Pakistan
Fourth Review Under the Stand-By Arrangement, Requests for Waivers of Performance Criteria, Modification of Performance Criteria, and Rephasing of Access: Staff Report; Staff Statement and Supplement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Pakistan.
Author: International Monetary Fund
Publication Date:
02 Jun 2010
eISBN:
9781455205202
Language:
English
Keywords:
ISCR; CR; financing; IFC strategy; deficit; outlay; expenditure restraint; short-term debt; headline inflation; broad money; IDP grant; long-term debt; Budget planning and preparation; Government debt management
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The 2010 staff report for the Fourth Review Under the Stand-By Arrangement addresses economic challenges faced by Pakistan. The implementation of the structural agenda faced delays but politically difficult reforms were assured to be executed. The resulting fiscal pressures had been expected to be largely offset by restraining nonpriority current spending. The authorities have shown their determination to pursue difficult, but necessary, reforms to implement the program despite lower-than-promised external assistance. IMF staff supported the requested rephasing of access and modifications to the performance criteria.

Abstract

The 2010 staff report for the Fourth Review Under the Stand-By Arrangement addresses economic challenges faced by Pakistan. The implementation of the structural agenda faced delays but politically difficult reforms were assured to be executed. The resulting fiscal pressures had been expected to be largely offset by restraining nonpriority current spending. The authorities have shown their determination to pursue difficult, but necessary, reforms to implement the program despite lower-than-promised external assistance. IMF staff supported the requested rephasing of access and modifications to the performance criteria.

I. Recent Developments and Near-Term Outlook

1. Political and security uncertainties remain high. The military campaign in South Waziristan has continued and resulted in an outflow of population from this and surrounding areas.1 The political situation has been affected by the Supreme Court ruling of December 17, 2009 rendering the 2007 National Reconciliation Ordinance (NRO) invalid.2 Finance Minister Shaukat Tarin resigned effective end-February. His successor, Mr. Abdul Hafeez Shaikh, who was appointed as Finance Advisor to the Prime Minister with the executive powers of finance minister, has reaffirmed the objectives and policy commitments under the program. The rest of the economic team remains in place. In April, the parliament approved the Eighteen Amendment to the Constitution that transfers some key presidential powers to parliament or the prime minister, and enhances provincial autonomy.

2. Economic activity has picked up but inflation has risen more than expected. Real GDP growth is likely to reach 3 percent in 2009/10, as projected. Early indicators point to a drop in wheat output, but the cotton harvest was better than expected. Also, the large-scale manufacturing index increased by 2.5 percent in July 2009–February 2010, relative to the same period in 2008–09. Headline inflation (y-o-y) increased from 10.5 percent in November-December 2009 to 13.7 percent in January 2010 (due mostly to a base effect, but also the unexpectedly large food and energy price increases) and remained elevated at just below 13 percent through March 2010.3 Meanwhile core inflation subsided somewhat. As a result, projected headline inflation (y-o-y) for end-June 2010 has been revised upward from 11 to 12 percent, while core inflation is still expected to drop to about 8 percent.

3. The SBP’s international reserves have been stable since October. The current account deficit in October 2009–February 2010 was 70 percent lower than in the same period in 2008–09. This improvement reflected mainly import contraction (due to lower commodity prices and a drop in the demand for other imports), lower profit remittances abroad, and stronger inflows of workers’ remittances. There was also some rebound in manufacturing exports. The improvement in the external current account has mitigated the impact of lower than expected external financing and helped maintain the official reserves at just above $11 billion (about 3% months of imports) through end-March. Looking forward, the delayed external financing is expected to be disbursed in the fourth quarter and the external current account through end-2009/10 is expected to narrow to below 4 percent of GDP, enabling the SBP to target a somewhat larger build-up of net foreign assets. This outlook, however, is subject to risks stemming from rising oil prices and a possible decline in remittances.

4. Broad money growth has continued to be weak. There was some pick-up in broad money growth in September–December 2009, which reflected a rebound in bank credit to businesses needing working capital, but money demand weakened in January–March 2010 with both cash and deposits declining in nominal terms. Credit to government continued to grow at double-digit rates (as projected), while credit to private sector remained sluggish. It also appears that the treasury’s efforts to replace the shortfall of foreign financing by borrowing from nonbank sources contributed to the weakening of money demand. The SBP continued to manage the difficult liquidity conditions by rolling over its repo position and injecting liquidity via swaps.4 After the 50 bps cut in the policy rate in November 2009, the SBP kept the policy rate unchanged at 12.5 percent in its January 30 Monetary Policy Statement, citing the likelihood of an uptick in inflation during the remainder of 2009/10, and maintained this position in its March 27 statement.

