Pakistan
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
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International Monetary Fund
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Publication Date:
13 Apr 2009
eISBN:
9781451830743
Language:
English
Keywords:
ISCR; CR; T-bill auction; SBP discount rate; Supreme Court ruling; Pakistan; short-term debt; headline inflation; private sector; broad money; transfer program; Current account deficits; Global; Pakistani rupee
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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.

Abstract

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))

article image
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)

article image
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

uA01bxfig01

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 http://www.imf.org/external/np/pp/eng/2006/110806.pdf.

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.

Table 4.

Pakistan: Monetary Survey and Analytical Balance Sheet of the State Bank of Pakistan, 2007/08–2009/10

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

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

Includes valuation adjustments.

Table 5.

Pakistan: Medium-Term Macroeconomic Framework, 2007/08–2013/14

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

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 12).

Including grants and earthquake-related expenditures.

Excluding grants and earthquake-related expenditures.

Table 6.

Pakistan: Medium-Term Balance of Payments, 2007/08–2013/14

(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.

For 2009/10–2013/14, includes unidentified disbursements from official creditors.

Table 7.

Pakistan: Medium-Term Fiscal Framework, 2007/08–2013/14 1/

(In percent of GDP; unless otherwise indicated)

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

Projections based on a staff scenario with tighter fiscal and monetary policies.

Projection for 2007/08 includes as development expenditure 0.3 percent of GDP corresponding to items classified as current expenditure in earlier years. Reclassification is maintained in all projection years.

Spending related to the 2005 earthquake.

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

Table 8.

Pakistan: External Debt, 2007/08–2015/16

(In millions of U.S. dollars, outstanding as end of each fiscal year)

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Sources: Pakistani authorities; and Fund staff estimates and projections.
Table 9.

Pakistan: Gross Financing Requirements and Sources, 2007/08–2009/10

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

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Sources: State Bank of Pakistan, and Fund staff estimates and projections.
Table 10.

Pakistan: Indicators of Fund Credit

(In millions of SDR unless otherwise specified)

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Source: Fund staff projections.

For 2008/09 and 2009/10, debt service includes payments related to EFF.

Table 11.

Pakistan: Access and Phasing under the Proposed Stand-By Arrangement, 2008–10

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Source: Fund staff.
Table 12.

Pakistan: Selected Vulnerability Indicators, 2007/08–2013/14

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

2008/09: spread on March 4, 2009.

Debt at remaining maturity is defined as maturing short-, medium-, and long-term external official debt.

Current account deficit plus amortization of external debt.

Public sector covers general (consolidated) government.

Based on the end of period debt stock in year t-1, and the baseline assumptions for the relevant variables (i.e., growth, interest rates, inflation, exchange rates) in year t.

Overall balance plus debt amortization.

Net debt is defined as gross debt minus government deposits with the banking system.

Financial sector includes all commercial and specialized banks; for government debt also includes non-banks, but excludes State Bank of Pakistan.

For 2005/06 data are on a calendar year basis (e.g., the value for 2005/06 denotes the observation for end-December 2005).

Table 13.

Pakistan: Financial Soundness Indicators for the Banking System, 2002–08

(At end-December)

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Source: Pakistani authorities.
Table 14.

Pakistan: Millennium Development Goals, 1990–2007 1/

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Sources: Pakistani authorities; Pakistan Millennium Development Goals Report (2004–06); World Development Indicators database (2007); and Fund staff estimates.

When data for a particular year are missing, the value reported corresponds to the closest year where data for that indicator are available.

*Aged 10 and above

*Aged 15 and above

Appendix I. Pakistan: Debt Sustainability Analysis

A. External Debt Sustainability Analysis

1. Pakistan’s external debt burden has been relatively moderate in recent years as a result of successive debt relief undertaken in the late 1990s and early 2000s. At end FY 2007/08, external debt stock stood at around 26½ percent of GDP (Table 1), and debt service was about 15 percent of exports of goods and services. Most of its debt were public sector debt—owed largely to official creditors, and there were limited private sector debt.

Table 1.

Pakistan: External Debt Sustainability Framework, 2004/05–2013/14

(In percent of GDP, unless otherwise indicated)

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

Derived as [r - g - r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = change in domestic GDP deflator in U.S. dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock. r increases with an appreciating domestic currency (e > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

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

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Exports and imports of goods and services

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.

