May 14, 2010

We thank staff for their continued commitment to assist Pakistan in addressing the economic challenges, as reflected in the high quality of this report. We wish also to convey our authorities’ appreciation to Executive Directors and management for their steadfast support to Pakistan’s adjustment and reform program. The economy of Pakistan has started to turn the corner and is now better poised to respond to evolving pressures and vulnerabilities.

Notwithstanding serious security challenges, the associated uncertainty, and the contractionary impact of the global crisis, the economy has come a long way since the approval of the stand-by arrangement some eighteen months ago. The authorities’ strong commitment to the ambitious Fund-supported stabilization program has played a central role in this evolution. They have courageously implemented some very difficult structural reforms and have tightened domestic demand. Performance at end-December 2009 was generally in line with the program, and all quantitative and continuous performance criteria through end–March have been met, except for minor deviations from the end-March ceilings on budget deficit, and net government borrowing from the State Bank of Pakistan (SBP). These deviations were on account of somewhat less than expected revenue, higher than expected security-related expenditures because of intensified military operations in Waziristan, and shortfalls in external disbursements, including under the Tokyo Agreement.¹ The authorities are requesting waivers for their nonobservance. Progress has continued on important structural reforms, with virtually all structural benchmarks being met, albeit with a few delays.

There are signs of economic growth picking up, with incipient recovery in both manufacturing and agricultural output. However, investment outlays are yet to recover and unemployment pressures remain strong. Although there has been some temporary uptick in inflation in recent months, the authorities are determined to maintain tight demand management to expeditiously return to the path of declining inflation as envisaged by the program. It is gratifying to note that the year-on-year core inflation declined in March 2010 to below 10 percent from a high of 18.5 percent in March 2009.

The external current account deficit is expected to decline further to about 3.8 percent of GDP in 2009/10 from 8.4 percent in 2007/08, as restrained monetary policy and a more flexible exchange rate policy have been maintained; the fiscal deficit, despite inevitable increases in security-related outlays, is estimated to be reduced by 2½ percent of GDP over the same period to about 5 percent, which helped reduce public debt. Even though there have been delays in the disbursement of bilateral donor commitments under the Tokyo Agreement and with sluggish global demand negatively impacting exports, foreign reserves have recovered and are expected to reach the equivalent of over four months of imports by the end of this fiscal year.

The authorities are acutely aware that the economy is poised at a crucial juncture. While major steps have been taken to reverse the deterioration of the past two years, they are determined to address the remaining challenges by durably improving the fiscal position, accelerating structural reforms, and enhancing efficiency in resource allocation under prudent demand management. They are firmly of the view that, notwithstanding current security-related pressures, unless energy shortages and inflation are quickly brought under firm control, it would be difficult to ensure resumption of sustained growth with internal and external stability. Hence the authorities’ firm commitment to their reform agenda and macroeconomic stability as ably summarized in the staff report.

In line with the revamped strategy, the SBP is determined to continue its tight monetary policy to bring core inflation in line with the planned downward path. The current monetary policy stance appears to have helped in restraining inflationary expectations as reflected in banks’ inclination to purchase longer maturity T-bills in the recent auctions. In line with the flexible exchange rate policy, the targeted reduction in inflation is also expected to stanch any real effective appreciation of the rupee and, thus, protect competitiveness.

An Energy Summit was held in April 2010, under the chairmanship of the Prime Minister and attended by all stakeholders, as well as representatives of the World Bank and the Asian Development Bank, to address challenges in the energy sector. In the event, a number of steps have been taken to conserve electricity and ensure that installed production capacity is better utilized, thus, improving growth outlook and employment opportunities. The near-term objective remains to increase electricity supply by increasing production capacity. In this context, additional natural gas is being allocated to power plants, while plans are afoot to commission 10 new power plants. It is important to note that electricity tariff rates have been increased by 60 percent over the 15 months ending in January 2010. The planned further 6 percent adjustment in April had to be delayed temporarily in order to ease the excessive burden on the population. The authorities are cognizant of the need to adjust and will continue to work toward eliminating the remaining tariff differential subsidies by adjusting electricity tariff rates in consultation with the World Bank and the Asian Development Bank; a comprehensive framework will be established by June 2010 for addressing the underlying shortages and subsidies.

