Pakistan
Second Review and Request for the Augmentation of Access Under the Stand-By Arrangement: Staff Report; Staff Supplement; Staff Statement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Pakistan
Author: International Monetary Fund
Publication Date:
21 Aug 2009
eISBN:
9781451830750
Language:
English
Keywords:
ISCR; CR; Pakistan; SBP overdraft; financial support; Gra; core inflation; exchange rate; current account; balance of payments; monetary policy; Tariffs; Global; debt service
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This paper discusses key findings of the Second Review for Pakistan and a request for the augmentation of access under the Stand-By Arrangement. Program performance has been mixed. All end-March quantitative performance criteria were met, but structural reform has been slower than programmed. The authorities indicated that the fiscal deficit ceiling may have been exceeded by 0.9 percent of GDP and, therefore, request a waiver of nonobservance for the related end-June 2009 performance criterion. The authorities also request waivers of applicability for other end-June quantitative performance criteria.

Abstract

This paper discusses key findings of the Second Review for Pakistan and a request for the augmentation of access under the Stand-By Arrangement. Program performance has been mixed. All end-March quantitative performance criteria were met, but structural reform has been slower than programmed. The authorities indicated that the fiscal deficit ceiling may have been exceeded by 0.9 percent of GDP and, therefore, request a waiver of nonobservance for the related end-June 2009 performance criterion. The authorities also request waivers of applicability for other end-June quantitative performance criteria.

I. Background

1. The volatile political and security situation has undermined economic confidence and complicated policy making. The military operations in the Swat Valley have resulted in nearly three million internally displaced persons (IDPs). The security situation also remains grave in other parts of the North West Frontier Province, Baluchistan, the tribal areas, and major cities. Looking ahead, supporting IDPs and reconstruction in the areas affected by military operations will be a major challenge.

2. To allow for greater social, development, and security spending, donors have made significant financial pledges to Pakistan. The Friends of Democratic Pakistan Meeting and Donor Conference held in Tokyo in April mobilized pledges of $5.7 billion, of which about $2 billion (1.1 percent of GDP)—mostly in the form of project loans—is expected to be disbursed in 2009/10. The authorities also expect that additional budgetary grants (amounting to about 0.3 percent of GDP) would be available to support spending on IDPs. Meanwhile, the bulk of donor support for IDP-related spending has been delivered outside the budget.

3. Donor support has created room for relaxing the fiscal deficit target for 2009/10, while maintaining the course of macroeconomic stabilization. Accordingly, the authorities and staff have agreed that the 2009/10 deficit target (excluding grants) could be increased to 4.6 percent of GDP, compared to the original program target of 3.4 percent of GDP, to accommodate spending expected to be financed with disbursements of Tokyo pledges. Based on the assumption of additional budgetary grants for IDPs, the authorities increased the fiscal deficit target (excluding grants) to 4.9 percent of GDP, as reflected in the budget approved by parliament.

4. The authorities have requested an augmentation of access by 200 percent of quota. A portion of the augmented access, equivalent to SDR 951.1 million ($1.4 billion), or 92 percent of quota, could be used to finance priority spending until the disbursements of donor support pledged for 2009/10 are received.

II. Recent Economic Developments

A. Overview

Output and Inflation

5. Growth has been anemic and the near-term outlook for economic activity, especially manufacturing, remains weak. A rebound in agriculture on the back of a bumper wheat crop helped maintain growth in positive territory. However, with increasing weakness in large-scale manufacturing, exports, and private sector credit, the estimate of real GDP growth for 2008/09 has been lowered from 2.5 to 2.0 percent. Moreover, the Federal Bureau of Statistics recently revised down real GDP growth for 2007/08 from 5.8 to 4.1 percent, indicating that the economic slowdown began before 2008/09.

6. Inflation has continued to decline, but core inflation remains high and persistent. With the price surge observed in the first half of 2008 now fully reflected in the base period CPI and the sharp contraction of bank credit growth to the private sector, headline inflation (year-on-year) declined from a peak of 25 percent in October 2008 to 13.1 percent in June. However, the pace of disinflation in the latter part of 2008/09 was somewhat slower than expected, mainly on account of a surge in food price inflation in February-April, as well as a higher government procurement price for wheat. Meanwhile, core inflation fell from 18.9 percent in November 2008 to 15.9 percent in June.

Money and Finance

7. Monetary growth has been low reflecting weak private demand for credit, but public sector borrowing has been high.1 The 100 bps cut in the policy rate (SBP discount rate) in April was widely anticipated and well-received by the market. The liquidity overhang, which emerged in the last quarter of 2008, was absorbed in the first quarter of 2009, and the key short-term interest rates are now within 200 bps of the policy rate. Banks have continued to show strong preference for treasury paper and the government was able to place its T-bills, investment bonds, and other instruments, including Term-Finance Certificates that were used to clear a portion of the “circular” debt.2 Nonbank budget financing (mostly through the National Saving Scheme) has been higher than programmed.

8. The SBP has allowed greater exchange rate flexibility in recent months, and gross official reserves rose from $3.5 billion at end-October 2008 to $9.1 billion at end-June 2009 (three months of next year’s imports). This amount exceeds the program’s target by $600 million despite lower than anticipated disbursements of balance-of-payments support (including from the Fund), and a reduction of $300 million in the net forward position. However, official reserves subsequently dropped to just below $8.4 billion as of July 20 due mainly to a temporary pick-up in official payments.

9. The slowdown in economic activity continues to affect bank soundness. Financial soundness indicators through end-March show that banks remained profitable and well-capitalized but experienced a significant increase in nonperforming loans (NPLs). The risk-weighted capital adequacy ratio rose from 12.2 percent at end-December to 12.9 percent at end-March due to higher eligible capital and lower risk-weighted assets resulting from the increased share of lending to the public sector. At the same time, NPLs rose from 9.1 to 11.5 percent of gross loans. The increase in NPLs affected all categories of banks, but was most pronounced among public sector commercial banks, whose NPLs rose from 12.5 to 17.5 percent of gross loans.