2. The debt ratio is projected to rise temporarily due to significant increase in external financing from official creditors (including the Fund) to help Pakistan with the recent balance of payments pressure. The debt stock would be around 32½ percent of GDP during 2008/09–2010/11, and then gradually decline about 27½ percent of GDP by 2013/14.

3. The debt service burden would increase but remain manageable during the projection period. Debt service as a ratio of exports of goods and receipts is projected to increase to 20 percent under the baseline scenario. This increase is sizable but debt service burden will decline markedly following repurchase of outstanding Fund credits.

4. The relatively benign debt outlook under the baseline scenario is subject to serious downside risks. They include risks from higher non-interest current account deficit, lower growth, higher depreciation, higher interest rates, as well as lower FDI flows (Figure 1). The standard bound tests show that debt ratios are sensitive to shocks to higher current account deficits, large depreciation of exchange rate, and lower FDI inflows given the large financing needs. For example, if non-interest current account deficits are higher by half of the ten-year standard deviation, the debt as a ratio to GDP would rise sharply and be over 10 percentage points higher than under the baseline scenario. Combined shocks to growth, current account, and depreciation could vault the end-period debt stock to around 45 percent of GDP, significantly higher than under the baseline scenario.

Figure 1.
Figure 1.

Pakistan: External Debt Sustainability—Bound Tests 1/

(External debt in percent of GDP)

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

Sources: Historical data from Pakistani authorities; and Fund staff estimates and projections1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Combined impact of shocks to growth, current account, FDI, and real depreciation.3/ Growh rate lower than the baseline scenarion by half of the ten-year standard deviation.4/ Current account deficit higher than the baseline scenario by half of the ten-year standard deviation.5/ Net flows of foreign direct investment are 50 percent lower than in the baseline scenario.6/ One-time real depreciation of 30 percent occurs in 2009/10.

B. Public Sector Debt Sustainability Analysis

5. Pakistan’s public sector debt burden declined through 2006/07, but has been rising since then, reflecting the expansionary fiscal stance. At end FY 2007/08, the public sector debt stock stood at 57.4 percent of GDP (Table 2), with domestic public debt (31.2 percent of GDP) slightly exceeding external public debt (26.2 percent of GDP). Interest payments (4.7 percent of GDP) are a significant burden for the budget, accounting for 32.6 percent of total revenue (excluding grants) and 26.3 percent of current expenditures. Interest payments on domestic debt accounted for only 12 percent of total interest expenditure, partially reflecting that official creditors account for the bulk of total external debt.

Table 2.

Pakistan: Public Sector Debt Sustainability Framework, 2004/05–2013/14

(In percent of GDP, unless otherwise indicated)

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

General government gross debt.

Derived as [(r - p(1 +g) - g + ae(1 +r)]/(1+g+p+gp)) times previous period debt ratio, with r = interest rate; p = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currenc denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denominator in footnote 2/ as r - π (1 +g) and the real growth contribution as -g.

The exchange rate contribution is derived from the numerator in footnote 2/ as ae(1+r).

For projections, this line includes exchange rate changes.

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.

Derived as nominal interest expenditure divided by previous period debt stock.

Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.

6. The public debt ratio is projected to decline gradually, reflecting fiscal consolidation and lower interest rates in line with macroeconomic stabilization. The stock of external public debt will increase temporarily in 2008/09 owing to external financing from official creditors (including the Fund) to address Pakistan’s recent balance of payments pressure. The total stock of public debt is projected to decline gradually to 47½ percent of GDP by 2013/14.

7. The burden of interest payments on the budget would be halved. The ratio of interest payments to total revenue (excluding grants) would decline from 31 percent in 2008/09 to 14 percent in 2013/14, despite an increase in interest expenditure on external public debt by about 65 percent in U.S. dollar terms.

8. The relatively benign outlook for public sector debt under the baseline scenario is subject to significant downside risks. The standard bound tests show that risks from shocks resulting from higher interest rates or lower growth are moderate, as they would slow down rather then reverse the medium-term decline in the public debt ratio (Figure 2). However, a primary balance shock as well as a 30 percent devaluation and a contingent liabilities shock would lead to a perceptible increase in the public debt ratio.

Figure 2.
Figure 2.

