Macroeconomic imbalances, structural weaknesses, and security and political concerns have negatively impacted Pakistan’s economy and kept growth below the level needed to reduce poverty and absorb the labor force.


Macroeconomic imbalances, structural weaknesses, and security and political concerns have negatively impacted Pakistan’s economy and kept growth below the level needed to reduce poverty and absorb the labor force.

Economic Background

Macroeconomic imbalances, structural weaknesses, and security and political concerns have negatively impacted Pakistan’s economy and kept growth below the level needed to reduce poverty and absorb the labor force.

1. Economic performance in Pakistan has been substandard in recent years. GDP growth has averaged only 3 percent over the past five years, insufficient to significantly improve living standards or fully absorb the growing labor force. With the population still rising quickly, per capita income growth has lagged behind other South Asian economies (Figure 1). While reliable recent data on poverty is not available, in 2006 some 23 percent of the population lived on under US$1 a day. According the UNDP, 49.4 percent of the population lived in multidimensional poverty. Growth has also been more volatile in Pakistan, in part reflecting poor economic management. Severe problems with the electricity supply and a difficult security situation have been important factors in anemic growth. Productivity growth has fallen sharply over the past two decades, undermining the country’s growth potential. International rankings also place Pakistan low in terms of business climate, governance, human development, and poverty, which also impair economic performance.

Figure 1.
Figure 1.

Pakistan: Selected Economic Indicators, 2008–13

Citation: IMF Staff Country Reports 2013, 287; 10.5089/9781484379615.002.A001

Sources: Pakistani authorities; and IMF staff calculations.

2. Private investment has fallen by nearly half over the past five years, reflecting sharp drops in both foreign and domestic investment. Domestic private investment dropped from 14 percent of GDP in 2007/08 to an estimated 10.9 percent of GDP in 2012/13 (Figure 2). Weak private sector credit growth has contributed to the decline—private credit has fallen in real terms in recent years, crowded out by rapidly rising public borrowing and a difficult macroeconomic environment. Foreign direct investment (FDI) peaked above 3 percent of GDP (well above other South Asia countries) in 2007/08, and has since fallen below ½ percent of GDP, putting further pressures on ailing international reserves. As a result, private consumption has been driving the aggregate demand, supported by workers’ remittances and farm income.

Figure 2.
Figure 2.

Pakistan: Selected Financial Indicators, 2008–13

Citation: IMF Staff Country Reports 2013, 287; 10.5089/9781484379615.002.A001

Sources: Pakistani authorities; Bloomberg; and IMF staff calculations.1/ Placement volumes are for all maturities and the Treasury Bill rate is a weighted average.

Pakistan: GDP and Productivity

(In y-o-y percent change)

Citation: IMF Staff Country Reports 2013, 287; 10.5089/9781484379615.002.A001

Sources: Pakistani authorities; and IMF staff calculations.

Doing Business Rankings, 2013

Citation: IMF Staff Country Reports 2013, 287; 10.5089/9781484379615.002.A001

Sources: World Bank Doing Business indicators, 2013; and IMF staff calculations.

Consumption and Investment

(In percent of GDP)

Citation: IMF Staff Country Reports 2013, 287; 10.5089/9781484379615.002.A001

Sources: Pakistani authorities; and IMF staff calculations.

Foreign Direct Investment, 2000-2012

(In percent of GDP)

Citation: IMF Staff Country Reports 2013, 287; 10.5089/9781484379615.002.A001

Sources: Pakistani authorities; and IMF staff calculations.1/ South Asia countries include: Bangladesh, India, Indonesia, Malaysia, Nepal, Philippines, Sri Lanka, Thailand, and Vietnam.

3. Headline inflation has fallen sharply in recent months, but underlying inflationary pressures remain. Weak private sector demand, a gas tariff cut, and a good harvest helped the sharp decline in inflation. Annual headline inflation dropped from 11.3 percent in June 2012 to 5.9 percent in June 2013. Core inflation, measured by stripping food, energy and transportation components of the CPI, has also declined but remains above 9 percent. Broad money growth remains near 15 percent, driven in part by the State Bank of Pakistan’s (SBP’s) continued financing of the large fiscal deficit. A resurgence in inflation remains likely until fiscal deficits ease and money growth slows.