10. Financial market indicators show a mixed picture. Pakistan’s sovereign spreads have declined but still remain high, at about 1,050 bps. After a three-month rally through mid-April, the stock market has stabilized. Since mid-April, the KSE index has been fluctuating around 7,200 points, about 20 percent above its 12-month low registered in January 2009, but about 70 percent below its 12-month high registered in July 2008. There has been a slight pickup in foreign interest in Pakistani equities in recent months. The National Investment Trust State Enterprise Fund (NITSEF), created to invest in eight eligible stocks of state-owned companies, with a careful timing of purchases, has not perturbed the functioning of the market. As of June 30, the NITSEF had invested just over half of its resources amounting to Rs. 20 billion. The NITSEF website states its investment strategy and discloses financial statements and details of security purchases each quarter.

Balance of Payments

11. With imports contracting sharply and workers’ remittances continuing to grow, Pakistan’s external current account position has improved. Despite lower exports, the current account deficit is estimated to have declined by $5 billion (3 percentage points of GDP) in 2008/09 due to a significant decline in imports, higher workers’ remittances, and increased support from the United States (for military expenses). During the period July 2008–May 2009,

  • exports declined by 2 percent relative to the same period of the previous year—a 5 percent drop in traditional exports such as textiles outweighed the pick up in nontraditional exports;

  • imports dropped by about 10 percent on account of a lower oil bill and significantly lower imports of telecom equipment, motor vehicles and parts, and other goods; and

  • workers’ remittances rose by nearly 20 percent.

12. As in many emerging markets, the financial account remains weak. With the global economic slowdown and political and security uncertainties, net financial flows declined by nearly $3 billion compared to 2007/08. FDI inflows, at $3 billion, were $2 billion lower and there was a net portfolio outflow of about $1.1 billion compared to a small inflow in 2007/08. Official lending was somewhat lower than expected, reaching $4.6 billion ($1.6 billion higher than in 2007/08).

Public Finance

13. Despite continuing revenue weakness, budget execution through end-March was prudent, but the end-June fiscal deficit target is likely to have been missed.

  • The collection of tax revenues by the Federal Board of Revenue (FBR) in 2008/09 fell short of the first SBA review projection by 1.2 percent of GDP, mainly owing to declining imports and slowing domestic demand. The revenue weakness also reflected a delay in tax administration reforms, which were subject to legal challenges. Also, the envisaged strengthening of taxpayer audits has not commenced. The weakness of FBR revenues was partially compensated by higher-than-programmed revenues from the petroleum development levy (PDL), despite a reduction of the PDL in May in response to Supreme Court comments.

  • The impact of the revenue shortfall was offset by expenditure restraint, and the end-March fiscal deficit target was met. The authorities re-prioritized development expenditures, while protecting social safety net spending.

  • Partial data for the last quarter of 2008/09 suggest that the end-June fiscal deficit target was exceeded by about 0.9 percent of GDP. Besides the continuing weakness of tax revenues, this reflected a surge in spending by provinces, as well as pressures to step up security- and IDP-related expenditures.

B. Program Implementation

Quantitative performance

14. Despite mixed policy implementation, all quantitative performance criteria for end-March were observed. The net foreign assets target was met with a sizeable margin, but the fiscal deficit target was met with difficulty.

15. Performance through end-June cannot yet be fully assessed. Preliminary information indicates that the performance criteria on the SBP’s net foreign and domestic assets and SBP credit to the budget were met, but the budget deficit target was missed by a significant margin.

Structural reform

16. Both end-March structural benchmarks have been completed, albeit with a delay in the case of the comprehensive plan for eliminating the inter-corporate circular debt.

  • In collaboration with the World Bank, the government developed by end-March a strategy and a time-bound plan to strengthen the social safety net. However, owing to limited administrative capacity, the rollout of the reformed Benazir Income Support Program (BISP) based on a poverty scorecard system will take longer than expected. Under the old BISP, 1.75 million families were approved at end-June, a number smaller than the original target of three million, and BISP disbursements in 2008/09 were lower than budgeted. However, BISP disbursements in 2009/10 are expected to increase substantially as the number of beneficiary families is targeted to increase to five million and eligible families will receive benefits for the entire year, independent of the timing of the approval of their eligibility (see ¶18 of the Second Supplementary Memorandum (SSMEFP)).

  • Agreement was reached between government and World Bank and ADB staffs on July 15, 2009 providing, among others, for the assumption of electricity sector debt by the government (see third bullet of ¶17).3 Full and timely implementation of the plan should eliminate the “circular” debt and prevent its re-occurrence.

17. Structural conditionality for end-June was not met, but corrective measures have been agreed.

  • The structural performance criterion on the submission to parliament of legislative amendments to harmonize the income tax and GST laws, for tax administration purposes, and reduce exemptions for both taxes was not observed. As a corrective measure, the authorities will submit to parliament by end-September 2009 legislative amendments to harmonize the sales tax, income tax, and federal excise tax laws with a view to facilitating tax administration (structural benchmark). However, meaningful progress in reducing tax exemptions will be achieved only with the introduction of the new broad-based VAT regime, which is scheduled to become effective on July 1, 2010 (see ¶28).

  • The submission to parliament of amendments to the banking companies’ ordinance (structural performance criterion) to enhance the SBP’s enforcement powers in banking supervision has also been delayed. The authorities will submit this legislation to parliament by end-August 2009 (structural benchmark—see ¶38).