Pakistan: Public Debt Sustainability: Bound Tests 1/

(Public debt in percent of GDP)

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

Sources: International Monetary Fund, Country desk data, and staff estimates and projections.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent ¼ standard deviation shocks applied to real interest rate, growth rate, and primary balance.3/ One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2009/10, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).

Attachment I. Pakistan: Letter of Intent

March 16, 2009

Mr. Dominique Strauss-Kahn

Managing Director

International Monetary Fund

Washington, D.C. 20431

Dear Mr. Strauss-Kahn:

The Pakistani authorities held discussions with Fund staff for the first review under the Stand-By Arrangement (SBA) and the 2009 Article IV consultation. Based on these discussions, we have updated our economic program for the remainder of 2008/09 and 2009/10, as reflected in the attached Supplementary Memorandum of Economic and Financial Policies (SMEFP). In support of this program, our authorities request the Executive Board of the Fund completes the first review and approve the second purchase under the SBA of SDR 568.54 million.

Although our economic stabilization program is off to a good start, we are fully aware of the challenges ahead. The sharply deteriorating global environment will affect Pakistan’s domestic economy, trade, and external financing. The government believes that the policies set out in the attached SMEFP are adequate to achieve the objectives of the program. However, it stands ready to take additional measures appropriate for this purpose, and will consult with the Fund in accordance with the policies of the Fund on such consultations. The Government of Pakistan will provide the Fund with information it may request to monitor progress in implementing its economic and financial policies.

We have recently modified cash margin requirements on letters of credit for certain imports, which resulted in nonobservance of the continuous performance criterion against imposing or intensifying exchange restrictions. We will issue a regulation to eliminate this restriction by end-June, 2009 and, on this basis, we request a waiver of nonobservance for the missed performance criterion.

We also consent to the publication of this letter, the attached SMEFP, the addendum to the Technical Memorandum of Understanding, and the related staff report.

Sincerely yours,

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Attachments:

Supplementary Memorandum of Economic and Financial Policies

Addendum to the Technical Memorandum of Understanding

Attachment II. Pakistan: Supplementary Memorandum On Economic And Financial Policies For 2008/09–2009/10

March 16, 2009

I. Introduction

1. This memorandum supplements our Memorandum on Economic and Financial Policies (MEFP) for 2008/09–09/10 of November 20, 2008. It describes policy implementation to date and lays out additional policies agreed in the context of the first review under the Stand-By Arrangement (SBA).

II. Recent Economic Developments

2. Our stabilization program is off to a positive start. Headline inflation has decreased from 25 to 20½ percent, the exchange rate has been broadly stable, the international reserves position has strengthened and, following the November discount rate increase, demand for Treasury bills has rebounded. All quantitative performance criteria through end-December 2008 (Table 1) were met and the implementation of the structural reform agenda is broadly on track (Table 2).

Table 1.

Pakistan: Quantitative Targets, December 2008–June 2010

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Notes: * denotes performance citeria.

Excludes IMF.

Table 2.

Pakistan: Structural Performance Criteria and Benchmarks

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The action plan was adopted in January 2009.

3. The deteriorating global economy is posing additional challenges for Pakistan. The world economy has slowed more quickly than envisaged, reducing demand for exports and carrying a risk of declining capital flows. Further, domestic economic activity has weakened. As a result both internal and external factors have made the environment for our economic stabilization program less favorable.

4. There are pressures on the budget. As a result of the slowdown in imports and domestic demand, budget revenues have been lower than projected in the first half of 2008/09 and this trend is expected to continue, however, this was largely offset by revenues from Petroleum Development Levy (PDL). Disbursement of multilateral program financing has been slow and projected privatization receipts for the 2008/09 budget are unlikely to materialize.

5. The State Bank of Pakistan (SBP) has tightened the monetary stance to reduce inflation and strengthen the external position. Increased confidence and improved terms of trade have helped stabilize the rupee at around Rs. 80 per U.S. dollar since mid-October 2008 and enabled the SBP to rebuild its gross international reserves to $6.9 billion at end-January, well above target.