4. The external position has weakened significantly and central bank reserves have declined to critical levels. While the current account deficit in 2012/131 is estimated at under 1 percent of GDP, due to lower imports and strong revenues from remittances and bilateral inflows,2 severe financial account shortfalls have produced the deterioration in reserves. Financial inflows have collapsed at the same time as debt service obligations (including to the Fund) have increased sharply (Tables 4, 8). Foreign direct investment has been meager and portfolio inflows have sunk. As a result, SBP gross reserves dropped to US$6 billion (under 1½ months of imports) as of end-June 2013. International reserves are now well below the Fund’s reserve adequacy metric3 and below 1½ months of imports cover.4 Net reserves have become negative, as gross reserves include over US$7½ billion in borrowed resources, including a substantial net short-term forward/swap position in the domestic market, outstanding Fund credit, and a currency swap arrangement with China.5

Contribution to CPI, January 2010–March 2013

(In y-o-y percent change)

Citation: IMF Staff Country Reports 2013, 287; 10.5089/9781484379615.002.A001

Sources: Pakistani authorities; and IMF staff calculations.

SBP Net International Reserves and Net Swap/Forward Position, July 2011–June 2013

(In billions of U.S. dollars)

Citation: IMF Staff Country Reports 2013, 287; 10.5089/9781484379615.002.A001

Sources: Pakistani authorities; and IMF staff calculations.1/ Net reserves excludes IMF liabilities, net swap/forward positions, and currency swap with China.

5. The rupee depreciated by 5.3 percent against the dollar during 2012/13, leaving the real effective exchange rate roughly unchanged.6 This relative stability of the currency carried a heavy price in reserves, however, particularly as the SBP intervened to hold the exchange rate roughly constant during the run-up to elections in the first half of 2013. Net SBP sales in the interbank market totaled about US$3.5 billion in FY2012/13. The real effective exchange rate remains somewhat stronger than what is suggested by fundamentals and desired policies. While several exchange rate assessment approaches7 suggest only a modest overvaluation of the exchange rate (of 3–6 percent), financial account flows, extremely low and falling foreign exchange reserves, and a weak foreign asset position all point to a more significant problem with external stability (Box 1).

Pakistan: Real Effective Exchange Rate (REER) and Current Account Balance (CAB)

(REER Index, 2000 = 100)

Citation: IMF Staff Country Reports 2013, 287; 10.5089/9781484379615.002.A001

Sources: Pakistani authorities; and IMF staff calculations.

6. The fiscal deficit remained large. The 2012/13 fiscal deficit (excluding grants) is estimated to be over 8½ percent of GDP, well above the original budget target (4.7 percent of GDP) due to slippages on both revenues and expenditures. The revenue shortfall of 1¼ percent of GDP relative to the 2012/13 budget is largely explained by the underperformance in tax collections in the previous fiscal year, inadequate tax administration, and a slowdown in economic activity. Higher expenditures (2¾ percent of GDP) reflect higher energy subsidies. Moreover, the provincial surplus envisaged in the budget has not materialized. With very low external financing, the deficit has been almost entirely financed domestically. Pakistan’s tax revenue-to-GDP ratio, at about 10 percent of GDP, remains among the lowest in the world among non-oil exporters.8 Tax loopholes, exemptions and concession have left a small pool for taxation. For example, agriculture is mostly outside the tax net, and the number of taxpayers filing income tax returns is very small relative to the size of the population (about 1 percent).

External Sector Assessment

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7. Revenue sharing agreement continues to pose a challenge to fiscal consolidation (Box 2). Pakistan is a federation where most of the revenues are collected by the central government and redistributed to the provinces—which in turn transfer some funds to lower levels of government. Under successive constitutional amendments and decisions by the National Finance Commission (NFC), transfers to the provinces have increased sharply in recent years at a time when the federal government has struggled to address its large fiscal deficits.9 Due to the nature of the revenue sharing arrangements, efforts by the federal government to increase most tax revenues would go into a common pool of which 57½ percent is automatically transferred to the provinces.

8. The energy sector is a major drag on economic activity. The sector remains saddled with considerable problems that have led to unreliable electricity supply and large fiscal costs, including price distortions, insufficient collections, costly and poorly targeted subsidies, inadequate governance and low efficiency in energy supply and distribution, regulatory inadequacies, and insufficient investment in new energy production and modernization. As a result, power outages (“load shedding”) have averaged around 8–10 hours a day, constraining production and employment. Output losses are estimated at 2 percent of GDP annually. Energy-related subsidies reached 1¾ percent of GDP in 2012/13, and payments arrears (“circular debt”)—estimated at 4 percent of GDP—continues to accumulate due to below cost recovery tariff rates, and delays in tariff determination and fuel cost adjustments. The government cleared 1.5 percent of GDP of this circular debt in June 2013 and is expected to clear an additional ¾ percent of GDP in the coming months.