  • The elimination of electricity tariff differential subsidies, originally scheduled for end-June 2009, has been postponed by one year (Box 1),4 In response to political pressures, the government backed off from an agreement with World Bank and ADB staffs on electricity tariff adjustments in the first quarter of 2009/10 that would have sufficed to eliminate tariff differential subsidies in the current fiscal year. However, on July 15, 2009, the government reached a revised agreement with World Bank and ADB staffs on a plan to increase electricity tariffs in the course of 2009/10 that would attain cost recovery in August 2010. While eliminating the need for tariff differential subsidies in the 2010/11 budget, this agreement implies the need for tariff differential subsidies in 2009/10 in the amount of Rs. 55 billion (0.4 percent of GDP). It also provides for a de-politicized regular tariff adjustment mechanism and the assumption of electricity sector debt (1.9 percent of GDP) by the government.

Restoring the Financial Viability of the Electricity Sector

Despite earlier restructuring attempts and the establishment of a regulatory agency, the financial situation of Pakistan’s electricity sector remains weak. This reflects insufficient tariff adjustments, nonpayment by the government of tariff differential subsidies, low collection rates in some regions (e.g., in the Federally Administered Tribal Areas (FATA) due to the security situation), and weaknesses in governance. Moreover, with frequent power outages and high tariffs paid by industrial producers on account of cross-subsidization between consumer groups, the power sector is a drag on growth. Substantial new investment is required to ensure that generation capacity keeps pace with demand, but private investors are reluctant to invest owing to unsustainable sector financing.

To restore the financial viability of the sector, the authorities had committed under the SBA to eliminate electricity tariff differential subsidies by end-June 2009. Reflecting rising fuel costs and the decision to refrain from adjusting tariffs, electricity subsidies rose to 1.3 percent of GDP in 2007/08 and contributed (together with rising fuel subsidies) to an increasingly unsustainable fiscal position. In the 2008/09 budget the authorities stated their intention to phase out electricity tariff differential subsidies by end-June 2009 and in November 2008 they increased average tariffs by 18 percent. In January 2009, the authorities announced their intention to raise tariffs by 4 percent in the first half of 2009 to phase out these subsidies by end-June 2009. However, tariffs were only raised by 1 percent in February.

In the face of a perceptible increase in fuel and nonfuel cost components, the authorities reached an agreement with World Bank and ADB staffs on May 21, 2009 on higher tariff increases. Revised calculations of the Pakistan Electric Power Company (PEPCO) had suggested that the required tariff increase would be between 17.5 and 41.5 percent, depending on the degree of load shedding, the extent of replacement of imported furnace oil with (less expensive) gas in electricity generation, and the assumption of electricity sector debt by the budget. According to this agreement, electricity tariffs were to be raised to eliminate tariff differential subsidies in 2009/10 and more gas would be used for electricity generation.

However, in the aftermath of the difficult parliamentary debate on the budget, the authorities considered the agreed tariff increases as politically too costly. In particular, they decided that the bulk of the required tariff increases would need to be postponed until after load-shedding had been reduced through additional generation capacity coming on stream.

On July 15, 2009, the authorities reached a revised agreement with World Bank and ADB staffs on a schedule for tariff increases that postpones the elimination of tariff differential subsidies to 2010/11. According to this agreement, electricity tariffs will be raised in three stages with a view to limiting tariff differential subsidies to Rs. 55 billion in 2009/10. Most importantly, the authorities agreed to regularize and de-politicize tariff adjustments by amending the National Electric Power Regulatory Authority (NEPRA) Act through a presidential ordinance by end-July 2009 to ensure (i) monthly tariff adjustments reflecting changes in the price of imported fuel/power purchased; and (ii) quarterly adjustments reflecting changes in all other cost components, with the notification of new tariffs being issued within 15 days from NEPRA determination. Monthly adjustments will start in August 2009 and quarterly adjustments in August 2010.

The agreement also provides for the assumption by the government of electricity sector debt in the amount of at least Rs. 277 billion (1.9 percent of GDP). About Rs. 216 billion of this amount reflects bank borrowings by power companies owing to insufficient tariff increases and nonpayment of tariff differential subsidies during 2004/05-2008/09, with another Rs. 61 billion reflecting FATA receivables and past arrears of the Karachi Electric Supply Company (KESC) to power companies. This debt will be transferred to a newly created state-owned holding company and its service will be assumed by the budget. The government is committed to completing an audit of these liabilities prior to their assumption.

18. The transition to the Treasury Single Account (TSA), a structural benchmark, is not yet complete. Significant progress was made in October 2008, when the authorities introduced a system preventing the accumulation of unspent balances in accounts outside the Federal Consolidated Fund. However, significant unspent balances remain in accounts at commercial banks, implying that the transition to a TSA is not yet complete. Following World Bank technical assistance in July 2009, the remaining balances with commercial banks will be surveyed. Identified government balances with commercial banks will be transferred to the TSA by end-June 2010, subject to an assessment of the impact on the banking sector’s liquidity.

19. After extensive discussions, the authorities have reached understandings with World Bank staff on the organization of a functionally structured tax administration. Under the new structure, the responsibilities for sales, income, and excise taxes will be consolidated in one domestic revenue department. To reduce the risk of renewed legal challenges, a new occupational group encompassing the staff of the newly created department will be created within the FBR. The new FBR management structure was put in place as of June 30, 2009 (by an Executive Order of the FBR Chairman) and the functional reorganization of the FBR, including the revision of the structures of Regional Taxpayer Offices (RTOs) and Large Taxpayer Units (LTUs), will be completed by end-September 2009. The government is expected to approve the required regulations by September 15, 2009 (structural benchmark—SSMEFP, ¶17 and Box 2).