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

6. The government and the SBP remain committed to address Pakistan’s economic problems despite the challenges posed by the global economic and financial crisis. Consolidating macroeconomic stabilization is essential for the economy, and financing constraints leave little room for countercyclical fiscal policy to counter slowing economic activity given the inherited economic imbalances. Hence, although growth is expected to be lower, and inflation is trending downwards, policies will continue to be geared to reducing the fiscal deficit, lowering inflation, and strengthening the external position. Nevertheless, improving and expanding the social safety net will continue to be central to the program. These policies will set the stage for higher investment and growth over the medium term and ensure vulnerable groups are protected. The success of our program also hinges on timely and generous support from the international community.

7. The program is built around the following revised economic parameters:

  • Real GDP growth of 2½ percent in 2008/09 and 4 percent in the following year;

  • Annual average consumer price inflation of 20 percent in 2008/09 and 6 percent in 2009/10; and

  • A current account deficit of 6 percent of GDP in 2008/09 and 4½ percent in 2009/10.

A. Fiscal Policy

8. We plan to maintain the path of fiscal adjustment in 2008/09–09/10. Our budget deficit target for 2008/09 remains unchanged. The shortfall in tax revenue will be compensated by additional revenue and expenditure measures to achieve an unchanged deficit target of Rs. 562 billion (4.3 percent of revised GDP). Fiscal consolidation will continue in 2009/10; the budget deficit is to be reduced by 0.9 percentage points to 3.4 percent of GDP. This consolidation is facilitated by the elimination of the fuel and electricity subsidies in 2008/09. Further, tax policy measures and the ambitious tax administration reform will increase the revenue and assure achievement of the 2009/10 deficit target, while creating fiscal space for strengthening our social safety net.

9. Revenue effort will play a key role in achieving the deficit target. The Federal Board of Revenue is targeting collection of Rs. 1,300 billion (10.0 percent of revised GDP) in 2008/09 including an additional yield of Rs. 65 billion on account of stepped-up auditing and enforcement. The authorities are also considering the levy of a carbon tax. Any shortfall in tax revenues will be compensated by revenues from the PDL, tax administration measures, and expenditure control measures.

10. The government will use non-SBP domestic sources to meet its financing needs. This approach is based on careful advance planning of quarterly budgetary borrowing requirements. Moreover, the Ministry of Finance (MoF) has taken several measures, in coordination with the SBP, to expand and enhance available financing options for the budget. To this end the MoF also successfully issued three Ijara Sukuks, 3 to 30 year tenor Pakistan Investment Bond, and interest rates on National Savings Scheme instruments have been increased, which have resulted in significant extra demand. In addition, T-bill auctions have been successful with significant reductions in the cut-off yields.

11. Treasury-bill auction management has improved. To increase transparency and planning, Treasury-bill auction calendars were issued in November and December, and will continue to be issued on a quarterly basis. As a step toward separation of public debt management from monetary policy operations, a volume-based auction approach has been adopted. Pre-announced auction volume targets will be observed and the accepted amount will generally be in line with the target to provide market participants with confidence to plan their investment. This approach complements the government’s planning of its budgetary borrowing requirement and facilitates liquidity management by the SBP.

12. Strengthening the social safety net is a key program objective. To this end, a poverty scorecard has been adopted to improve targeting of the Benazir Income Support Program (BISP).

  • The roll-out of the scorecard system for the selection of beneficiary families has started, and is expected to be completed in 16 districts as a pilot program by end-May 2009. The roll-out of the scorecard to all 130 districts is planned to be completed between December 2009 and June 2010. As the roll-out of BISP turned out to be more complicated than originally envisaged, BISP disbursements did not take place in the first half of the fiscal year. However, we have now approved 1.5 million beneficiary families using the pre-scorecard targeting system and expect to disburse the budgeted amount of Rs. 34 billion. In addition, we are continuing the implementation of Bait-ul-Mal with a budget of Rs. 6.7 billion and the province of Punjab has commenced its own cash transfer program with an envelope of Rs. 17 billion in FY 2008/09. The Small Public Works Programs of Rs. 28 billion also provide a social safety net for the rural and urban poor through small-scale employment opportunities.

  • Looking forward, the number of families benefiting from BISP cash transfers will be increased to 5 million in 2009/10 using the new scorecard system, implying budgetary expenditure of Rs. 65 billion. For 2010/11, an increase in the number of beneficiary households to 7 million is envisaged. In addition, the province of Punjab is expected to continue its own program in FY 2009/10. The government is also considering reforming other components of the social safety net system, including the merger of the cash transfer component of Bait-ul-Mal with the BISP.