5. Risks to the budget, including on account of quasi-fiscal pressures, have risen. These pressures included an increase in the energy sector’s “circular debt” and losses from wheat procurement and other commodity operations. Inter-enterprise arrears in the energy sector (circular debt) have increased by about 0.8 percent of annual GDP in the first three quarters of 2009/10 due mainly to nonpayment by energy companies to suppliers and nonpayment of bills by government agencies.5 To regularize a major portion of this debt, the government decided to deduct outstanding electricity dues of government institutions from their accounts and refinance the remainder (an estimated 0.5 percent of GDP), together with a portion of the pre-2009/10 circular debt, by issuing additional bonds. Wheat procurement and other commodity operations have added an estimated 0.2 per cent of GDP to quasi-fiscal pressures on account of losses incurred by public procurement agencies. And, the SBP remains concerned about lending for commodity operations crowding out credit to the private sector.6 Also, setting high procurement price for wheat has contributed to food price inflation.

6. T-bill placements have proceeded smoothly. The volume targets for T-bill placements were met or exceeded. T-bill rates mirrored the 50 bps cut in the policy rate in November, dropping below 12 percent in early January. T-bill yields have increased, however, following the news of the pick-up in inflation in January and the weighted average T-bill rate stood at about 12.3 percent in mid-April. Meanwhile, the secondary market for treasury bills and other government paper has deepened with the SBP’s establishment of a new electronic bond-trading platform in January.

7. The exchange rate has been broadly stable in nominal terms. The rupee depreciated from Rs 83 per U.S. dollar at end-September 2009 to Rs 84–85 per U.S. dollar in February–April 2010. However, due to rising inflation, the real effective exchange rate appreciated by 1.6 percent in the last three months of 2009. The cessation of the provision of foreign exchange for oil imports by the SBP in mid-December did not have a significant impact on the interbank foreign exchange market.

8. The stock market has continued its upward trend. There was a downward correction of about 10 percent in late 2009, which reflected increased political and security uncertainties in the wake of the campaign in South Waziristan, and the downgrading of the ratings of several Pakistani banks by Merrill Lynch. But the market recovered subsequently, following the announcement of better than expected earnings by several large banks and companies. Analysts also noted a positive impact owing to the completion of the third program review. Sovereign debt ratings of Pakistan have not changed since November, while Pakistan’s EMBIG spread dropped from 700 bps in November 2009 to 460 bps in mid-April.

9. Poverty has likely risen. Pakistan saw a significant decline in poverty during the pre-crisis period with the share of the population living in poverty dropping from 34.5 percent in 2001/02 to 17.2 percent in 2007/08. However, the economic slowdown and the erosion of purchasing power caused by inflation suggest that these gains in poverty reduction may have been partly reversed. The 2007/08 household survey results indicated that poverty started rising already toward the end of that fiscal year. While the continuation of this trend is yet to be confirmed by the next household survey, it is to be noted that food and non-food prices rose by 23.7 and 18.4 percent, respectively, between 2007/08 and 2008/09, resulting in a 21 percent reduction in purchasing power.

II. Program Implementation

10. Except for a small overrun on the budget deficit target, all performance criteria through end-December were met. Revenue collection by the Federal Bureau of Revenue (FBR) in July–December fell short of the program’s target by close to 0.2 percent of GDP and there was a similar shortfall in provincial tax and nontax revenue, but the authorities offset revenue shortfalls by restraining current and development spending, while accommodating 0.3 percent of GDP in additional security spending. As a result, the budget deficit (excluding grants) exceeded the program target by 0.02 percent of GDP.7

11. Two quantitative performance criteria for end-March were missed. Preliminary information indicates that the performance criteria on the SBP’s net foreign assets (NFA) and domestic assets were met by wide margins, but the ceilings on the overall budget deficit (excluding grants) and net government borrowing from the SBP were missed.