20. The earlier intensification of exchange restrictions has been reversed. The SBP has removed all cash margin requirements on letters of credit introduced before the program. The intensification of such requirements earlier this year had resulted in the nonobservance of the continuous performance criterion against imposing or intensifying exchange restrictions.

III. Policy Discussions

A. Macroeconomic Framework for 2009/10

Output and Inflation

21. Staff has revised down its real GDP growth projection for 2009/10 from 4 percent to 3 percent. The expected modest recovery in 2009/10 from the estimated outcome for 2008/09 takes into account, on the one hand, weaker global growth in 2009 and, on the other, the expectation of improved supply conditions in the energy sector and the relaxation of the fiscal stance, including a significant increase in development spending. Over the medium term, growth is expected to recover gradually, reaching 6 percent a year by 2014/15, the average rate registered during 2001–08.

New Structural Conditionality

Prior Action

By end-July 2009—Amendment by a presidential ordinance of the NEPRA Act to ensure (i) monthly determination by NEPRA of the fuel adjustment surcharge in line with international fuel prices, with automatic implementation upon determination; and (ii) quarterly determination of overall electricity tariffs by NEPRA and notification of the adjusted tariffs within 15 days. Any review requests of overall tariffs will be completed within 15 days; if this is done within this period, the results of the review will be taken into account in the subsequent determination.

  • Macroeconomic relevance: In the absence of a de-politicized mechanism for regular electricity tariff adjustments, sizable financial imbalances in the electricity sector are likely to resurface.

Structural Benchmarks

By September 15, 2009—(i) Government approval of regulations to form new occupational groups within the FBR and revise the structures of Regional Taxpayer Offices and Large Taxpayer Units; (ii) Amendment of all relevant laws and rules.

  • Macroeconomic relevance: Tax administration reform will broaden the tax base and improve tax efficiency and collection. It is an indispensable component of the tax reform needed to achieve fiscal sustainability, and for introducing the VAT.

By end-2009—Submission of the VAT law to Parliament.

  • Macroeconomic relevance: The adoption of a broad-based VAT is the cornerstone of the revenue effort over the medium term, and a crucial component of the authorities’ strategy to finance the needed increase in public investment without recourse to external borrowing or crowding out domestic private investment.

22. Inflation is still expected to decline to single-digits and to drop further over the medium term. This outlook, however, is subject to risks. The disinflation momentum could be endangered by higher oil prices, electricity tariff increases, higher wages, and the fiscal expansion. Accordingly, a more active monetary policy may be needed to manage inflationary pressures.

Balance of Payments

23. The current account deficit is expected to decline moderately from 5.1 percent of GDP in 2008/09 to 4.7 percent in 2009/10. A higher oil bill is projected to be more than offset by a further slowdown in non-oil imports (reflecting weak GDP growth), while exports, workers’ remittances and other current account transfers are likely to decline as the prospects for a global recovery remain uncertain.

24. The capital and financial account surplus will likely be insufficient to finance the current account deficit. Official flows are projected to be $3.3 billion higher than in 2008/09, boosted by Tokyo-related disbursements and the increased SDR allocation, while private capital inflows, while broadly unchanged, are subject to large risks. As a result, the overall balance of payments is expected to post a deficit, while gross reserves are expected to increase due mainly to Fund disbursements.

B. The Budget for 2009/10

25. The budget was the central issue for the second review. Parliament approved the budget on June 25, after considerable debate, which brought to the fore significant resistance against additional revenue measures.5 The introduction of the carbon surcharge, although ultimately passed, proved particularly contentious.6 The budget features a deficit of 4.9 percent of GDP, compared with 4.6 percent agreed in May, to allow for higher support for IDPs. The authorities expect that the increased financing needs will be met by additional IDP-related external grants, and intend to limit the deficit to 4.6 percent of GDP if IDP-related grants are not forthcoming. The authorities recognize that the additional donor support from Tokyo provides only temporary room for meeting critical spending needs, and that the tax reform effort should be accelerated to ensure a sustained increase in revenue over the medium term. The authorities also agreed that if Tokyo-related disbursements are delayed or fall significantly short of expectations, the deficit target would be reduced.7

26. The approved budget for 2009/10 reflects the following priorities:

  • Efforts to bolster revenue. While the budget provides for more than a dozen tax policy measures, the yield of many of them is modest. The most important measures are the introduction of (i) a carbon surcharge (later renamed as “Petroleum Levy”) on petroleum products (to replace the PDL); and (ii) excise taxes on a number of services (e.g., banking services and insurance). Moreover, the budget provides for increases in the rates for (i) the withholding tax on imports;8 (ii) the excise tax on cigarettes; and (iii) the capital value tax on real estate (a transaction tax). However, the yield of these measures (0.4 percent of GDP) falls short of the targeted increase in the tax-to-GDP ratio under the original program (0.6 percent).

  • On the expenditure side, the budget aims to (i) provide adequate resources for IDPs; (ii) increase development spending (partially funded by donor support pledged at Tokyo); (iii) support several key industries through subsidies, including for exports; and (iv) a general increase in civil servants’ salaries by 20 percent (while wages for security forces involved in the anti-terrorism campaign are to be doubled).

Discussion on revenue policies

27. The authorities believe that additional revenue measures are politically infeasible in the near term. In this context, they emphasized that they needed to preserve their political and institutional capital for the introduction of the VAT. Staff acknowledged this point but indicated that, to reduce vulnerability and provide resources for needed outlays, and because additional donor support would only be available for limited period, a strong revenue effort was needed. Staff also pointed to the significant risks related to the rather optimistic revenue projections and the effects of the delays in tax administration reform, which could undermine revenue performance early in the current fiscal year. However, given the significant resistance to revenue measures in the parliamentary debate of the budget, the authorities felt that submitting additional revenue measures would be difficult and could only be done, if necessary, in the context of a supplementary budget later in the year.

