll-out and the government’s decision not to scale up Bait-ul-Mal (an existing cash transfer program) will likely result in lower-than-projected spending on social transfers in 2008/09 (Box 4; SMEFP, ¶12).

  • The authorities have accelerated the preparation of a plan to deal with the circular debt. The circular debt (inter-corporate debt in the energy sector) has risen on a net basis from Rs. 51 billion (0.4 percent of GDP) in mid-October to close to Rs. 189 billion (1.5 percent of GDP) as of March 6. The authorities’ plan involves the issuance of Term-Finance Certificates (TFCs) at Karachi Interbank Offered Rate (KIBOR) + 175 bps to cover Rs. 98 billion in outstanding liabilities of Pakistan Electric Power Company (PEPCO) to its suppliers, which should enable a significant increase in electricity production that is needed to help the recovery in the industrial sector. The TFCs will have a 5-year maturity with government guarantee. Financial schemes to raise funds through the sale/lease of government property are also being considered to cover the remainder of the circular debt (SMEFP, ¶18).

III. Policy Discussions

A. Near-Term Economic Outlook and the Macroeconomic Framework

15. The authorities and staff reached understandings on a revised macroeconomic framework for 2008/09–09/10. The outlook for the remainder of 2008/09 remains difficult, in particular for the manufacturing sector. As a result, the growth projection for 2008/09 was revised downwards to 2.5 percent, from 3.4 percent in the original program. A further downward revision was deemed unwarranted at this stage, given the strength of agricultural output and the good performance of the services sector (Figure 4). Nevertheless, the revised growth projections are subject to significant downside risks and real GDP growth in 2008/09–09/10 could be by 0.5–1.0 percentage points lower. With a continued strong performance in agriculture and electricity sector reforms, which are expected to improve supply conditions in the large-scale manufacturing, growth is projected to pick up to 4 percent in 2009/10.10 Under conservative assumptions for the remainder of 2008/09 (food and energy prices remaining flat, and core inflation of one percent per month), year-on-year headline inflation would decline to 10 percent by June 2009 (compared with 20 percent in the program), and to 6.5 percent by June 2010. This accelerated pattern of disinflation will cause average annual inflation to drop from 20 percent in 2008/09 to 6 percent in 2009/10.11

Figure 4.
Figure 4.

Pakistan: Output and Inflation Indicators 2004/05–2008/09

Citation: IMF Staff Country Reports 2009, 123; 10.5089/9781451830743.002.A001

Sources: Pakistani authorities; and Fund staff projections.

Social Protection in Pakistan

In spite of sustained economic growth over the last decade, poverty remains high. According to the World Bank, the poverty rate declined from 34 percent in 2001 to about a quarter of Pakistani households in 2005/06. The poor and non-poor alike remain vulnerable to risks such as health, disability, unemployment, and sharp increases in the price of food. Poverty reduction is complicated by the deficiencies in the social safety net, as well as under-investment in health and education.

In response, the government launched the Benazir Income Support Program (BISP) in September 2008 to provide cash grants to the poorest families. Under the BISP, each eligible family is to receive Rs. 1,000 per month. The FY 2008/09 budget allocated Rs. 34 billion (0.3 percent of GDP) to BISP. However, until recently BISP lacked an objective targeting mechanism, with beneficiaries being identified by the Members of the National Assembly.

In late January 2009, the authorities agreed with the World Bank on a reform of BISP through the introduction of an objective targeting mechanism. This reform is based on a scorecard system for identification of poor households. The roll-out of the scorecard system in at least 16 districts (a pilot phase) is expected to be completed by May 2009, while the roll-out to all 130 districts is to be completed between December 2009 and June 2010. The roll-out will need to be paced according to capacity and ability to implement in the face of political and security constraints. The number of benefiting families is to reach 5 million in 2009/10 and 7 million in 2010/11. To ensure proper targeting of BISP transfers, the authorities envisage using the new scorecard system to scrutinize beneficiaries that were identified under the pre-scorecard selection process.

In addition to BISP, there are two other nation-wide cash transfer programs with different modes of financing and delivery, but similar objectives:

  • Bait-ul-Mal: Spending on Bait-ul-Mal has increased substantially over the last decade and the number of beneficiaries increased from about 200,000 in 1998 to about 1.4 million in 2007.