9. Private sector credit has declined in real terms, while monetary aggregates continued to be driven mainly by the government’s financing needs. Broad money increased by about 14½ percent in 2012/13, largely determined by budget support provided by the banking system, while private credit expanded by only 2.5 percent in nominal terms, the lowest level in recent years. Reserve money grew by 12½ percent, almost fully driven by direct fiscal borrowing from the SBP which more than offset the impact of a large decline in SBP net foreign assets (NFA). Since July 2012, the SBP has reduced its policy rate by a cumulative 300 basis points to 9 percent, citing declining inflation and the need to promote growth.

Pakistan: Composition of Reserve Money

(In y-o-y percent change)

Citation: IMF Staff Country Reports 2013, 287; 10.5089/9781484379615.002.A001

Sources: Pakistani authorities; and IMF staff calculations.

Revenue Sharing Arrangements in Pakistan: A Challenge to Fiscal Consolidation

Revenue sharing in Pakistan is regulated by a series of constitutional amendments and NFC awards. Key elements are as follows:

  • The National Finance Commission (NFC) is established by the Constitution and is chaired by the Federal Finance Minister, with the Provincial Finance ministers as members. Its main charter is to recommend the distribution of specified taxes between federal and provinces governments—and among provinces.

  • The 7th NFC Award. The award increased the share of pool revenues that is transfer to the provinces to 56 percent in FY2010/11 and 57½ percent afterwards (from 45 percent in FY2009/10). This award will expire in FY2015/16 and a new award should be negotiated.1

  • The 18th Amendment. A 2010 constitutional amendment devolved the functions of 18 ministries to the provinces, and states that future NFCs shall not reduce the share of resources allocated to the provinces by a previous commission.

  • The Council of Common Interest. Established by the constitution, it consists of the Chief Ministers of the provinces and an equal number of ministers of the federal government (chaired by the Prime Minister). The 18th amendment strengthened its role as a mechanism for resolving conflicts.

To address that federal government’s large fiscal imbalance, revenue mobilization will have to play an important role in restoring fiscal stability. The federal government will need to use additional revenues resulting from tax measures or improvements in tax administration to reduce the deficit. Lowering the share of resources, however, runs counter to the 7th NFC award and the 18th amendent of the Constitution. Options could include applying a lower provincial share of the pool only at the margin or—on a transitional basis—committing the Provinces to run surplus. Such cooperative outcomes could be pursued under the umbrella of the Council of Common Interest. Eventually, a revamp of the revenuesharing formula will be required when the 8th NFC Award is negotiated over the next two years. A better match needs to be obtained between revenue and expenditure responsibilities which would not leave the federal government with chronic deficit, while the provinces run surpluses. A secondary objective of the new formula should be to better divide revenue responsibilities to facilitate an improved tax system. Currently, income tax responsibilities are divided by type of income and sales tax responsibilities are split between goods and services, which complicates tax administration.

1 Mustafa, Usman, 2011, “Fiscal Federalism in Pakistan: The 7th National Finance Commission Award and Its Implications,” PIDE Working Papers 2011: 73.

10. The financial system is dominated by banks that have been relatively healthy but nonperforming loans remain high. Overall capital adequacy remained well above the statutory minimum capital requirement (CAR), at 15.1 percent at end-March 2013. The banking system as a whole is liquid and profitable and deposit growth has remained strong (nearly 16 percent) in recent years. Nevertheless, nonperforming loans (NPLs) are high (14.7 percent), and a few banks operating below CAR. The high concentration of assets in public debt (around 37 percent of total assets) at a time of weak public finances is another source of risk. While NPLs are relatively well-provisioned for the system as a whole (over 70 percent), the slowdown in economic activity and pressures on the balance of payments continue to affect bank soundness.

Outlook and Key Risks

An unchanged policy mix would elevate overall vulnerabilities and crisis risks and cloud Pakistan’s economic prospects.

11. Under unreformed policies, Pakistan’s economic situation will continue to deteriorate, and near-term crisis risks are high. Low and declining SBP reserves leave the country vulnerable to a balance of payments crisis from even relatively minor external or domestic shocks (¶13). Domestic risks also emanate from the fiscal imbalance with the attendant high government debt rollover requirements (30 percent of GDP per year), a severe energy crisis, and security problems. On the fiscal side, staff’s baseline scenario projects continued weak revenue collection and high energy subsidies would generate a budget deficit of around 8½ percent of GDP.10 With continued monetization of fiscal deficits and further depreciation of the rupee, inflation will likely increase in the coming months and return to double digits. The current account deficit is projected to be around 1 percent of GDP by end-June 2014. However, the baseline balance of payments is expected to remain under pressure given weak export growth and large net capital outflows,11 with reserves declining to around US$3.5 billion by end-June 2014 (0.8 months of imports), and the rupee is projected to continue depreciating against the U.S. dollar.