28. The authorities renewed their commitment to press ahead with the introduction of a broad-based VAT in 2010/11. They recognized that time is of the essence and emphasized that the introduction of a broad-based VAT in mid-2010 was a key pillar of their medium-term fiscal strategy. To help build a consensus for the VAT within the government and discuss options for its introduction, the authorities will organize a high-level conference in September with federal and provincial participation. To ensure its timely introduction, the authorities will prepare by end-September 2009 a detailed time-bound action plan for VAT implementation. A draft VAT law will be submitted to parliament by end-December 2009 (structural benchmark—SSMEFP, ¶16).

Discussion on expenditure policies

29. The budget provides Rs. 50 billion (0.3 percent of GDP) for IDP assistance. The-authorities assume that this expenditure will be grant-financed. Nevertheless, should IDP-related grants not be forthcoming, the authorities will implement contingency measures to contain the deficit to 4.6 percent of GDP. Staff noted that this may involve cutting non-IDP development spending and other nonessential outlays. And, staff reiterated that the program imposes no limits on the amount of IDP-related spending that could be financed by nonbudgetary grants.

30. The authorities’ decision to delay by one year the phasing out of electricity tariff differential subsidies implies significant additional expenditures. Tariff differential subsidies of Rs. 55 billion (0.4 percent of GDP), which are not included in the approved budget, will be required in the current fiscal year. Moreover, the amount of electricity sector debt to be assumed by the government will be somewhat higher than budgeted (Rs. 277 billion as compared to Rs. 216 billion), resulting in additional interest payments of Rs. 10 billion. The government is in the process of hiring an internationally-renowned firm to audit the debt to be assumed by the budget. This audit, to be finalized by end-September, is expected to help address governance concerns. To compensate for the higher-than-budgeted subsidies on account of delayed electricity tariff increases, higher-than-budgeted interest payments for electricity sector debt, and lower revenues from the petroleum levy, the authorities decided to reduce nonpriority development spending, while protecting social safety net, education, and health spending.

31. Staff questioned the prominence of sectoral subsidies in the budget. The authorities emphasized the importance of supporting socially-sensitive sectors and export promotion in the current global economic environment. Staff welcomed the reduction in fertilizer subsidies from 0.3 percent of GDP in 2008/09 to 0.1 percent in 2009/10, but noted that budgetary resources would continue to be used for poorly targeted subsidy schemes, including for wheat and sugar, which undermined a level playing field for investors. Staff also raised concerns about the budgetary contribution for the envisaged Export Investment Development Fund.

32. Staff discussed measures to ensure adequate central government control over provincial spending. To this effect, the authorities agreed to limit the use of the SBP overdraft by provinces to six weeks of their wage bills. The federal government, in consultation with provincial governments, will introduce a respective binding Ways and Means ceiling effective August 1, 2009. Moreover, the provinces will reach an agreement with the Ministry of Finance and the SBP by end-September 2009 on a schedule for reduction of the outstanding debt stock resulting from provincial overdrafts (SSMEFP ¶13).

C. Monetary and Exchange Rate Policies

33. Staff argued that the policy interest rate should remain on hold until core inflation shows a further significant decline; an appropriately tight monetary stance would also help contain price pressures from the more expansionary fiscal policy. The authorities argued that the recent declines in headline and core inflation justified a further reduction in the policy rate. The staff urged caution, as core inflation had not come down as rapidly as anticipated, fiscal revenue was still under pressure, and the timing of external disbursements was highly uncertain. Staff also emphasized the need to combat inflationary pressures from higher fuel and energy prices and increased public sector wages. The authorities agreed to keep the factors influencing interest rate policy under review, expecting that economic and financial developments would allow for easing interest rates soon.

34. Public sector domestic borrowing requirements will remain high, despite the Tokyo-related disbursements covering the increased budget financing needs. The overall public sector borrowing requirement is expected to increase due to (i) higher projected credit to public sector enterprises for resolution of the “circular” debt and (ii) an increase in credit for commodity operations (e.g., wheat procurement underwritten by the government). To ensure that public sector borrowing does not further constrain lending to the private sector, the SBP and the Ministry of Finance are working on increasing the attractiveness of government bonds as a saving/investment instrument for individuals and nonbank institutional investors.

35. Meanwhile, the SBP has laid the basis for reforming its monetary policy framework. To that end, an explicit corridor for overnight money market rate will be introduced in mid-August 2009 to strengthen the role of the interest rate as a policy instrument. The width of the interest rate corridor will initially be 300 basis points with a view to narrowing it to 200 basis points at a later stage. Key additional changes in support of the corridor include (i) the lengthening of the reserve maintenance period from one to two weeks; (ii) fully-lagged determination of the reserve requirement; and (iii) greater standardization of open market operations. The authorities prefer to review the policy rate quarterly, but are aware that the interest rate corridor may require more frequent policy rate adjustments. Significant enhancements of the monetary policy framework by strengthening the independence of the SBP, are also envisaged under the proposed amendments to the SBP Act (to be presented to parliament by end-September 2009—SSMEFP ¶33), including the creation of an independent Monetary Policy Committee.

36. With increased reliance on interest rates for monetary management, exchange rate policy will be geared more decisively toward the attainment of the reserve accumulation targets. The authorities recognized that exchange rate policy would need to remain flexible to reduce external vulnerabilities, ensure external sustainability, and foster competitiveness. The SBP will pursue a flexible exchange rate policy and continue to phase out the provision of foreign exchange for oil imports. In this regard, the SBP has issued a circular announcing that it will cease providing foreign exchange for import of diesel and other refined petroleum products effective August 1, 2009.