  • Zakat: This program is financed by private contributions. However, these contributions have declined substantially over the last decade.

Also, there are several small programs that provide social welfare and care services to persons with disabilities, child laborers, and others. Moreover, a public works program provides employment opportunities in small-scale rural and urban projects. Pakistan also uses a wheat subsidy to address food price shocks. The province of Punjab has also recently launched its own cash transfer program.

The effectiveness of these programs is hampered by low coverage of the poorest households and substantial leakage of benefits to non-poor households. The World Bank estimates that these programs cover only 5 percent of the population. Moreover, around 32 percent of Zakat benefits and 25 percent of Bait-ul-Mal benefits accrue to non-poor households. Their effectiveness is further diminished by benefits being small and infrequent, and by governance issues.

Consolidation of safety net programs and better funding could help to enhance their effectiveness. Given the similar nature of BISP and Bait-ul-Mal, one option would be to merge the two programs in 2009/10, and use at least a part of the resources for Bait-ul-Mal to scale up BISP; another option would be to increase their complementarities.

Revised Macro Economic Program, 2008/09–2009/10

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Source: Fund staff projections.

16. The external current account deficit is projected to narrow in 2008/09 and 2009/10, but there are downside risks. The projected external current account in 2008/09 is slightly better than originally envisaged, with lower imports expected to outweigh a weaker export performance (Figure 5). A further improvement is expected in 2009/10, mainly on account of the full-year effect of lower oil prices. However, the projected improvement in the current account may not materialize if exports drop sharply or private transfers decline.

Figure 5.
Figure 5.

Pakistan: External Sector Indicators, 2004/05–2008/09

Citation: IMF Staff Country Reports 2009, 123; 10.5089/9781451830743.002.A001

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

17. The financial account surplus is now expected to be slightly lower than originally projected, due mainly to the worsening environment for foreign direct investment (FDI) and privatization-related inflows. Disbursements of official budget support from China, a commodity support loan from Saudi Arabia, and higher disbursements under short-term oil import facility from the Islamic Development Bank would offset delays in disbursements from the World Bank and the Asian Development Bank. In addition, net private capital flows would be better than envisaged as the expected sharp outflow of foreign capital from the stock market did not materialize. Consequently, the overall external balance for 2008/09 is now projected to be better than programmed by about $500 million, whereas, despite the large anticipated improvement in the current account, the balance-of-payments improvement projected for 2009/10 would be limited to $700 million because of the downward revision in the projected official and private capital inflows.

B. Policies for the Remainder of 2008/09 and 2009/10

18. The authorities agreed that consolidating the gains made in macroeconomic stabilization remains the key priority. In this context, discussions focused on (i) the appropriateness of the fiscal program and the deficit targets for 2008/09 and 2009/10; and (ii) the monetary policy stance. The following considerations featured prominently in the policy discussions:

  • The availability of external financing. Securing the programmed amount of external financing (mostly privatization proceeds) for the budget will be challenging (see ¶19). A donor conference, tentatively scheduled for April 17 in Tokyo to be co-hosted by the Government of Japan and the World Bank, will provide an opportunity to seek additional external assistance.

  • The scope and desirability of fiscal easing in light of the weakening economic activity. The authorities do not see scope for relaxing the fiscal stance and have opted for an unchanged fiscal deficit target as a cornerstone of their stabilization efforts.

  • The scope for modifications in interest rate policy. The discussions on interest rate policy sought to balance the objectives of further reducing the still high (albeit rapidly declining) inflation and ensuring non-SBP financing of the budget with the need to provide adequate credit to the slowing economy. The authorities agreed that it was premature to reduce interest rates at this stage, but saw the need to reassess interest rates down the road in order to stimulate a pick-up in economic activity.

  • The impact of the economic downturn on the banking sector. The SBP has been monitoring conditions in the banking sector closely; concerns arise about bank asset quality because high interest rates and the economic slowdown have made banks vulnerable to an increase in nonperforming loans in their corporate loan portfolio.