  • The budget deficit target was exceeded by an estimated 0.4 percent of GDP (including 0.2 percent of GDP based on application of program adjustors), due mainly to the revenue shortfall, which reached an estimated 0.7 percent of GDP in the first three quarters of 2009/10. While the authorities made significant cuts in current and, to a smaller extent, development spending to reduce the slippage, these savings were partially absorbed by an estimated 0.4 percent of GDP in additional security outlays in the third quarter, which included spending on the reconstruction of infrastructure in the areas affected by the conflict.8 At the same time, shortfalls in grants for internally displaced persons (IDP grants) and Tokyo-related multilateral support increased the margin of nonobservance via adjustors.

  • The target for net government borrowing from the central bank was exceeded by 0.2 percent of GDP. The authorities had expected significant external financing inflows in the last weeks of March to settle the intra-quarter overdraft. These inflows are now expected in the fourth quarter of 2009/10. Meanwhile, the authorities will strengthen government liquidity management and reduce recourse to the SBP overdraft to ensure that targets for borrowing from the SBP are met.

Pakistan: Fiscal Outcome, July 2009-March 2010 and FY 2009/10 Program

(In percent of GDP)

article image

Includes statistical discrepancy.

The difference in the revenue-to-GDP ratio between the 3rd and 4th reviews is 0.1 percent of GDP, as discussed in 14. The difference shown in this table appears larger due to rounding.

Relative to the 2009/10 budget.

12. There were some delays in implementing the structural agenda, but important and politically risky reforms have moved forward.

  • The federal VAT bill was submitted to the parliament on February 25. The provincial VAT bills were submitted to the provincial assemblies in late March, following consultations with provinces and preliminary parliamentary discussions on the federal law.9 With the submission of the federal VAT bill and four mutually consistent provincial VAT bills, the authorities met the prior actions for the fourth program review. However, the Sindh government also submitted a parallel Sales Tax on Services Bill, which poses a risk to the timely passage of the VAT bill and the overall consistency of the VAT package. The authorities indicated that the differences with Sindh would be resolved soon. They also recognize that the federal and provincial components of the VAT legislative package will need to be fully consistent to avoid problems of cascading and tax competition. Also, the government’s proposals seek to establish a uniform tax rate for most goods and services and to limit the scope of zero-rating and exemptions in order to ensure that the VAT yields the required revenue increase (SMEFP ¶11)

  • There has been some progress on tax administration reform. The implementation of the expeditious refund system (ERS) in all Regional Taxpayers Offices (RTOs) and Large Taxpayers Units (LTUs) (end-March structural benchmark) has begun and is expected to be completed by end-June. The ERS enables timely and accurate verification of sales tax refund claims submitted by exporters and mitigates the risk of refunding fraudulent claims. The ERS was tested at the Islamabad LTU on a pilot basis. Now the pilot has been extended to the Lahore RTO and the system is expected to be fully deployed by end-June in all RTOs and LTUs. To this effect, the FBR issued a regulatory order in late March requesting manufacturing exporters registered at the Lahore RTO to start submitting their refund claims electronically through the ERS from the April sales tax period onwards. Manufacturing exporters registered at all other RTOs and LTUs will begin to use the ERS in the July tax period (SMEFP ¶12).

  • Electricity tariff adjustments have been slower than expected. Full implementation of the 6 percent adjustment agreed with the World Bank and the Asian Development Bank (ADB) for October was completed in December. Subsequently, tariffs were raised by 12 percent on January 1, as scheduled.10 A further 6 percent increase was originally expected on April 1; the authorities have now indicated that they will implement this increase later, back-dated to April 1, although no specific timeline has been set. Monthly adjustments on account of fuel cost changes have continued, albeit with some lags; however, the quarterly determination of the required tariff adjustment for July–September was not implemented, but covered by subsidies; as of end-March, the authorities had transferred to the Pakistan Electric Power Company the Rs 55 billion (0.4 percent of GDP) budgeted for tariff differential subsidies in 2009/10 and an additional Rs 12 billion (0.1 percent of GDP) in budgeted funds to the Karachi Electric Supply Company. While the authorities had previously indicated that the quarterly adjustment (for October-December, 2009) would be implemented in early April and the quarterly adjustment (covering January-March, 2010) would be notified and implemented on time, they have later questioned the feasibility of these (as well as further monthly fuel price) adjustments. The authorities continue discussions with the World Bank and the ADB staffs on a way forward on these issues, including on actions to eliminate tariff differential subsidies, and have committed to establishing by end-June 2010 a comprehensive framework (agreed with the World Bank and the ADB) for dealing with cost pressures and supply shortages in the electricity sector (SMEFP ¶14).