D. Financial Sector Issues

37. NPLs have increased but bank capital and liquidity remain adequate. The SBP recognized that deteriorating asset quality (with NPLs likely to have increased further in the second quarter of 2009) may transmit into the solvency indicators, but it considered that this risk was being addressed through a strict enforcement of accelerated provisioning requirements (25 percent for all loans overdue by 90 days).9 The SBP expects the NPLs to continue increasing for another quarter but, based on actions taken by the commercial banks to restrain consumer lending and with the financial situation of the textile sector bottoming out, it remains confident that asset quality indicators will gradually improve later in 2009/10, especially if the credit to private sector recovers. Nevertheless, several banks will need to restructure their large exposures. Moreover, a bankruptcy law will be submitted to parliament in August 2009 to help rehabilitate weak but viable companies and liquidate insolvent ones.

38. The SBP has continued to enhance the regulatory framework. Preparations of legislative amendments to strengthen the effectiveness of SBP enforcement in the area of banking supervisions are under way. Draft amendments have already been discussed by the government and will be sent to parliament before end-August (SSMEFP ¶31). In order to create more breathing room for banks, the SBP has revised downward the targeted increases in minimum capital requirements (to be met gradually), but has maintained unchanged the minimum capital adequacy ratios to ensure the financial strength of banks.

IV. Augmentation

39. The authorities have requested augmentation of access under the SBA of SDR 2.0674 billion (200 percent of quota) to meet the country’s increased balance of payments needs. If approved, the requested augmentation would increase access under the SBA from 500 to 700 percent of quota, allowing for a further strengthening of the level of international reserves. Increased access is justified as insurance against increased risks stemming from the deeper and more sustained deterioration in global economic conditions than initially expected. In this context, the augmentation will provide a strengthen buffer against downside risks associated with (i) a further and possibly sharper slowdown in exports; (ii) a drop in remittances; and (iii) continued constraints on private external financing. Additional access will also allow the authorities to better manage the pressures on reserves from inconsistencies in timing between priority spending needs and donor disbursements.

40. Augmentation is proposed to be phased in within the duration of the SBA as extended through end-2010. Because of the delay in completing the second review, the augmentation must be combined with (i) a rephasing of purchases; and (ii) the extension of the arrangement and a change in the projected dates of availability to ensure a realistic timeline for the disbursements of Fund resources.

Use of Fund resources for budget financing

41. Given that the disbursements of Tokyo-related donor support in 2009/10 are likely to be back-loaded, a portion of Fund resources will be used for budget financing. This would allow the government to meet urgent spending needs early in 2009/10, including the provision of assistance to IDPs, without having to rely on additional domestic financing which could undermine economic stabilization. It would also help resolve the potential balance-of-payments problem by avoiding undue pressures on the reserve position and foreign exchange market.

42. To this effect, about $1.4 billion (0.8 percent of GDP) of Fund resources will be made available, on a temporary basis, for budget financing during 2009/10. This amount broadly corresponds to social sector and IDP-related priority spending financed from additional donor funds pledged in Tokyo. This amount is also within Pakistan’s capacity to repay the Fund, assuming that the targeted adjustment is achieved (see ¶43).

  • The designated part of Fund resources will be credited directly to the Ministry of Finance’s dedicated account at the SBP in three installments at the time of Fund disbursements projected for August 2009-March 2010. The budget will draw on this account to finance its priority needs until Tokyo-related pledges are disbursed. The budget will be responsible for servicing any outstanding Fund credit used for budgetary purposes through the SBP, which remains the fiscal agent.

  • The budget will replenish the dedicated account to the amount borrowed from the Fund as Tokyo-related pledges are disbursed (expected by end-2009/10), at which time the SBP will assume the related liability to the Fund and debt servicing.

  • If the Tokyo-related disbursements fall short of the projected $2 billion in 2009/10, part of this shortfall (up to $1.4 billion) at year’s end would be covered by Fund resources. In this event, the budget will replenish the dedicated account as soon as the delayed disbursements are received. In any event, however, Fund resources would not be used to cover shortfalls in the disbursement of pledges from multilateral donors.

Capacity to repay the Fund

43. The proposed augmentation is within Pakistan’s capacity to repay the Fund, provided the program is successfully implemented. With the augmentation, Pakistan’s GRA credit outstanding would peak at nearly 72 percent of gross international reserves, equivalent to 5.9 percent of GDP, by 2010/11 (compared with 65 percent of gross international reserves in 2009/10 at the time the SBA was approved), while debt service payments would peak at about 35.9 percent of end-period gross reserves and 15.3 percent of exports of goods and services in 2013/14. These metrics are high relative to other exceptional cases, and indicate substantial risks to the capacity to repay the Fund. However, the authorities’ past record of servicing Fund obligations has been very good.

44. Given the continued balance-of-payments pressures and the strength of program commitments, Pakistan continues to meet the four criteria for exceptional access (Box 3).

V. The Medium-term Outlook and Debt Sustainability

45. The medium-term economic outlook is fragile. A slower global recovery, higher commodity prices, and political instability, as well as existing constraints on energy and infrastructure pose significant risks to the outlook. The global crisis, which erupted with full force after the adoption of the program, has significantly affected Pakistan’s medium-term economic prospects. Growth is likely to be lower than originally envisaged and private capital inflows will take longer to recover. As a result, stronger policies will be needed to support competitiveness and the medium-term fiscal adjustment effort. Also, higher domestic borrowing and/or foreign debt-creating inflows (including Tokyo-related) will be needed to smooth the impact of the adjustment on consumers and taxpayers.

Exceptional Access Criteria

Criterion 1: Experiencing or potential to experience exceptional balance of payments pressures on the current or capital accounts. Pakistan continues to experience large balance of payments pressures. The rebound in oil prices has rekindled pressures on the current account, and risks of lower exports and remittances could further increase the current account deficit. In addition, capital inflows—already much lower than originally envisaged—could decline further on account of global de-leveraging and loss of investor confidence due to domestic political instability. These increased pressures result in a need for Fund financing that cannot be met within the normal limits. Reserves are expected to recover by the end of the program period to levels considered adequate by traditional metrics, but will remain well below pre-crisis levels and those of comparator countries.