12. Over the medium term, Pakistan’s economy will continue to underperform and vulnerabilities will remain high unless comprehensive reforms are implemented. With low savings and investment, high fiscal deficits, weak private credit, unresolved energy problems, core inflation in double digits, and ongoing security problems,12 baseline real GDP growth is likely to remain around 3 percent with considerable potential volatility, well below the needed growth to make a significant dent on unemployment (Text table below). Credit to the private sector would continue to be crowded out, contributing to depressed private investment. The fiscal deficit would continue to deteriorate, requiring financial repression to maintain debt sustainability. The external position would be under increasing pressure despite low current account deficits by international standards. The international reserves cushion would become uncomfortably low (below one month of imports), despite assuming large unidentified inflows. Total debt would rise significantly over the medium term and government financing needs remain large and while external debts are sensitive to exchange rate shocks, domestic debts could deteriorate with adverse interest rate shocks.

Pakistan: Baseline and Reform Scenarios, 2013/14–2017/18

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

Debt in the baseline scenario do not include future circular debt that may need to be taken over by the government.

Assumes average employment-growth elasticity of 0.51.

13. The risks to the medium-term outlook are tilted to the downside (Box 3). Without significant policy adjustments and support from the international community, large domestic and external vulnerabilities could well depress economic outcomes beyond the baseline. While, the fragile foreign reserves position is sensitive to external shocks and could negatively impact the macroeconomic stability, the internal shocks, in particular energy shortages and security concerns could further prevent private sector investment and stall growth. Key risks include the following:

  • Pakistan’s energy crisis threatens the broader economy. The sector is burdened with structural problems, price distortions, insufficient collection, theft, untargeted subsidies, inadequate supply, and poor governance. Long and unpredictable blackouts, reaching 16 hours/day in some areas, have been disruptive for businesses, while adding to dissatisfaction and frustration among the population.

  • Security concerns could increase economic risks. Pakistan faces significant insurgency problems in the regions bordering Afghanistan, which could intensify with the drawdown of NATO forces there. Sectarian violence in Balochistan and other provinces has been another source of unrest, while street crime in Karachi adds to security concerns.

  • Vulnerability to oil price shocks has risen in recent years. While oil imports declined from 33 percent of imports in 2001 to about 16 percent in 2004, they have risen each year since, and the oil vulnerability index has risen (Box 4). In contrast, food price vulnerability is about one-third of oil vulnerability and has been declining in recent years.

  • Pakistan is vulnerable to inward remittance spillovers. While a decline in oil prices would lower import pressures, there might be adverse indirect effects on reduced remittances from workers in oil exporting countries (60 percent of Pakistan’s remittances come from the Middle East).

  • A further global economic decline could impair Pakistan’s exports. A further downturn in Europe would have negative effects, as ¼ of Pakistan’s exports go to Europe, and most non-Middle East remittances come from Europe. Although links to most emerging markets are weak and capital flows to Pakistan are small, slow growth in emerging markets could add to external sector risks.

  • The financial sector is not in imminent danger, but banks remain vulnerable to a further deterioration in the overall macro-economic environment. The trend over the last decade confirms a close negative relationship between the performance of economy and buildup of NPLs (Figure 3). The balance sheets of commercial banks are also highly exposed to government securities, so a fiscal crisis—if it materialized—would have a large impact.

Figure 3.
Figure 3.

Pakistan: Selected Banking and Financial Indicators

Citation: IMF Staff Country Reports 2013, 287; 10.5089/9781484379615.002.A001

Sources: Pakistani authorities; and IMF staff calculations.

14. Reforms will substantially reduce Pakistan’s vulnerability to crisis. A reform package including significant fiscal consolidation, a more flexible monetary and exchange rate policy, and comprehensive structural reforms would reduce crisis risks stemming from unsustainable fiscal and balance of payments positions. Reforms would also make the economy more resilient against shocks by increasing financial buffers, as the improved policy environment would likely attract significant international financial support.

Pakistan: Risk Assessment Matrix 1/

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1 The Risk Assessment Matrix shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood of risks listed is the staff’s subjective assessment of the risks surrounding the baseline. The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with authorities.

Pakistan’s Vulnerability to Food and Oil Price Shocks 1/

Food, energy and transportation comprise about half of the consumer basket. Surprisingly, 20 percent of the food basket is taken by milk and milk products, while vegetables (14½ percent), wheat and bread (12½ percent), and cooking oil (10 percent) are the other major categories. As a whole, food items make up about 36 percent of the consumer basket, while energy and transportation constitute about 14 percent of the basket.