Fiscal policy

19. In the near term, fiscal policy will be challenged by the shortfalls of revenue and external financing. The slowdown in economic activity is affecting the revenue base and is likely to result in a shortfall in the Federal Board of Revenue (FBR) collections relative to the original 2008/09 program target.12 The authorities indicated that they intended to limit this shortfall through administrative measures, including tax audits;13 additional revenues from the PDL; and possibly the introduction of a carbon tax (SMEFP, ¶9). To help increase the revenue-to-GDP ratio by 0.6 percentage points in 2009/10, the authorities are also planning to broaden the tax base across all sectors of the economy, including by reducing the scope of tax exemptions and zero-rating. However, the timing of these reforms will depend on the tax administration’s capacity to process refunds. Other revenue measures, such as the introduction of a carbon tax or a gross asset tax, are under discussion, but are yet to be approved. External budget financing (including project financing) will likely fall short of the original program projections by $1.9 billion or 1.2 percent of GDP, due mainly to the absence of external privatization proceeds. As the global environment is not expected to improve rapidly, a similar shortfall is projected also for 2009/10. To compensate for this, the authorities will be seeking external bilateral support. In addition, the MoF intends to tap nonbank sources of domestic financing, following several successful placements of Pakistan Investment Bonds (PIBs) and Ijara Sukuks since September (SMEFP, ¶10).

20. The authorities recognize that in the current circumstances the room for countercyclical fiscal policy is very limited. Consequently, they remain firmly committed to achieving the program’s original nominal fiscal deficit (excluding grants) target for 2008/09 (Rs. 562 billion, or 4.3 percent of the revised GDP—Figure 6). The fiscal deficit target for 2009/10 has been set at 3.4 percent of GDP, consistent with the fiscal effort of 0.9 percentage point of GDP envisaged in the original program; any further adjustment would be overly procyclical and could only be justified if the risks of higher inflation or a of resurgence of SBP financing of the government were imminent.

Figure 6.
Figure 6.

Pakistan: Fiscal Policy Indicators, 2004/05–2008/09

Citation: IMF Staff Country Reports 2009, 123; 10.5089/9781451830743.002.A001

Sources: Pakistani authorities; and Fund staff projections.

21. The authorities indicated that they stood ready to further restrain spending in case this was necessary to offset any revenue shortfalls. To this end, the authorities had begun to prioritize and rationalize development spending.14 Further contingency measures may need to be identified to avoid last-minute expenditure compression in case of a larger-than-expected revenue shortfall. Development spending for 2009/10 will be reviewed in the context of the Medium-Term Budget Framework, which is under preparation (SMEFP, ¶16).15 Room for expenditure cuts in other areas is very limited owing to the high share of interest and security spending, the need to provide for adequate operation and maintenance, and increased outlays under the strengthened social safety net (Box 4). Regarding the latter, cash transfers to the poor are projected to increase from 0.4 percent of GDP in 2008/09 to 0.6 percent in 2009/10. Moreover, the recently announced wheat procurement program for 2009–10 may involve expenditures that exceed Rs. 40 billion (0.3 percent of GDP) already included in the fiscal framework for 2009/10, unless international wheat prices rebound to the current price support level.16

Monetary Policy

22. Discussions focused on clarifying monetary policy objectives and measures to strengthen its effectiveness in the context of the reforms envisaged under the program. Under crisis conditions, monetary policy has been subject to several competing pressures. The SBP has had to use its policy discount rate to defend its international reserves position, bring down inflation, and ensure that interest rates are high enough to encourage demand for T-bills. At the same time, it has used OMOs to stabilize bank liquidity. Measures taken under the program helped re-focus monetary policy on a narrower set of goals. Notably, the adoption of the pre-announced T-bill auction calendar has de-linked government debt management from monetary policy operations. Looking forward, the SBP staff indicated that this, together with steps to increase the operational independence of the central bank, would help establish short-term interest rates as the operational target and focus on price stability as the primary monetary policy objective.17 To this effect, market conditions permitting, the SBP intends to implement an explicit corridor for short-term interbank rates effective August 1, 2009.