  • Owing to administrative capacity constraints, the rollout of the scorecard-based targeting system for the Benazir Income Support Program (BISP) has taken longer than envisaged. As a result, social spending in 2009/10, though still significantly higher than in 2008/09, will likely be below the budgeted amount. Also, 15–20 percent of BISP payouts will be delivered to beneficiaries identified before the scorecard was introduced. The authorities (with help from World Bank staff) are exploring ways to accelerate the nationwide rollout of the poverty-scorecard system (SMEFP ¶13).

  • The amendments to the Banking Companies Ordinance (BCO) were approved by the National Assembly on February 8 and are expected to be approved by the Senate in early May. These changes will strengthen the SBP’s ability to deal with problem banks (SMEFP ¶26). The amendments to the SBP Act, aiming at enhancing operational independence of the central bank, were introduced to the National Assembly on March 17 and will be considered by the Committee on Finance and Revenue in the coming weeks.

  • The draft Corporate Rehabilitation Act (CRA) has been revised to create a mechanism that could allow the write-down, write-off, or subordination of creditor claims for a small group of the largest distressed companies in the economy. World Bank staff has raised concerns about several aspects of the revised draft, and is recommending that it be realigned with the best practices in bankruptcy law before it is submitted to parliament. World Bank experts have pointed out that, with these new provisions, the operation of the CRA could raise issues of financial stability (because banks would be required to absorb the loss of significant levels of non-performing loans), and concerns about fiscal discipline (because of the contemplated use of public funds to purchase claims and assets with no clear market value). The authorities are reviewing the draft to address these shortcomings.

III. Policy Discussions

13. Policy discussions focused on the fiscal program for the remainder of 2009/10, the structural reform agenda, and a possible tightening of the monetary policy stance to address the rebound in inflation. Staff also discussed with the authorities measures to address fiscal risks and financial sector issues, focusing on ways to improve financial sector stability and strengthen the regulatory framework.

Fiscal policy

14. Security weighs heavily on the near-term fiscal outlook, and, while identifying measures to address most of the end-March slippage, the authorities saw the need to relax the 2009/10 budget deficit target by 0.15 percent of GDP to 5.1 percent of GDP.

  • The authorities believe that the end-June budget deficit target (excluding grants) should be relaxed from 4.9 percent of GDP to 5.1 percent in order to allow room for additional security spending while avoiding excessive cuts in development spending and protecting priority social spending. They consider the revised budget deficit target achievable under ambitious but realistic revenue assumptions and further expenditure restraint.

  • Revenue through end-June is projected to fall short of the program target agreed at the time of the third program review by 0.1 percent of GDP.11 This projection takes into account: (i) the performance in the first three-quarters of 2009/10; (ii) revenue collection measures which are expected to boost revenue in the last quarter by 0.2 percent of GDP; and (iii) 0.6 percent of GDP in nontax revenue from the U.S. Coalition Support Fund (CSF)12 expected in the fourth quarter (see below).

  • Current expenditure is projected to be higher than envisaged, due primarily to additional security spending (over 0.5 percent of GDP in the second half, mainly in the third quarter). As noted above, most of the additional security spending have been accommodated by restraining other current spending, but the authorities have indicated that the overall amount of current outlays will need to increase by 0.1–0.2 percent of GDP to avoid undue cuts in priority spending. They agreed however that any additional subsidies (e.g., to cover losses from wheat procurement—see ¶17) would need to be accommodated within the overall unchanged envelope for subsidies.

  • Development spending is currently projected to remain as envisaged at the time of the third program review, except for minor cuts in federal development outlays (less than 0.1 percent of GDP). The authorities indicated, however, that any additional fiscal pressures, including from revenue underperformance, would be offset by further restraint in non-priority federal development spending and, to this effect, identified appropriate contingencies of 0.3 percent of GDP.

  • Attaining the revised fiscal deficit target will depend on obtaining the budgeted receipts (refunds) from the CSF. The CSF receipts projected for 2009/10 amount to $1.35 billion (nearly 0.8 percent of GDP). Of this amount, Pakistan has received thus far $349 million (0.2 percent of GDP). The Pakistani and U.S. authorities are working toward a timely release of the remaining funds.