13. An action plan to strengthen tax administration was adopted in January and steps to improve revenue collection have already been taken. Most notably, the sales tax and income tax administrations were integrated on functional lines at the HQ level to enhance the effectiveness of tax administration. The full integration at the field level will be completed by end-December 2009. A detailed integration plan is being prepared as stipulated in the Action Plan. Other measures include the introduction of a unique tax payer identification number, strengthening of the Large Taxpayer Unit, and improved tax audits. The World Bank is providing technical assistance to implement further tax administration reforms, including strengthening of the refunds system for the General Sales Tax (GST).

14. The government is pursuing a major tax reform agenda. A key step will be the replacement, starting in 2010/11, of the GST with a broad-based VAT. At the same time, the government is exploring options to increase revenue in 2009/10. In particular, sales, excise, and income tax laws will be reviewed to minimize exemptions and zero-rating. The timing of these reforms hinges on the capacity of the tax administration to process refunds. To support tax policy reforms, the government has requested Fund and World Bank technical assistance.

15. The MoF has taken measures to strengthen payment control while work on a Single Treasury Account is progressing. A key improvement is the introduction of a system preventing accumulation of unspent balances in accounts outside the Federal Consolidated Fund (FCF). All new budget releases are made through assignment accounts that are part of the FCF. To avoid destabilizing outflow of deposits from the banking system, remaining unspent balances (outside the FCF) will be allowed to be gradually reduced and eliminated. This process will take longer than earlier expected and will not be completed by June 30, 2009.

16. The MoF is working to establish a Medium-Term Budget Framework (MTBF). A calendar for the preparation of the MTBF has been established and the initiating document for medium-term budget preparation has been submitted to line Ministries. The MTBF will be submitted to the Cabinet in March/April 2009 together with the draft strategy paper. The document will provide a framework for the budget process, inform its strategic directions, establish resource envelopes, and identify policy reforms needed to fulfill the medium term fiscal consolidation objectives.

17. In collaboration with the World Bank, the government has finalized a schedule for electricity tariff adjustments to eliminate tariff differential subsidies by end-June, 2009. As a first step under this plan, tariffs were increased by 1 percent effective February 1, 2009. Tariffs will be raised further to result in a cumulative increase of 4 percent by end-June. Changes in the fuel cost component of electricity tariffs (the fuel adjustment surcharge) will continue to be reviewed on a monthly basis and adjusted as needed. The Asian Development Bank is also supporting power sector reforms jointly with the World Bank.

18. We plan to resolve inter-corporate debt in the energy sector (circular debt). As a first step, we have prepared an issue of government-guaranteed Term Financing Certificates by Pakistan Electric Power Company (PEPCO) to settle amounts it owed to banks and suppliers. Further, we are preparing a plan to address ongoing losses on account of operational and collection losses of distribution companies, PEPCO and an independent power producer.

B. Monetary and Exchange Rate Policy

19. Monetary policy will aim at lowering inflation. The SBP will calibrate monetary policy to balance concerns about the slowdown in economic activity, subject to the overall objective of lowering inflation. Provided that the expected decline in inflation materializes and market confidence remains positive, there could be scope for a more accommodative monetary policy stance. However, the SBP stands ready to adjust policies if inflation resurges or if international reserves come under pressure. We will continue to avoid SBP financing of the budget.

20. The SBP will further improve its monetary policy framework. Market conditions permitting, the SBP remains committed to introduce in July 2009 an explicit corridor for overnight money market rate to enhance market signaling, strengthen the effectiveness of liquidity management, and reduce volatility in short-term market interest rates (see ¶ 19 in the MEFP). Use of an explicit interest rate corridor in support of the operational target will improve the transmission of a change in the policy rate (SBP discount rate) to the economy and so help achieve the objective of price stability.

21. The SBP will continue to pursue a flexible exchange rate policy. The exchange rate will continue to reflect market conditions and facilitate adjustments to achieve a sustainable external balance and macroeconomic stability. Interventions will be largely aimed at achieving the program’s net foreign asset targets. The flexible exchange rate policy will be facilitated by phasing out SBP provision of foreign exchange for oil imports, according to the schedule in the program. As a first step, the SBP has ceased providing foreign exchange for the import of furnace oil as of February 1, 2009.