While food imports have been steady, oil imports have increased drastically. Wheat and cooking oil are the main subcomponents of food imports and together make up about 5 percent of total imports. While wheat imports fluctuate each year depending on the domestic harvest and government export policy, cooking oil imports has been hovering around 4 percent of total imports for the past decade. Pakistan’s largest import item is oil, averaging 27 percent of total imports in the past decade. Oil imports declined from 33 percent of imports in 2001 to about 16 percent in 2004 but have risen each year since, while international oil prices increased and simultaneously electricity generation fuel mix has shifted toward oil.

Composition of the Consumer Price Index Basket

(In percent)

Citation: IMF Staff Country Reports 2013, 287; 10.5089/9781484379615.002.A001

Source: Pakistan Bureau of Statistics.

International Oil prices and Food and Oil Imports

(In percent of total imports)

Citation: IMF Staff Country Reports 2013, 287; 10.5089/9781484379615.002.A001

Sources: Pakistani authorities; and FAOSTAT.

Imports of Food Items

(In percent of total food imports)

Citation: IMF Staff Country Reports 2013, 287; 10.5089/9781484379615.002.A001

Sources: FAOSTAT; and IMF staff estimates.

Pakistan has become more vulnerable to oil price shocks in recent years. Growing oil demand for electricity production, coupled with rises in the international oil price, have increased Pakistan’s vulnerability to oil price shocks. Oil now accounts for about one-third of electricity generation in Pakistan, a significant increase from the 2004 level of 16 percent. As a result, the oil price vulnerability index2 has risen steadily since 2004 and reached its highest level in recent years. The food price vulnerability index is about a third of the magnitude of the oil index and has been declining in recent years. However, the food index is highly volatile and depends largely on factors related to wheat, such as the size of the domestic harvest and government trade policy.

Vulnerability to Food and Oil Price Shocks 1/

Citation: IMF Staff Country Reports 2013, 287; 10.5089/9781484379615.002.A001

Sources: Pakistani authorities; FAOSTAT; and IMF staff calculations.1/ Index is normalized to 100 in 2000 and adjusted with import weights; the higher values indicate high vulnerability.

Electricity Generation

(In GWh)

Citation: IMF Staff Country Reports 2013, 287; 10.5089/9781484379615.002.A001

Source: EIA.

1 Prepared by Asghar Shahmoradi, with research assistance from Paul Zimand.

2 We have used an index, developed by IMF staff, to measure how vulnerable Pakistan is to rising food or oil prices, “vulnerability to food and oil shocks indices.” The index is a weighted combination of the ratio of oil/food imports to total household consumption (as an indicator of oil/food dependency); the ratio of food/oil imports to total merchandise imports (as an indicator of the burden of oil/food imports); and the inverse of the level of GDP per capita (which measures the capacity to provide oil/food safety nets for domestic consumers). Please see for further details.

15. Adjustment would raise medium-term growth prospects. As these reforms take hold, savings and investment rates would increase, inflation would fall, real GDP growth would rise significantly, and unemployment would decline. Over the medium term and with fiscal deficits reduced to sustainable levels, debt levels would decline rapidly, lowering the country’s vulnerability to exchange and interest rate shocks (text Table 1).

16. Adjustment policies also carry risks, but they can be mitigated by improved social protection. Fiscal consolidation would undoubtedly be contractionary in the near term,13 but the negative effects can be mitigated by: (i) increasing targeted transfers to the most vulnerable population; (ii) increasing investment by improving private sector access to credit; and (iii) alleviating acute energy supply bottlenecks to increase productive capacity. In the short-run, immediate action to address financial imbalances, improve the energy sector fuel mix, and enhance governance could improve energy supplies sufficiently to contribute up to 1 percentage point to GDP growth.14 Over 3 years, the positive effects of greater price stability and policy predictability on investment and consumption behavior together with pro-growth structural reforms—such as comprehensive energy reforms, trade liberalization, improvements in the investment climate—along with donor support would place the economy on a sustainably higher growth path.

Authorities’ Views

17. The authorities share staff’s concerns about short-term crisis risks, and are strongly committed to short-term adjustment measures together with structural reforms to boost medium-term growth. They are more optimistic than staff about the growth outlook under a reform scenario, however. The 2013/14 budget assumes a 4–4½ percent rise in GDP growth and the government envisages growth rising to around 7 percent in the medium-term, while staff view 5 percent as a more likely positive scenario. The SBP also retains a more sanguine view of inflation prospects than staff.