The authorities have also taken decisive steps to redress the underlying quasi-fiscal pressures related to the energy sector’s circular debt, which has militated against improving supply. A major portion of this debt will be handled by deducting bills owed by governmental institutions from their accounts, and the remainder will be refinanced by issuing bonds. The Federal government has already released Rs.20 billion out of its dues of Rs. 66 billion.

The adjustment program will continue to be underpinned by a comprehensive fiscal reform strategy aimed at reducing the budget deficit to a sustainable level in the shortest possible time. The intensified response to the security situation, which was a major factor in the small overrun of the budget deficit as of end–March, 2010, will continue to weigh heavily. It is for this reason, and to ensure that critical developmental outlays are retained, that the Government has sought a small upward adjustment in the deficit target for end–2009/10. With the accelerated disbursements of security-related receipts under the U.S. Coalition Support Fund (CSF) and expected higher privatization proceeds ($800 million from the UAE Itesalat), notwithstanding continued shortfalls in disbursements under the Tokyo Agreement, it would be possible to meet the authorities’ revised budget target for the year while allowing accumulation of the targeted additional foreign reserves. The Government will also endeavor to discontinue use of ad-hoc transfers from the SBP to cover revenue shortfalls by improving its own liquidity management.

A cornerstone of the ongoing fiscal reforms is to restructure the budget so as to eliminate its deficit bias and improve efficiency. In addition to the development of the medium-term budget framework that will target a sustainable reduction in the deficit while increasing developmental outlays, devolution to provinces, strengthened tax administration, and reduction of fiscal risks in the public enterprise sector (particularly, in electricity), a permanent increase in revenue generation capacity is the focal point of reform. Despite political costs, the authorities have shown determination in submitting bills in the national and provincial assemblies for the introduction of the VAT by July 1, 2010. It is expected that the VAT legislation will be approved by end-May. The introduction of VAT will help in the enlargement of the tax base and revenue mobilization which will, among other things, go a long way in increasing domestic savings. Technical preparations for the implementation of VAT are moving apace. In addition to meeting the prior action requirements for the Fourth Review, this important measure will likely help address the gridlock that has so far stymied fundamental fiscal reforms. Moreover, the reform of tax administration is proceeding as planned. The budget financing options are being diversified in order to reduce reliance on SBP financing.

Progress has also been made on structural reforms in the financial sector. On May 6, 2010, the Standing Committee of the Senate passed the bill for amending the Banking Companies Ordinance in order to increase SBP’s capacity, among other things, to deal with problem banks, strengthen governance in public financial institutions, and foster bank compliance with capital adequacy requirements. The National Assembly—the lower house—has already passed the bill, which will be sent back to the Senate for consideration. In addition, a law to enhance SBP’s operational independence is under consideration in the Assembly. In conjunction with reforms to the commodity operations, especially wheat procurement, and the resultant containment of credit for such operations, it would be possible to increase space for private sector credit. The SBP is also working on mechanisms for encouraging credit to the SME sector where considerable potential for growth and employment exists.

In conclusion, the authorities have shown their determination to pursue very difficult, but necessary, reforms to implement the program despite lower than promised external assistance. The nonobservance of the end-March quantitative performance criteria on the overall budget deficit and net government borrowing from the SBP were temporary and reflected, in large part, factors beyond the authorities’ control, such as delays in the disbursement of foreign financing. Notwithstanding the continued security-related pressures, the authorities are firmly committed to achieving program objectives in the period ahead. They will, therefore, highly appreciate Executive Directors’ support for the requested waivers, program modifications, and rephasing of access.