C. Financial Sector and Safeguards Issues

22. Stress tests by the Financial Sector Assessment Program Update mission, using June 2008 data, and updated by the SBP using September data, indicated that banking system in general was resilient. Most banks, including all large banks, would remain solvent, but some non-systemic banks would face insolvency under a severe crisis scenario. The capital injection needed to restore the capital adequacy ratio of the twelve largest banks to the minimum regulatory capital adequacy ratio of 8 percent was 2.3 percent of GDP in the worst case scenario. This relatively low level reflects the low credit-to-GDP ratio and the relatively high capital buffers. The main sources of risk for the vulnerable banks were a major deterioration in credit quality, mainly in the textile industry and exposure to the equity market. Default of the largest exposures put significant strains on solvency given the large concentration of exposures in some banks. The SBP has obtained similar results on the basis of end-September data. A few banks representing less than 10 percent of system assets face financial pressures, which are being addressed by the SBP and their owners through mergers or fresh injection of equity. Progress by these banks in resolving their problems is being monitored closely by the SBP.

23. The financial sector has so far weathered the storm well, but the outlook calls for careful monitoring. Provisional figures for December 2008 show gross non-performing loans (NPLs) have increased from 7.7 percent of total loans in June 2008 to 9.1 percent in December 2008, while net NPLs to net loans increased from 1.3 to 2.5 percent in the same period. However, the capital position of the banking system has improved, with the capital adequacy increasing from 12.1 to 12.2 percent of risk-weighted assets.

24. Measures to improve banking resolution and banking supervision are being implemented. In December 2008, the SBP adopted a problem bank management and contingency plan for dealing with problem banks. The document includes criteria for liquidity support, assessment of bank problems, criteria for use of scarce resources, assessment of existing legal powers and intervention procedures. The effectiveness of the SBP’s powers to enforce its banking supervision policies will also be strengthened and amendments to the banking legislation to this end have been drafted and will be submitted to Parliament before end-June 2009.

25. A draft revision of the SBP law has been prepared and it will form the basis for strengthening the operational independence of the central bank. The recently established inter-agency committee, which includes the MoF, is expected to propose measures to strengthen the operational independence of the SBP, based on the draft SBP law, by end-April 2009. A new central bank law will be submitted to Parliament by December 2009.

26. A new bankruptcy law is under preparation. It will help rehabilitation of viable companies and expeditious resolution of other highly indebted companies thus paving way for banks to clear their long outstanding loans. A review committee is finalizing the draft law which it will submit to the MoF by end-July 2009.

27. The SBP has adjusted the rules on collateral and valuation of securities. Regarding recognition of Forced Sale Value (FSV) of certain collateral, in 2007, SBP withdrew the benefit of the FSV for determining provisioning requirements in order to create a cushion in the balance sheet of banks. Recognition of FSV of collateral is permissible in most countries. In 2009, SBP has allowed partially the FSV benefit (up to 30 percent) of pledged stock as well as residential and commercial properties. Regarding valuation of securities, the imposition of a floor on the stock prices at stock exchanges last August, impeded price discovery for 3½ months in 2008. Accordingly, the Securities and Exchange Commission of Pakistan (SECP) allowed companies to delay recognition of any losses on securities (available for sale) in their income statements until end-December 2009. Losses need to be recognized immediately in capital positions, without routing them through their income statements. Any gains or delays in loss recognition from this treatment cannot be used to pay cash or stock dividends. Further, companies are also required to gradually realize losses in their income statement on quarterly basis and ensure full realization of the impairment by end-2009. SBP has allowed the banks the option to follow instructions issued by SECP regarding recognition of impairment on their capital position, but encouraged early recognition in income statements.

28. The National Investment Trust’s State Enterprise Fund (NITSEF), created to take advantage of market conditions to invest in eight government-owned/controlled companies, has begun its operations. It has an initial capital of Rs. 20 billion. The participating institutions comprise banks, the State Life Insurance Company and the Employees Old Age Benefits Institution, which lent funds to NITSEF against a government guarantee. As of mid-February, the NITSEF had invested Rs. 7 billion. The NITSEF makes its purchases through the Stock Exchange at best available price. It will disclose its financial statements, investment strategy, and purchases on a quarterly basis on a dedicated website.