Criterion 2: Sustainable public debt in the medium term. Pakistan’s public debt (domestic and external, excluding obligations to the IMF), is projected to remain at around 57 percent of GDP over the medium term. Public debt, including obligations of the IMF is projected to peak at 63.5 percent of GDP in 2010/11, and decline to 57.8 percent of GDP in 2013/14. The significant increase in the public debt-to-GDP ratio compared with that at the time of the SBA approval reflects mainly the government decision to assume the electricity sector debt and the increased borrowing needs of the budget to deal with the impact of the global economic crisis on domestic economy, as well as increased security and social spending. There is a high probability that Pakistan’s public debt will remain sustainable in the medium term; the reforms envisaged under the program and the projected fiscal consolidation will enable a gradual decline in the public debt-to-GDP ratio. The external debt would increase from 29.9 percent of GDP in 2008/09 to 35.5 percent in 2010/11, before declining gradually to 32.5 percent of GDP by 2013/14. Domestic interest payments are projected to decline, while the external debt service burden is projected to rise but remain manageable.

Criterion 3: Access to private capital markets. Until recently, Pakistan had been able to access international financial markets by issuing Eurobonds, Global Depository Receipts, and exchangeable bonds, as well as through nonresidents’ portfolio investment in domestic securities. Pakistan has maintained a good record in servicing its external private debt despite difficult economic conditions. It is expected that the country can regain access to international capital markets and see a pickup in FDI within two to three years, provided that the adjustment effort is successfully implemented, financial market conditions continue to normalize, and cross-border private capital flows recover to pre-crisis levels.

Criterion 4: Strong policy reform program. Program implementation has been broadly satisfactory. The staff continues to believe that Pakistan has sufficient institutional capacity to deliver the required adjustment, as evidenced by the successful implementation of Fund-supported programs during 2000/01-2004/05, and performance under the current SBA. Staff also believes that Pakistan has the political capacity to deliver the required adjustment. However, while there are reasonable prospects for success if the proposed policies are implemented, the risks to the program remain very high, as implementation can be affected by the difficult political, security, and economic conditions.

46. The external debt sustainability analysis shows that the debt stock would remain moderate and external debt service manageable. The external debt stock would increase from 29.9 percent of GDP in 2008/09 to 35.5 percent in 2010/11, before declining gradually to 32.5 percent of GDP by 2013/14. The debt service as a ratio of exports of goods and receipts is projected to increase from below 15 percent to 20 percent during the same period, reflecting in part, repayments of Fund credit. This outlook, however, is subject to serious downside risks, including a possibly higher noninterest current account deficit, slower growth, larger depreciation, higher interest rates, and lower FDI flows. Combined shocks to growth, current account, and depreciation could vault the end-period debt stock to around 49 percent of GDP, a level significantly higher than in the baseline scenario.

47. Since the conclusion of the last Article IV consultation in April 2009, public sector debt sustainability prospects have been affected by the assumption of electricity sector debt by the budget and the higher projected deficit. Total public sector debt (excluding obligations to the IMF) relative to GDP is now expected to increase from 56 percent in 2008/09 to 56.8 percent in 2009/10. This reflects primarily the upward revision of the 2009/10 fiscal deficit target to 4.6 percent of GDP to allow for the spending of the additional donor financing pledged in Tokyo and the assumption by the budget of electricity sector debt of 1.9 percent of GDP. While the last public sector DSA projected a gradual decline in this ratio, it is now projected to stay virtually constant around 57 percent through 2012/13, with a marginal decline (to 56.3 percent) starting only in 2013/14. This reflects a projected increase in foreign borrowing by 7.3 percentage points of GDP between 2009/10 and 2013/14, while domestic debt is projected to decline at a similar pace. Public debt (including obligations to the Fund) will reach a peak of 63.5 percent of GDP in 2010/11 and decline to 57.8 percent of GDP in 2013/14. While there is a high probability that the debt will remain sustainable assuming the program is fully implemented, the outlook is subject to significant downside risks. The standard bound tests show that all shocks (primary balance shock, interest rate shock, growth shock, and real exchange rate shock) lead to an increase in the debt-to-GDP ratio by several percentage points. The effect of a real exchange rate shock is particularly pronounced, reflecting the rising weight of external debt in total public debt. This implies that the authorities will need to stand ready to take additional fiscal measures, as needed.

VI. Staff Appraisal

48. Despite shortcomings in policy implementation, Pakistan’s economy has continued to stabilize. Reforms in the financial sector and the foreign exchange market have been progressing broadly as envisaged, and steps have been taken to strengthen the social safety net. Revenue mobilization efforts, however, have proven inadequate, as tax policy and tax administration reforms have been delayed. Also, major expenditure overruns in the last quarter of 2008/09 revealed significant weakness in control over provincial spending. Moreover, the authorities have not been decisive in addressing long-standing problems in the energy sector. Together with the global crisis, energy problems have affected adversely Pakistan’s growth potential and burdened public finances.

49. Tax reforms are needed to make the economy less vulnerable and allow the steady flow of revenue needed to reduce poverty and develop basic infrastructure. Increasing tax revenue is crucial for reducing macroeconomic vulnerability and providing lasting fiscal space for poverty-reducing spending. The low revenue effort constrains the government’s ability to deal with the pressing needs of the population, which are now compounded by the large number of IDPs. In this regard, the authorities need to move decisively with the VAT preparations and adhere strictly to the timetable for introducing the VAT on July 1, 2010. Of equal importance is the renewed commitment to tax administration reform.