23. The authorities and the staff agreed that at this juncture there was no clear-cut case for an immediate change in interest rates. In the November 2008 MEFP, the authorities had committed to considering a further increase in the discount rate in January 2009; however, given the evolving domestic and international economic situations, the SBP did not see the need for a further increase at that point.18 At the same time, the SBP considers it premature to reduce the discount rate at this juncture, as core inflation remains elevated. In the discussions, the authorities hinted at the desirability of interest rate cuts—after further progress in reducing inflation—as a countercyclical measure. Staff agreed that there was no immediate need to increase interest rates and that current trends suggested that easing monetary conditions might be desirable and possible, provided that international reserves remain adequate, inflation continues to decline and the budget could be financed through T-bill placements in the commercial banks. Staff cautioned, however, that given the expected external financing shortfall, the authorities may need to raise more funds in the domestic market. They also remarked that large financing needs resulting from the wheat procurement program and placements of TFCs to address the circular debt issue could also hinder the decline in interest rates.19

Exchange Rate

24. Notwithstanding a sizable nominal depreciation in 2008, the rupee remains slightly overvalued in real effective terms (Box 5). The real effective exchange rate (REER) depreciated steadily over the first three quarters of 2008, but has appreciated since September before stabilizing recently at end-2007 levels. The recent REER appreciation reflected large inflation differentials, as well as cross currency movements of the U.S. dollar against Pakistan’s major trading partners since September. The macroeconomic balance approach suggests that in real effective terms the rupee is presently about 5–10 percent above the level consistent with Pakistan’s current account deficit norm of 3.6 percent of GDP. Other approaches point to similar results.

25. Since the inception of the program, intervention in the foreign exchange market has been largely aimed at achieving the NFA targets, but more recently the focus has shifted somewhat toward exchange rate stability. Staff recommended that the SBP continue to pursue a flexible exchange rate policy and intervene mainly to build up official reserves. As the program NFA targets for the remainder of 2008/09 appear well within reach, the SBP was encouraged to accumulate higher than programmed international reserves as a safety cushion against heightened risks to the balance-of-payments outlook. The authorities generally agreed with the staff’s recommendation, but noted that setting over-ambitious reserve targets may adversely affect market expectations, given the increased uncertainty about balance-of-payment flows (including from official sources). Staff cautioned about creating firm expectations of exchange rate stability, and noted that excessive focus on exchange rate stability may clash with the introduction of the explicit interest rate corridor.

Financial sector issues

26. The authorities recognized the importance of risks from the deteriorating economic outlook and the need to continue monitoring developments in the banking system very closely. Credit concentration among a few borrowers is a source of concern and stress tests clearly identified a deterioration in credit quality as an important risk, that may materialize as a result of the economic downturn, as it did in other countries. It was noted that the legislative changes aimed at strengthening the SBP’s enforcement powers and the new bankruptcy law under preparation will contribute to enhancing financial sector stability (SMEFP, ¶26).

Pakistan—External Competitiveness and Exchange Rate Assessment

Pakistan’s export growth has been broadly in line with its competitors in recent years. After a strong performance in the late 1990s, export growth has moderated. The growth of textiles and other traditional exports has slowed, but nontraditional exports have risen significantly in recent years. Since 2000, Pakistan’s average annual export value growth has been about 12 percent, similar to that of Bangladesh and higher than Sri Lanka’s, but below export growth in China and India.

Regional Growth in Merchandise Export Value

(In percent)

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Source: World Economic Outlook

The Pakistani rupee is assessed to be slightly above equilibrium using CGER estimates. In real effective terms, the rupee is now close to its 2007 level, despite a large nominal depreciation against the U.S. dollar in 2008. Its more recent appreciation is less significant than that of most of its neighbors, and reflects in large part high inflation differentials with trading partners. The macroeconomic balance (MB) approach suggests that the current level of real exchange rate is about 5–10 percent above the level consistent with the equilibrium current account deficit (“current account norm”) of around 3.6 percent of GDP. Preliminary estimates based on the equilibrium real exchange rate approach suggest that the rupee is around 2 percent above equilibrium. The external sustainability approach estimates that in real effective terms, the rupee is about 7 percent above the value needed for the current account deficit to decline to the level that stabilizes the ratio of Pakistan’s net foreign liabilities to GDP at its 2007 level.1


Regional Real Effective Exchange Rates

Citation: IMF Staff Country Reports 2009, 123; 10.5089/9781451830743.002.A001

Source: IMF Information Notice System.
1The methodologies are described in detail in “Methodology for CGER Exchange Rate Assessments”, which can be found at

27. The discussions also focused on measures adopted recently by the SBP to help corporate borrowers service their debt to commercial banks. Specifically, the SBP has announced a relief package for the industrial sector (mainly textiles) that allows the banks and development finance institutions (DFIs) to defer for one year the repayment of principal outstanding under Export-Oriented Projects schemes, including the Debt Swap Facility and the Long-Term Financing Facility (LTFF). Subsequently, the SBP also offered similar relief for the refinancing of loans under the SBP Export Finance Scheme (EFS). Staff cautioned the SBP on expanding the scope of its quasi-fiscal operations by relaxing the rules governing these schemes, and stressed the need for increased transparency in this area.