29. The safeguards assessments of the SBP’s financial control systems pointed to the need to improve SBP’s internal controls further. It recommended changes in the voting structure of the Audit Committee, improving internal controls, and establishing a Board committee to centralize risk management across all bank activities. The SBP intends to implement changes in these areas to change the voting structure of its Audit Committee in April 2009, to improve its internal controls by end-June 2009, and establish a Board Committee to centralize risk management by end-December 2009.

IV. Program Risks and Monitoring

30. The program remains subject to considerable risks. The economic situation in trading partner countries could deteriorate further and result in lower demand for exports, workers’ remittances, and private capital flows. The recovery of domestic and external demand could take longer than anticipated, which would further undermine the revenue targets. As economic activity weakens, the risks to the domestic financial sector increase.

31. The program will remain subject to quarterly program reviews and quarterly performance criteria as specified in Table 1 for the remainder of 2008/09. The attached addendum to the Technical Memorandum of Understanding adds a definition of external payments arrears and provides for reporting of information on new liabilities incurred or guaranteed by the government in settling the circular debt, The adjustors, defined in the TMU, dated November 20, 2008, remain applicable.

V. Program Financing

32. The program requires additional financing to reduce its risks and enhance growth prospects. As noted, while the program is financed for 2008/09, financing constraints leave little room for countercyclical policy and there is a need for additional financing to finance social safety expenditure, development spending and enhanced security needs. The upcoming donor meeting in late March/April is pivotal for mobilizing additional financing, supporting our adjustment efforts, and reducing risks to the program.

Attachment III. Pakistan: Addendum to the Technical Memorandum of Understanding

March 16, 2009

1. The Technical Memorandum of Understanding (TMU) of November 20, 2008 will remain in effect except for the changes described below.

2. The following definition is added to Section I:

  • External payment arrears are defined as unpaid debt service by the government beyond the due date under the contract and any grace period.

3. The following program reporting requirement is added to Section III:

  • Information on new liabilities incurred or guaranteed by the government in settling the circular-debt, including government guarantees of Term Financing Certificates (TFCs) issued by Pakistan Electric Power Company (PEPCO). The information will include the size of the government exposure, the duration of the guarantee or claim, and any other provisions relevant for the government’s exposure.

4. The attached table replaces Table 2 in the TMU.

Table 1.

Pakistan: External Program Financing For Budget for 2008/09

(In millions of U.S. dollars)

article image
Sources: Pakistani authorities; and Fund staff projections.
1

Fiscal year starts July 1st.

2

For a detailed discussion of the early developments following the approval of the SBA, see the staff report for the Interim Review under the Emergency Financing Mechanism.

3

The weekly Sensitive Price Index (SPI) which tracks utility rates, transportation, and prices of food and other household items for low-income groups increased at a year-on-year rate of 24 per cent (in late February), reflecting the lingering effect of large food price increases in the first half of 2008. This high increase in SPI is a source of concern for vulnerable groups.

4

Aggregate market capitalization (AMC) was Rs. 1.86 trillion or $23.5 billion on December 31, 2008; down by 61 percent (in rupee terms) from the peak of April 18, 2008; however, two-thirds of this drop was already reflected in the end-September 2008 AMC data.

5

Although, the authorities maintained a premium between domestic and international petroleum prices, the retail prices of petroleum products were significantly reduced to pass in part the benefit of lower oil prices to consumers. On December 1, the retail prices of gasoline and diesel were reduced by Rs. 9 and Rs. 4 per liter to Rs. 57.7 ($0.73) and Rs. 48.0 ($0.61), respectively.

6

Reserve money grew by 6.5 percent (year-on year) through end-December (5.8 percent in the program), while broad money grew by 8.7 percent (9.6 percent in the program). Overall, the demand for rupee-denominated assets has strengthened since October 2008, as evidenced by an increase in rupee deposits relative to foreign-currency deposits. However, some of the effects observed through December reflected banks’ efforts to improve performance indicators by the end of the financial year (which coincides with the calendar year). Preliminary figures for January show a drop in deposits and weaker broad money growth. Relatedly, the spreads between lending rates and deposit rates widened from 660 bps in January 2008 to nearly 780 bps in January 2009, with weighted average lending and deposit rates at 14.66 and 6.88 percent, respectively.