15. The feasibility of the revised fiscal deficit target also hinges on higher privatization receipts (from abroad), which are expected to cover the additional budget financing needs and shortfalls in overall external grants. The external financing assumptions and program adjustors have been changed to reflect the offsetting effects of reduced projections for IDP grants and multilateral financing, and a substantial increase in privatization receipts and non-IDP grants.13 As a result, the relaxation of the fiscal deficit target will not entail an increase in the government’s domestic financing needs and will not affect the public debt-to-GDP ratio. Moreover, the authorities agreed to lock in a part of the over-performance relative to the end-December NFA target to ensure that the relaxed fiscal position does not compound external vulnerabilities; to this effect, the NFA target for end-June 2010 has been revised upward by $300 million. Fund financing to the budget at year-end is expected to be about $700 million; about a half of the IMF disbursements to the budget will be reimbursed to the SBP in the last quarter of 2009/10, as envisaged at the time of the third program review.

16. Preparations for the medium-term budget framework for 2010/11–12/13 have started. The initial Budget Strategy Paper has been approved by the cabinet. The medium-term strategy (which will lay the basis for the 2010/11 budget) aims at reducing the fiscal deficit (excluding grants) by about 2½ percent of GDP over three years while increasing the share of development spending (linked to foreign grants). The strategy also seeks to achieve a significant devolution of resources from the federal budget to the provinces (from 4.4 percent of GDP in 2009/10 to 7.4 percent by 2012/13), consistent with understandings reached in the context of the National Finance Commission (NFC) Award last December.14 To this effect, the divisible pool of resources is projected to increase by 3 percent of GDP, of which 2.4 percent will be on account of the introduction of the VAT.

17. The authorities continue to seek ways to address fiscal risks in the public enterprise sector. They plan to curb the losses of the public enterprises, estimated at Rs 200–250 billion (1⅓-1⅔ percent of GDP) on an annual basis, by restructuring eight major entities (SMEFP ¶21).15 To improve transparency, the Ministry of Finance has also started to publish on its website information on the stock of government guarantees.16 The recurrent problem of circular debt in the energy sector is to be resolved by strengthening the management of the regional electricity distribution companies (their top managers, including CEOs, will be subject to performance contracts to reduce companies’ losses and improve their financial management), while the payment arrears to the electricity companies incurred by government agencies will be cleared by making at-source deductions from their budget allocations (SMEFP ¶15). Regarding wheat procurement and other commodity operations, the authorities aim to cover the losses of the government procurement agencies within the existing budget envelope for subsidies. The wheat procurement target for the 2010 season has been reduced and the overall amount of commodity credits will be subject to a cap (SMEFP ¶16).

18. The authorities reconfirmed the timetable for VAT implementation. In parallel to pressing forward with the legislative agenda (with passage of the VAT laws now expected by end-May 2010), the authorities are making progress on technical preparation for the implementation of the VAT by July 1, 2010. The key steps remaining include procuring the information technology and supporting equipment (including to manage refunds), stepping up staff training at the FBR, and an ongoing information campaign to familiarize taxpayers with the VAT framework.

Monetary and exchange rate policies

19. Monetary policy will continue to focus on combating inflation and strengthening international reserves. Headline inflation (y-o-y) is expected to subside in the months ahead, but there is a risk that inflationary expectations become more entrenched. In this context, the SBP indicated that it would change the monetary policy bias toward tightening (and later signaled it in its March 27 decision) and, subsequently, it would increase the policy rate if inflation continues to exceed expectations. The SBP will keep the exchange rate flexible, which will help ensure that the accumulation of international reserves continues.

20. The SBP will also seek ways to broaden the government securities market and increase the space for private sector credit. In this regard, a reduction in credit related to commodity operations and the clearance of public enterprise debt (e.g., in the energy sector) will help. The SBP considers that additional space may come from the development of the debt securities market, including with the use of the electronic bond-trading platform, which is expected to attract more nonbank investors to the government securities market.

Financial sector

21. Financial soundness indicators through end-December point to a continued, albeit slow, deterioration in bank conditions. Nonperforming loans (NPLs) increased further in the last quarter of 2009, and regulatory measures adopted last fall to foster the restructuring of NPLs have not yet yielded the intended results. NPLs are generally adequately provisioned for and banks remain profitable and generally well-capitalized, but a few small and one medium-sized bank face capital deficiencies, partly related to increases in minimum capital requirements and capital adequacy ratios. Most of these banks have agreed with the SBP on plans to comply with the increased requirements by mid-2010, including through mergers and fresh capital injections by foreign and domestic partners. The exposure of Pakistani banks to Dubai World is reported to be limited to one bank that has adequate capital to absorb the possible losses. On a separate matter, there are concerns about the “fit and proper” qualifications of some bank managers and owners, as well as a generalized concern over governance (e.g., related to directed lending) in some public banks. The SBP intends to draw on its strengthened supervisory powers (arising from BCO amendments) to address these concerns.