Article IV Discussions: Toward Higher and more Inclusive Growth

Policy discussions focused on macroeconomic policies and structural reforms needed to avoid a crisis and to improve sustainably Pakistan’s medium-term growth outlook.

18. Pakistan’s key economic challenge is to put the policies in place needed to alleviate large and persistent external vulnerabilities and to generate high, stable economic growth. This will involve short-term stabilization policies to reduce crisis dangers and restore fiscal and balance of payments sustainability, thus creating the preconditions for a recovery in investment. Simultaneously, efforts need to begin on profound structural reforms to boost growth potential over time. Together, these policy initiatives will help mitigate vulnerabilities, strengthen economic performance, creating jobs and reducing unemployment (Box 5). Stronger policies will help mobilize multilateral financial support from donors and encourage private sector capital inflows, which will help to address Pakistan’s external stability problem.

A. Return to Fiscal Sustainability

19. The fiscal stance is not sustainable and requires significant consolidation to ensure sustainability. Over the past few years, declining tax revenues and increasing energy subsidies have worsened an already large fiscal deficit. Domestic financing of the fiscal deficit has produced severe crowding-out of private sector credit, and a reliance on negative real interest and direct financing from the SBP. Public debt has climbed above 60 percent of GDP with very short average maturity of domestic public debt, and increased vulnerability of external debt service to currency depreciation.

Medium-term Fiscal Sustainability

Citation: IMF Staff Country Reports 2013, 287; 10.5089/9781484379615.002.A001

Sources: Pakistani authorities; and IMF staff calculations.Note: The debt stabilizing primary balance is calculated assuming growth at 3 percent.

20. The 2013/14 federal budget represents an important initial step towards the needed fiscal consolidation. The budget targets a deficit of 6.5 percent of GDP. The tax package included in the budget is expected to raise revenues by about ¾ percent of GDP. However, in staff’s view it makes only limited progress towards a more efficient and equitable tax system, and further efforts will be needed to reach the medium term targets envisaged by the government. Tax revenue will likely fall short of the budget target, but the authorities are willing to take action to compensate (¶50). Likewise, the reduction in subsidies envisaged in the budget will not fully materialize despite the authorities’ strong plan to reduce the subsidies.

Unemployment in Pakistan

The labor force is growing and providing employment opportunities remains challenging. Pakistan’s population growth rate of 2.2 percent (annual average) over the last decade is among the highest in developing economies1 with about 40 percent of the population below the age of 15. With participation rates also rising, the labor force is expected to grow by 3.5 percent in the coming years. High unemployment among the youth is particularly widespread,2 and only 25 percent of employment is in the formal sector. Although, the official unemployment rate is about 6.7 percent in 2012/13, the rural unemployment rate (9.1 percent as of 2012Q3) is twice the urban rate (4.8 percent as of 2012Q3).

Without significant reform, unemployment will rise in the coming years. Weak macroeconomic policies and structural problems, particularly in the energy sector, would lead to low growth and high unemployment in the coming years. Under the baseline scenario, the projected GDP growth hovers around 3 percent over the medium term. According to staff calculations the unemployment rate will rise from 6.7 percent in 2012/13 to about 9.0 percent by 2017/18.3

Pakistan: Unemployment Rate Forecasts

(In percent of labor force)

Citation: IMF Staff Country Reports 2013, 287; 10.5089/9781484379615.002.A001

Sources: Pakistan Bureau of Statistics; IMF Labor Market Template, and IMF staff estimates.

Under a Fund supported program, GDP growth will pick up and unemployment would decline gradually. The program envisages a mix of macroeconomic policy changes and structural reforms aiming to boost GDP growth over the course of the program. Although, GDP growth will initially decline due to fiscal contraction, it will steadily increase to about 5 percent. The unemployment rate will increase slightly in the first two years of the program, but it will decline to about 5.8 percent by 2017/18.

1 Almost twice the average rate of emerging and developing economies.2 Youth unemployment rate was estimated to be above 10 percent in 2011, about almost twice as high as unemployment rate among adults aged over 25 years.3 Based on the template developed in the Middle East and Central Asia Department. The template uses estimates of employment-growth elasticities that have been produced using a variety of econometric methods including individual country time-series regressions and panel data estimation methods. For further details, see: “A Template for Analyzing and Projecting Labor Market Indicators,” Technical Note Manual, IMF, 2012.