50. The delay in implementing much needed reforms in the energy sector drains the public finances and constrains the country’s medium-term growth prospects. This entails significant budgetary costs (in the form of subsidies and debt service payments) and undermines macroeconomic stabilization. The authorities need to proceed swiftly with the envisaged tariff increases and the implementation of the new automatic tariff adjustment mechanism to de-politicize the tariff adjustment process. Further delays or backtracking will result in the crowding out of other needed expenditure, and inadequate investment to increase generation and distribution capacity.

51. The macroeconomic outlook for 2009/10 remains difficult, and the external position is subject to considerable downside risks. Pakistan’s main economic challenges in 2009/10 will be (i) consolidating macroeconomic stability and maintaining the momentum of supporting reforms, including in the energy sector; (ii) dealing with the impact of the global crisis on exports and economic activity; and (iii) mobilizing political support for tax policy and administration reforms. To achieve the program objectives, the authorities will need to focus on mobilizing donor support, pressing ahead with fiscal consolidation, and tax, electricity sector, and financial sector reforms.

52. The additional donor support pledged in the Tokyo conference and the augmentation of access under the SBA will help meet these challenges, but such financing should be regarded as temporary and used as a bridge until a much stronger medium-term revenue effort bears fruit. Mobilizing higher revenue to reduce the public debt-to-GDP ratio should be a key policy objective. A credible tax reform is needed to ensure fiscal sustainability and to create fiscal space for expanding the social safety net, and increasing investment in human and physical capital.

53. The 2009/10 budget has been constructed with a view to providing adequate space for priority spending, but its implementation should be monitored closely. In particular, the authorities should ensure that the redistributive function of the budget is consistent with the government’s social policy objectives, with spending on IDPs, support for poor households, and other well-targeted social spending taking precedence over transfers to politically connected groups. Also, development spending must be properly timed to ensure adequate resources for IDPs, regardless of the availability of the external grants.

54. Monetary policy needs to be vigilant to prevent a resurgence of inflation. The relaxation of the fiscal policy stance, electricity tariff increases, and the rebound in oil prices will add to inflationary pressures. Moreover, the present round of wage increases in the public sector, if not managed properly, may trigger an economy-wide realignment of wages, with attendant effects on inflation and competitiveness.

55. Exchange rate policy should aim at strengthening competitiveness and further strengthening the international reserves position. In this regard, the accelerated phasing out of the foreign exchange provision for oil imports payments is a key step in the right direction.

56. Accelerating reforms to strengthen the independence of the SBP and pressing forward with the legislative amendments to increase SBP’s supervisory powers is of great importance. Theses reforms are critical for enhancing the monetary policy framework and maintaining the stability of the banking system in the present difficult environment.

57. Despite the difficulties in implementing program commitments, the authorities have made significant efforts to keep the program on track. Progress made toward reducing inflation and strengthening the external position, the measures to improve the social safety net, and the adoption of a budget for 2009/10 that provides adequate basis for further macroeconomic stabilization and much needed social spending, constitute appreciable achievements, particularly taking into account the security developments, the global economic recession, and the difficult domestic political environment. The nonobservance of the end-June performance criterion on the fiscal deficit reflects to a large extent temporary pressures on account of unforeseen security- and IDP-related expenditure needs in the last quarter of 2008/09 and excessive provincial spending. A waiver is justified given the temporary nature of these unforeseen expenditures and the measures to control the use of overdrafts by provinces. The recent agreement with World Bank and ADB staffs on the electricity sector reform also signals a desire to address the deep-seated problems in that sector. With these considerations in mind and based on the strength of the updated commitments expressed by the authorities in the attached SSMEFP (including the corrective actions aiming to enhance the implementation of the structural reforms under the program), staff supports the requested waivers of nonobservance for the two missed structural performance criteria and the end-June quantitative performance criterion on the fiscal deficit, waivers of applicability for other end-June quantitative performance criteria, the rephasing of purchases and the extension of the arrangement through end-2010, and recommends the completion of the second review and the approval of the augmentation of access by 200 percent of quota.

Figure 1.
Figure 1.

Pakistan: Selected Economic Indicators

(June 2008–End June 2009, unless otherwise indicated)

Citation: IMF Staff Country Reports 2009, 265; 10.5089/9781451830750.002.A001

Source: Pakistani authorites.
Figure 2.
Figure 2.

Pakistan: Financial Market Indicators

Citation: IMF Staff Country Reports 2009, 265; 10.5089/9781451830750.002.A001

Sources: Pakistani authorities; and Bloomberg.1/ Volume in millions of shares.2/ Placement volumes are for all maturities and Treasury bill rate is a weighted average.
Figure 3.
Figure 3.

Pakistan: Real and External Sectors, 2005/06-2009/10

Citation: IMF Staff Country Reports 2009, 265; 10.5089/9781451830750.002.A001

Sources: Pakistan authorities and Fund staff projections.1/ At factor cost.
Figure 4.
Figure 4.

Pakistan: Fiscal Policy Indicators, 2007/08-2009/10

Citation: IMF Staff Country Reports 2009, 265; 10.5089/9781451830750.002.A001

Sources: Pakistan authorities and Fund staff projections.
Table 1.

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

(Population: 160.9 million (2007/08))

(Per capita GDP: U.S.$1,042 (2007/08))

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

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

Fiscal year ends June 30.

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

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

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.

Table 2.

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

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

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

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

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

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 2009/10 projections, this figures includes unidentified IDP-grants in the amount of $404 million.

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.

Reflects assumption of electricity sector debt by the budget.

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 2009/10 projections, this figures includes unidentified IDP-grants in the amount of $404 million.

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.

Reflects assumption of electricity sector debt by the budget.

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.