28. The authorities have also eased some regulatory provisions to help banks amortize the losses incurred during the KSE closure (SMEFP, ¶27–28). Staff expressed concern about a loosening of prudential regulations at a time when the economic downturn is likely to put stress on banks’ financial positions.

C. Exchange Restrictions and Trade Policy

29. Cash margins on letters of credit give rise to an exchange restriction. A measure establishing cash margin requirements on LCs for certain imports had been introduced in May 2008, prior to the approval of the SBA. This measure was recently modified to apply to LCs for imports of goods that were not previously subject to such requirements. Staff concluded that the imposition of cash margin requirements on LCs gives rise to an exchange restriction subject to Fund approval under Article VIII, Section 2(a) and that the recent modification of this measure results in an intensification of this restriction and in a breach of the continuous performance criterion against imposing or intensifying exchange restrictions. The authorities have been working with staff to address this matter and will issue a regulation to reverse this intensification by end-June 2009. On this basis, the authorities request a waiver for the nonobservance of the continuous performance criterion.

30. Pakistan’s trade policy has been mainly geared towards export diversification in the nontraditional sector, by reducing the cost of doing business and enhancing productivity and competitiveness in manufacturing. The government has also made efforts to enhance market access for Pakistan’s exports—particularly to development partners. Recent initiatives include duty free access to the U.S. market for goods manufactured in the designated Reconstruction Opportunity Zones, and more preferential access to the EU market.

D. Safeguards Assessment and AML/CFT Issues

31. The Safeguards Assessment update is substantially completed. The update report indicates that the operational environment at the SBP has been strengthened since the last assessment, but that action is needed to address the absence of operational independence and to enhance controls over program data reporting. The safeguards assessment also pointed to the need to improve further the SBP’s financial control systems. SBP staff acknowledged these concerns, which will be addressed gradually. Specifically, an inter-agency committee will complete its work on how to strengthen the operational independence of the SBP by end-April 2009, and a new central bank law will be submitted to Parliament by December 2009. The SBP is also planning changes in the voting structure of its Audit Committee, steps to enhance internal controls, and the establishment of a Board committee to centralize risk management. SBP staff had some reservations regarding the implications of the International Financial Reporting Standards features that have not yet been adopted in Pakistan. In particular, they expressed concern that mark-to-market valuation requirements could expose the SBP to pressures for transferring unrealized profits to the budget. However, necessary mechanisms to preclude such distribution are proposed to be included in the forthcoming amendment of the SBP Act.

32. Pakistan faces significant risks of money laundering and terrorism financing. Several steps have been taken to strengthen its anti money laundering and combating of financing of terrorism (AML/CFT) regime, but the scope of preventive measures needs to be expanded and enforcement should be more stringent. An Anti-Money Laundering Ordinance has been promulgated, a financial intelligence unit has been established, and a wide range of terrorism financing activities have been criminalized. The regulations issued by the SBP and the Securities and Exchange Commission provide a good basis to improve protection against money laundering and terrorism financing and enhance transparency. However, further efforts are needed to establish the autonomy of money laundering offenses and complete the list of predicate offences, Also the criminalization of financing of terrorism organizations (other than prohibited ones) remains ambiguous and the scope for freezing assets is too narrow. Further, available legal powers to prosecute money laundering and terrorism financing are not being properly used.

E. Medium-Term Outlook and Debt-Sustainability Analysis

33. The authorities laid out an ambitious medium-term framework but recognized that the economic downturn will delay the transition toward the targeted growth path. Real GDP growth is projected to recover to 4 percent next year, and to 7 percent a year by 2013/14. Headline inflation is expected to decline rapidly to 6 percent by 2009/10. The current account deficit is envisaged to narrow to more sustainable levels as fiscal consolidation continues and the real effective exchange rate adjusts gradually to its equilibrium level. This, together with improved market access, a recovery in foreign direct investment, and increased financing from official sources would enable the SBP to maintain the reserve cover of about three months of imports over the medium term. Growth will be sustained by structural reforms and increased public investment, especially in the energy sector, and improved access to water for agriculture. With the current account adjustment dictated by external sustainability constraints, much of the investment will be financed from domestic sources. It is assumed that mobilization of private savings, in combination with a considerable increase in the revenue-to-GDP ratio (see below), will permit a significant increase in domestic investment, which would be facilitated by well-targeted public investment, public-private partnerships, and improved financial intermediation.