22. The SBP is evaluating the modifications proposed by the Basel Committee to strengthen the regulatory framework. In many respects, the framework used in Pakistan already meets the proposed enhanced requirements, but the SBP will conduct a full impact assessment of the Basel Committee proposals in the near future. A preliminary assessment suggests that the introduction of the additional criteria would confirm that Pakistani banks are liquid and well-capitalized. Banks’ capital is largely composed of Tier 1 capital, a large share of banks’ assets is held in liquid (government) securities, and banks’ exposure to derivative products is very low.

IV. Rephasing and Key Issues for the Fifth Review

23. Given the proposed rephasing of access and the resulting change in the number and schedule of reviews, the next (fifth) review will focus on the implementation of the VAT and reaching agreement on the 2010/11 budget. In view of the delay in the fourth review, the authorities have requested rephasing of access under the arrangement. Specifically, in order to allow a sufficient period prior to the next review to advance core elements of the reform agenda, the authorities have requested that the last three purchases (and associated reviews) under the arrangement be consolidated into two, with access of about SDR 1.15 billion (equivalent to about 111 percent of quota) being made available at the completion of each review. Accordingly, the fifth review, originally scheduled for June, could now take place in August. It will assess the performance of Pakistan under the quantitative performance criteria through end-June 2010 and will focus on the structural agenda that was originally to be reviewed both under the fifth and the sixth reviews:

  • Implementation of the VAT (structural benchmark for July 1, 2010). The remaining intermediate steps include: (i) the approval (by end-May) of the federal VAT bill by parliament and consistent provincial VAT bills by the provincial assemblies; (ii) promulgation of the regulations ensuring their orderly implementation within a month of their approval; and (iii) legislation to harmonize the existing tax laws with the VAT Act (expected to be submitted in early June, 2010).

  • Reaching agreement on the 2010/11 budget.17 The next year’s budget must be consistent with the principles of macroeconomic stability and public debt sustainability, taking into account the accrual of liabilities stemming from quasi-fiscal operations. Availability of external financing is likely to be a key constraining factor. The agreement on the 2010/11 budget and the supporting macroframework is also needed to establish the quantitative performance criteria for end-September 2010, which will constitute conditionality for the sixth review and seventh (final) purchase under the SBA.

V. Debt Sustainability and Other Issues

24. Debt sustainability outlook has remained broadly unchanged relative to the third program review. The updated debt sustainability analysis (DSA) shows that external debt remains low under the medium-term baseline scenario, while the public debt remains high but is expected to decline gradually.

  • External debt edges up from 31 percent of GDP in 2009/10 to 33½ percent in 2010/1111/12, but declines steadily thereafter. It would rise to 40 percent in the event of shocks to oil prices or FDI, but exceed 50 percent only in the event of a simultaneous shock to growth, the current account, and FDI combined with a real depreciation. Thus the risks to external solvency are not large, but need to be contained.

  • Public debt, including Fund credit to the budget, is projected to peak at 56½ percent of GDP in 2009/10 (and 61½ percent of GDP in 20010/11 including all liabilities to the IMF), and then decline to below 50 percent by 2014/15. Simulations show that growth, primary balance and interest rate shocks, as well as a combined shock involving all these components, would not push the public debt-to-GDP ratio above 60 percent. However, the 30 percent depreciation shock would push it above 70 percent, while the contingent liability shock would raise it to 65 percent. Also, Pakistan’s public debt-to-revenue ratio exceeds 400 percent (more than twice the emerging markets countries’ average) and interest payments consume about one third of budget revenues (more than in any emerging market country). Public debt is, therefore, a source of vulnerability and needs to be reduced. The authorities recognize this need and in the preliminary version of the Budget Strategy Paper project to bring public debt below 50 percent of GDP in the medium term.

25. In January the SBP removed the exchange restriction on advance payments against letters of credit. In doing so, it reiterated the need for banks to assess the bona fide nature of the underlying transactions.