21. Policy actions should permanently strengthen the fiscal stance. Staff advocated a reduction of the deficit to around 3–3½ percent of GDP in the medium-term to ease crowding out and set the public debt on a firmly declining path—back below 60 percent of GDP by 2016/17. As shown in the Debt Sustainability Analysis (Table 11 and Figure 4), moderate shocks to the interest rate, growth, or the primary balance will result to debt levels above 65 percent—albeit stable, which highlights the need for reducing the debt ratio to well below the 60 percent of GDP envisaged in the Fiscal Responsibility Law. In staff’s view, the 60 percent of GDP threshold remains too high for a country like Pakistan with a low tax-to-GDP ratio and exposure to significant external and internal shocks. The consolidation should begin aggressively with measures focusing on the revenue side and on energy subsidies, and continue until the medium-term targeted deficit is reached. In order to protect the neediest from the effects of the envisaged fiscal consolidation, targeted cash transfer programs need to be expanded (see ¶50). Among critical fiscal reforms are the following:

Figure 4.
Figure 4.

Pakistan: Public Debt Sustainability: Bound Tests 1/2/

(Public debt in percent of GDP)

Citation: IMF Staff Country Reports 2013, 287; 10.5089/9781484379615.002.A001

Sources: Pakistani authorities; and IMF staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ For historical scenarios, the historical averages are calculated over the ten-year period, and the information is used to project debt dynamics five years ahead.3/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and primary balance.4/ One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2014, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).
  • Tax policy. Pakistan’s tax to GDP ratio for 2012/13 was 9.7 percent of GDP—significantly less than the 11.4 percent of GDP in 2002/3—so fiscal consolidation will have to rely heavily on tax policy changes to broadening the tax base.15 The implementation of a full Value Added Tax (VAT) remains the first-best option to raise tax revenue, but if this remains politically unfeasible, other permanent tax policy measures could be considered to come closer to it by wholesale reductions in exemptions and concessions, and by fully incorporating services into the tax net. The administrative authority to grant tax exemptions via Statutory Regulatory Orders (SROs) should be eliminated to prevent further degradation of the tax net. Income tax should integrate income from all sources, concessions and exceptions should be eliminated, withholding should be adjustable, with the minimum tax on turnover remaining as a control for deductions.

  • Tax administration. In a country of nearly 180 million people, only 1.2 million individuals and firms file income tax returns, (of which half are corporate income tax filers). Some 118,000 entities are enrolled in the sales tax system but only 15,000 actually pay any tax, with 82 percent of total sales and federal excise revenue coming from only 100 companies. These low numbers reflect the long-standing failure of the Federal Board of Revenue (FBR) to efficiently administer the system and the inability of previous reform efforts to deliver sustained results. The authorities need to develop and implement a strategy to strengthen tax administration, with the technical assistance of the Fund and the World Bank. While key elements of the strategy will need to be defined, it should include significantly stepping-up the FBR’s enforcement activities and improving its legal authority (such as to facilitate asset seizures for tax evaders and to presumptively bill taxpayers). The anti-money laundering framework will need to be fully applied in this effort.

  • Expenditure reforms. The composition of public spending should shift to more growth friendly outlays, including infrastructure, health, and education, with the phasing out of untargeted energy and commodity subsidies, currently around 1.9 percent of GDP (Box 6). Targeted income support programs should be strengthened. Civil service reform should also be considered, to improve the quality of the public service, reduce corruption, and contain the public wage bill.

Reducing Energy Subsidies

The authorities have launched their plan to gradually eliminate most of the energy subsidies.1 The four phase plan is expected to reduce the subsidies from about 1.8 percent of GDP to 0.3–0.4 percent of GDP in three years.

  • Phase I. The first phase entailed the almost full elimination of the subsidy for industrial, commercial, bulk, and AJ&K2 users, accomplished through an increase in tariff of about 50 percent at end--July. The majority of domestic consumers are excluded from increases at this stage.

  • Phase II. The second phase entails the elimination of the subsidy for consumption over 200Kwh, SCARP3, and others (public lighting, housing schemes, railways, HVTL4), and reducing the subsidy in agriculture by about 13 percent. The corresponding price increases have already been approved and notified—effective October 1st.

  • Phases III and IV. In FY 2014/15 and FY 2015/16 the authorities will reduce the remaining subsidies (on agriculture and consumption below 200Kwh) in order to reduce the fiscal burden to 0.3-0.4 percent of GDP. By the end of Phase IV the subsidy for consumption above 200Kwh will be eliminated, and it will be reduced for those below 200Kwh. While most households will see price increases, subsidies will remain for the lowest level consumers and increases in targeted transfer programs will also protect the poorest.