34. A significant increase in revenue as a share of GDP remains the cornerstone of the medium-term framework. In this regard, the introduction of a broad-based VAT, which constitutes the most important tax policy reform, is scheduled for 2010/11. An increase in the revenue-to-GDP ratio to above 14 percent of GDP by 2013/14, together with a sharp reduction in subsidies and ill-targeted development spending, would be needed to create fiscal space for high quality public investment and an adequate increase in outlays on poverty reduction. In the context of the 2009/10 budget preparation cycle, the authorities are working on their first fully-fledged Medium-Term Budget Framework (MTBF); this should strengthen the predictability of funding and bring credibility and stability to their budget plans. The authorities intend to use the MTBF to determine the development budget envelope in the context of well-specified and fully-costed programs, including those aimed at alleviating poverty, as described in Pakistan’s second Poverty Reduction Strategy Paper (SMEFP, ¶16).

35. Pakistan’s debt dynamics did not change substantially compared with the assessment made at the time of approval of the SBA (Appendix I). Under the baseline scenario, the external debt outlook has improved slightly as a result of the lower current account deficits but the debt trajectory remains unchanged. Domestic public debt is expected to rise somewhat owing to lower privatization proceeds.

36. Downside risks to the relatively benign debt sustainability outlook are significant. The external debt ratios are sensitive to higher current account deficits, lower FDI inflows, and large exchange rate depreciation. Domestic debt ratios are sensitive to shocks to the primary fiscal balance, growth, and interest rates, as well as to contingent fiscal liabilities that could arise during the projection period.

IV. Staff Appraisal

37. Pakistan’s stabilization program is on track. Fiscal consolidation and improved coherence between fiscal and monetary policies are bringing under control the factors that led to large imbalances in recent years. As a result, headline inflation has declined, the exchange rate has been broadly stable, the international reserve position has strengthened, and the demand for treasury bills has rebounded. Performance under the program has been satisfactory, and all the quantitative performance criteria through December 2008 were met.

38. Structural reforms have progressed broadly as envisaged. A contingency plan for handling problem banks has been prepared and is being strengthened; an action plan to reform tax policy and administration has been adopted and will be implemented with technical assistance from the IMF and the World Bank; and tariff differential electricity subsidies will be fully eliminated by the end of June 2009. The authorities have also designed a plan to address the stock of circular debt, which should ease the constraints on economic growth originating in the energy sector. Stronger incentives are needed to arrest the accrual of circular debt.

39. Looking ahead, with the weaker global outlook and slower domestic activity, the risks to Pakistan’s economic and financial prospects have risen notably. While Pakistan is benefiting from the decline in petroleum prices and the external current account deficit is narrowing, the decline in the demand for exports and uncertainty about workers’ remittances are important risks to the external outlook. Weakening bank credit to the private sector and dimmer prospects for external private finance are also constraining growth. Political risk is also higher.

40. Fiscal policy has come along well, but remains under pressure. Staff recognizes that the fiscal targets for December 2008/09 were met with great effort under difficult circumstances. Staff commends the authorities for adhering to the program’s fiscal target for 2008/09 and the fiscal adjustment for 2009/10. The fiscal program for these two years, however, contains ambitious revenue targets in the context of slowing economic activity. The widening revenue shortfall in the third quarter of 2008/09 suggests that meeting the revised revenue target for 2008/09 will be challenging. Accordingly, an early identification of additional contingent revenue and expenditure measures would help avoid the need for a sharp last-minute expenditure compression.

41. There is a pressing need to strengthen the social safety net. Social protection is a key element of the authorities’ program. The roll-out of the scorecard system under the BISP has started, and the number of families benefiting from BISP cash transfers should increase considerably in the coming two fiscal years. Looking ahead, it is important to review the other components of the social safety net to identify overlaps and gaps in the system. Consideration could also be given to merging the cash transfer component of the Bait-ul-Mal system with the BISP, as well as eliminating gaps and overlaps between the federal and provincial programs to free resources for scaling up BISP.