26. An update of the March 2009 safeguards assessment of the SBP was completed in February 2010. It found that efforts had continued to strengthen the SBP’s safeguards framework. The SBP also accepted the proposed timetable for implementing most safeguards measures and agreed that the external auditors should proceed with confirming the level of foreign reserves at end-2009 directly with their counterparties. Amendments to the SBP Act are pending parliamentary discussion and approval.

VI. Staff Appraisal

27. The authorities have committed to addressing the third quarter fiscal slippage and continue to press ahead with structural reforms in the context of a difficult political and security environment. Looking forward, achieving fiscal objectives will remain the key policy challenge, particularly given that the security situation is affecting both revenue and expenditures. At the same time, the recent pick-up in inflation re-emphasizes the importance of fiscal prudence.

28. Staff supports the relaxation of the 2009/10 budget deficit target (excluding grants) by 0.15 percent of GDP to 5.1 percent of GDP. The additional fiscal space will allow for additional security spending, and financing it through privatization receipts would avoid further debt creation. However, achieving the revised fiscal deficit target will require strong tax collection efforts and expenditure restraint. In particular, the FBR revenue target is ambitious; attaining it will require political backing and decisive steps to address tax evasion and avoidance. Moreover, further ad-hoc transfers from the SBP to cover revenue shortfalls should be avoided and the government’s liquidity management should be strengthened (e.g., through pre-financing) to limit recourse to the SBP overdraft. Expenditure restraint will be critical, but expenditure compression should be limited to non-priority projects while protecting spending on poverty reduction and assistance to the internally displaced persons. The revised budget deficit target is also subject to risks related to the timing of the external inflows and unforeseeable security-related spending pressures.

29. Despite institutional and political hurdles, the authorities have made progress (albeit with some delays) in preparing for the introduction of the VAT. Looking forward, further efforts are needed to ensure that the VAT is implemented on July 1, as scheduled. The federal and the provincial parts of the VAT legislative package need to be made consistent to avoid problems of cascading and tax competition. Moreover, it will be critical to limit exemptions and properly calibrate the VAT rate in order to ensure an adequate revenue yield. The introduction of a broad-based VAT is crucial for boosting tax revenue in the medium term. The pool of budgetary resources, an increasing share of which will be devolved to the provinces, must increase significantly to support the new revenue-sharing arrangements and allow for high priority spending. The transfer of revenues to provinces must be accompanied by a transfer of spending responsibilities, which will require a significant strengthening of budget execution functions at the provincial levels.

30. The rollout of the enhanced targeting mechanism under the BISP needs to be accelerated. In this regard, strengthening of the social safety net is of utmost importance to address the likely deterioration in poverty indicators.

31. Risks to the public finance from quasi-fiscal operations need to be contained. Plans to curb quasi-fiscal losses are welcome, and need to be implemented. In this context, the initiative to restructure the eight large SOEs needs to be translated into action. In the electricity sector, a comprehensive framework to eliminate tariff differential subsidies is urgently needed. Losses from wheat procurement should be dealt with in a transparent manner and credit for commodity operations should be contained to allow adequate space for private credit. Overall, the authorities will need to ensure that spending on subsidies remain within the budgeted level.

32. Monetary policy should be geared at restoring the trend toward price stability. Inflation must not become entrenched at current levels, as it will increase poverty, impede economic recovery, and harm long-term growth prospects. The SBP should raise the policy rate promptly if inflationary pressures do not abate as expected. SBP’s efforts need to be supported by fiscal policy.

33. The SBP should be empowered to better support financial sector stability. Key areas for improvement include strengthening governance in public financial institutions, strictly enforcing “fit and proper” rules, and fostering bank compliance with capital adequacy requirements. In this regard, the timely approval of the amendments to the Banking Companies Ordinance by the Senate is of utmost importance. Similarly, it would be important to obtain early parliamentary approval of the amendments to the SBP Act.

34. External financing remains a risk to the program. A strengthened current account will allow for a continued accumulation of reserves; Pakistan’s capacity to repay the Fund remains broadly adequate and will not be affected by the requested rephasing of access. However, the balance of payments continues to be subject to uncertainties including the timing of donor financing and privatization receipts.

35. Compared to a year ago, the economy is clearly in a much less risky state, but vulnerabilities remain considerable. Despite pressures on the security front and a difficult domestic political setting, the authorities have made progress in advancing a number of politically difficult reforms, including raising electricity and fuel prices and tightening monetary policy. These steps have helped stabilize the economy. Looking ahead, the budget will remain subject to spending pressures on security and financing uncertainties, and monetary policy will need to contend with continued inflationary risks. Moreover, a number of tough structural reforms need to be made, especially the introduction of VAT. And, with a weak economy and high inflation, poverty is rising. These challenges call for strong policies.