7

The PRESO loan of $500 million is expected to be approved by the World Bank before end-March.

8

The interbank market supplied all foreign exchange for furnace oil imports (presently accounting for about 20 percent of petroleum product imports) prior to July 8, 2008.

9

Regarding the structural benchmark for end-June 2009, the authorities indicated that a single treasury account had already been created but the consolidation of the government funds in that account would not be feasible by end-June. This issue will be taken up in the discussions for the second review.

10

The resolution of the circular debt is expected to boost electricity production, which at present is not capacity-constrained but the backlog of payments to power providers results in load-shedding. Significant investment will be needed to increase electricity production over the medium term (see ¶33). The authorities’ plans emphasize tapping renewable energy sources, nuclear power, and cross-border provision of electricity within the region; see: http://www.mowp.gov.pk.

11

The expectation of a rapid decline in inflation is also reflected in the yield curve, which remains flat, while 12-month T-bills were more heavily oversubscribed in recent auctions compared to shorter-term maturities.

12

January revenue data indicate that the shortfall in revenue collected by FBR has increased, but PDL collection has been on track to meet the revised annual target. Preliminary FBR data for February indicate a further increase in the revenue shortfall.

13

The authorities have started implementing a comprehensive auditing system, targeting in a first step about 500 large taxpayers. It is also expected that strengthening of audits will improve voluntary compliance.

14

About two-thirds of development spending in the 2008/09 budget are domestically-financed.

15

The authorities remain in close consultation with the World Bank on the rationalization of development spending. In this regard, the MTBF is expected to take into account the recommendations of the ongoing public expenditure review (expected to be completed in March).

16

The authorities envisage procurement of 6.5 million tons of wheat from the 2009 harvest (projected at 25 million tons) at the current support price of nearly $300 per ton (Rs. 950 per 40 kg). In February, international wheat prices in official bulk transactions were between $230 and $240 per ton (FOB).

17

An interagency committee was established in January to review the proposed amendments to the SBP Act of 1956 with a view to strengthening the operational autonomy of the SBP.

18

See SBP’s Monetary Policy Statement for January–March 2009 (http://www.sbp.org.pk/m_policy/index.asp).

19

Nonetheless, using TFCs to regularize the energy sector companies’ relations with commercial banks is a positive development from the point of view of bank liquidity and credit availability.

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Cover IMF Staff Country Reports
Pakistan: 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
Author:
International Monetary Fund
Volume/Issue:
Volume 2009: Issue 123
Publisher:
International Monetary Fund
ISBN:
9781451830743
ISSN:
1934-7685
Pages:
87
DOI:
https://doi.org/10.5089/9781451830743.002
  • Figure 1.
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    Figure 1.

    Pakistan: Financial Market Indicators

    (August 2008–February 2009, unless otherwise indicated)

  • Figure 2.
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    Figure 2.

    Pakistan: Monthly Macroeconomic Indicators

  • Figure 3.
    View in gallery
    Figure 3.

    Pakistan: Monetary and Credit Indicators

  • Figure 4.
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    Figure 4.

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

  • Figure 5.
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    Figure 5.

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

  • Figure 6.
    View in gallery
    Figure 6.

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

  • View in gallery

    Regional Real Effective Exchange Rates

  • Figure 1.
    View in gallery
    Figure 1.

    Pakistan: External Debt Sustainability—Bound Tests 1/

    (External debt in percent of GDP)

  • Figure 2.
    View in gallery
    Figure 2.

    Pakistan: Public Debt Sustainability: Bound Tests 1/

    (Public debt in percent of GDP)

Figure 1.

Pakistan: Financial Market Indicators

(August 2008–February 2009, unless otherwise indicated)
Figure 2.

Pakistan: Monthly Macroeconomic Indicators
Figure 3.

Pakistan: Monetary and Credit Indicators
Figure 4.

Pakistan: Output and Inflation Indicators 2004/05–2008/09
Figure 5.

Pakistan: External Sector Indicators, 2004/05–2008/09
Figure 6.

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

Regional Real Effective Exchange Rates
Figure 1.

Pakistan: External Debt Sustainability—Bound Tests 1/

(External debt in percent of GDP)
Figure 2.

Pakistan: Public Debt Sustainability: Bound Tests 1/

(Public debt in percent of GDP)