42. Over the medium term, higher budget revenues are critical for creating fiscal space for development and social spending. Government revenue are low by international standards, which constrains capital accumulation, spending on maintenance, and social outlays. Against this background, a vigorous implementation of the government’s ambitious tax reform agenda is essential. Specifically, the replacement of the General Sales Tax with a broad-based VAT in 2010/11 is a key reform. The establishment of the MTBF will also be an important step for strengthening the public finances.

43. The SBP’s monetary policy stance is appropriate, and needs to remain flexible to address risks. Staff agrees with the authorities’ intention to keep interest rates on hold for the time being in order to lock in the gains made in lowering inflation and avoid financial pressures. Looking ahead, there should be scope for lowering interest rates, provided that inflation continues to decline, international reserves are further strengthened, and the government avoids recourse to SBP financing.

44. The envisaged strengthening of the SBP’s policy framework is welcome. Looking forward, the SBP will need to ensure that the introduction of the explicit interest rate corridor does not constrain the objective of strengthening its external international reserve position. In addition, the operational independence of the SBP needs to be enhanced, and its quasi-fiscal operations should be transparently accounted for and eventually eliminated.

45. The AML/CFT regime is not yet effective. To ensure its effectiveness, Pakistan should prepare a ML/FT risk analysis, adopt a national AML/CFT strategy, and consolidate the institutional framework.

46. Exchange rate flexibility should continue to facilitate external adjustment. The CGER estimates suggest that the Pakistani rupee is slightly overvalued. Arguably, the exchange rate has been too stable recently, and more flexibility may be needed in the future to deal with uncertain inflows. Intervention needs to remain largely geared to achieving the program’s NFA targets but, conditions permitting, any excess NFA accumulation will constitute a useful self-insurance against risks to the balance-of-payments outlook.

47. Pakistan’s financial system has weathered the crisis thus far, but needs to be monitored carefully. The FSAP stress tests and the authorities’ own updates are encouraging. Nevertheless, with the slowing in economic activity and rising NPLs, the risks to the system are rising. In this connection, the recent formulation of plans for dealing with problem banks is welcome. At the same time, care should be taken that the changes introduced to the regulatory framework and the extension of the refinancing period under the SBP’s discount credit schemes do not prevent a timely assessment of potential problems and result in unintended regulatory forbearance.

48. Pakistan needs additional external assistance to reduce risks and provide some scope for countercyclical policies by allowing greater development and social spending. The program is financed for 2008/09 and 2009/10, but financing constraints leave little room for countercyclical spending. The upcoming donor meeting provides an important opportunity for mobilizing additional assistance.

49. In light of performance to date and the policy intentions expressed by the authorities in the attached LOI and SMEFP, staff recommends the completion of the first review under the SBA. Noting the authorities’ commitment to reverse by end-June 2009 the intensification of the exchange restriction related to cash margin requirements on LCs for certain imports, staff supports the authorities’ request for a waiver of nonobservance of the continuous performance criterion against imposing or intensifying exchange restrictions as the measure giving rise to the restriction is minor and temporary.

50. It is proposed that the next Article IV consultation for Pakistan take place within 24 months subject to the provisions of the decision on consultation cycles in program countries.

Table 3a.

Pakistan: Consolidated Government Budget, 2007/08–2009/10

(In billions of Pakistani rupees)

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Sources: Pakistani authorities for historical data; and Fund staff for estimates and projections.

For 2007/08, financing figures are provided by the Ministry of Finance.

In 2007/08, PR 23 billion (0.2 percent of GDP) of current expenditure has been reclassified as development expenditure.

Comprises BISP, Bait-ul-Mal, and Pakistan Poverty Alleviation Fund.

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.

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

Table 3b.

Pakistan: Consolidated Government Budget, 2007/08–2009/10

(In percent of GDP; unless otherwise indicated)

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Sources: Pakistani authorities for historical data; and Fund staff for estimates and projections.

For 2007/08, financing figures are provided by the Ministry of Finance.

In 2007/08, PR 23 billion (0.2 percent of GDP) of current expenditure has been reclassified as development expenditure.

Comprises BISP, Bait-ul-Mal, and Pakistan Poverty Alleviation Fund.

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.

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