36. Staff supports the requested waivers and program modifications. Staff supports the requested waivers for the nonobservance of the end-March 2010 quantitative performance criteria on the overall budget deficit (excluding grants) and net government borrowing from the SBP on the grounds that their nonobservance was, in part, temporary (reflecting, among others, the delay in the disbursements of foreign financing), and adequate remedial actions have been agreed upon to address the remaining slippage. The criterion on the budget deficit was breached due to emergency spending pressures and revenue shortfalls, both reflecting to a large extent the unstable security situation. Shortfalls in IDP grants and Tokyo-related support from multilateral donors increased the margin of nonobservance via adjustors. Looking forward, the modified budget deficit target will allow the authorities to accommodate higher security spending. Also, external financing assumptions have been firmed up. Regarding the net borrowing from the SBP, the authorities have undertaken to improve government liquidity management and reduce its dependence on central bank financing. Staff also supports the requested rephasing of access and the modifications to the end-June performance criteria for overall budget deficit (excluding grants) and the net foreign assets of the SBP, which reflect understandings consistent with the principle of continued macroeconomic stabilization and the need to reduce external vulnerability.

37. Staff recommends the completion of the fourth review. Security spending has put substantial pressure on the budget, and political and capacity constraints have affected the implementation of the structural agenda. Key reforms, however, their complexity and political challenges notwithstanding, reached the implementation stage. The most important of them—the parliamentary submission of the VAT legislative package—makes the introduction of the VAT possible in time for the next fiscal year, as reconfirmed recently by the authorities. Also, the needed reforms in tax administration moved ahead mitigating the possible downside risks associated with the VAT introduction. More needs to be done to ensure that other important structural reforms achieve a satisfactory momentum, including in the electricity sector and commodity operations. Given the authorities’ successful track record in equally difficult areas, such as petroleum pricing and petroleum taxation and the liberalization of the foreign exchange market, staff remains confident that these complex and politically challenging reforms can be implemented.

Figure 1.
Figure 1.

Pakistan: Selected Economic Indicators

(March 2009-March 2010, unless otherwise indicated)

Citation: IMF Staff Country Reports 2010, 158; 10.5089/9781455205202.002.A001

Source: Pakistani authorites.1/ Annualized month on month core and headline inflation are based on a three month moving averages of the respective indices.2/ Positive values indicate netpurchasesin the interbank market.
Figure 2.
Figure 2.

Pakistan: Financial Market Indicators

Citation: IMF Staff Country Reports 2010, 158; 10.5089/9781455205202.002.A001

Sources: Pakistani authorities and Bloomberg.1/ Daily traded volumes are in millions of shares.2/ Placementvolumesare for all maturitiesand the Treasury Bill rate is a weighted average.
Figure 3.
Figure 3.

Pakistan: Real and External Sectors, 2006/07–2010/11

Citation: IMF Staff Country Reports 2010, 158; 10.5089/9781455205202.002.A001

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

Pakistan: Fiscal Policy Indicators

Citation: IMF Staff Country Reports 2010, 158; 10.5089/9781455205202.002.A001

Sources: Pakistani authorities and Fund staff estimates and projections.1/ Excluding IMF lending.
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: 17.2 percent (2007/08))

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

Fiscal year ends June 30.

In all tables Revised Program refers to projections published in the report for the Third Review under the SBA (Country Report 10/6).

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

Excludes obligations to the IMF except budget financing, military debt, commercial loans, and short-term debt.

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

Excluding gold and foreign currency 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.

Figures for revenue, grants, and expenditure are based on the projections agreed with the authorities in February 2010.

For 2009/10 projections, this figure includes Rs. 145 bn on security operations.

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.

7/ Excludes obligations to the IMF except budget financing, 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.

Figures for revenue, grants, and expenditure are based on the projections agreed with the authorities in February 2010.

Figures for deficit (excluding grants) and domestic bank and nonbank financing are based on preliminary estimates through March 2010.

For 2009/10 projections, this figure includes Rs. 145 bn on security operations.

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.

7/ Excludes obligations to the IMF except budget financing, military debt, commercial loans, and short-term debt.