Energy subsidies

(In percent of GDP)

Citation: IMF Staff Country Reports 2013, 287; 10.5089/9781484379615.002.A001

Sources: Pakistani authorities; and IMF staff calculations.

Pakistan strategy is broadly consistent with the lessons learned from previous energy reforms. Their strategy addresses the six key elements usually linked with successful reforms: (i) they developed a comprehensive energy sector reform plan with long-term objectives, (ii) they have launched a communication strategy, (iii) the price increases are phased and sequence differently across energy products, (iv) they are strengthening their cash transfer program to protect the poor, (v) they are working towards improving the efficiency in state-own enterprises, and (vi) they are working towards improving the timeliness of the pricing mechanisms.

1 Fuel price changes are passed through to electricity prices on a monthly basis.2 Azad Jammu and Kashmire.3 Salinity Control and Reclamation Program.4 High Volatge.
  • Fiscal federalism reforms. The revenue sharing system needs to be reformed to increase provinces’ incentives to rely less on federal transfers and more on their own revenue-raising efforts (Box 2). A mechanism needs to be put in place to set and implement statutory limits on provincial fiscal balances, supported by strengthened limits on provincial borrowing. In the short-run, a binding agreement should be negotiated between the provinces and the federal government, perhaps at the Council of Common Interest (CCI) to ensure that additional revenues raised under a fiscal consolidation plan are used for deficit reduction rather than to facilitate additional provincial spending. To the extent possible, this agreement should be supported by sanctions and by technical modifications of the revenue transfer system (i.e., a legislated “lock-box”).

  • Public financial management reforms. Commitment control systems for the general government need to be implemented for better public financial management. The authorities also need to strengthen their fiscal debt office to improve deficit financing through lengthening the maturity of domestic debt, building a longer yield curve, and eventually returning to external private markets for some fiscal financing (see also ¶33).

Authorities’ Views

22. The new government feels strongly that the previous fiscal path was unsustainable and is committed to a process of fiscal consolidation. The authorities view the FY2013/14 budget, approved by parliament on June 27, 2013, as a significant step in that direction. The authorities are more optimistic than staff about the potential for short-term revenue gains via improvements in tax administration. While agreeing on the need to eliminate many SROs to reduce tax loopholes, they were less enthusiastic about eliminating the ability to issue new SROs, which they see as a flexible and quick-response tool for addressing tax policy needs. Staff noted that SRO authority could be eliminated for creating new concessions or exemptions, while retaining it for other policy purposes. On fiscal federalism reforms, the authorities noted that significant constitutional and political barriers exist to a wholesale overhaul of the system.

B. Realigning Monetary Policy for Macroeconomic Stability

23. The SBP has pursued an accommodative monetary policy to lift weak private investment and growth, in light of falling headline inflation. The policy rate has been cut repeatedly over the past two years by a cumulative 500 basis points to 9 percent. In addition, in FY2012/13, the SBP continued direct financing of the large fiscal deficit (accounting for almost all of the increase in reserve money). Open market operations and foreign currency swaps have also pumped additional liquidity into the market. As a result, despite falling net foreign assets, monetary aggregates expanded relatively quickly. However, this accommodative policy did not bear fruit in terms of private sector stimulus—private credit shrank in real terms.

24. Pakistan has arrived at a critical balance of payments situation through a combination of: (i) past current account deficits occasionally coupled with weak financial accounts; (ii) reliance on external official financing to deal with financing gaps while maintaining an emphasis on relative exchange rate stability; and (iii) the disappearance of even modest private financial inflows following the global financial crisis of 2008. The first step in decreasing the risk of a crisis is for the central bank to accumulate reserves through net purchases in the foreign exchange market. In the mediumterm, a fiscal consolidation plan would help boost national saving, catalyze international support, and lead to an improvement of the financial account.

25. Prudent monetary and exchange rate policies are needed to address declining reserves and contain projected rebound in inflation.16 Staff advised that monetary and exchange rate policies should focus on rebuilding foreign exchange reserves and maintaining price stability. The SBP should signal a clear policy shift to market participants through purchasing foreign exchange in the interbank market to bolster reserves. Staff reiterated that the SBP should refrain from further direct lending to the government and limit open market liquidity injections to the economy. Inflation reduction should be a top priority of the SBP, as inflationary pressures will likely materialize in the coming 12–18 months. The SBP’s policy rate should be set prudently to contain expected inflationary pressures, to maintain positive real interest rates to attract deposits; and to help rebuild reserves.

26. The SBP continued to intervene in the foreign exchange market. The SBP’s net sale of foreign exchange in the spot market totaled US$3.35 billion in 2012/13, almost 70 percent of total loss in reserves. Staff argued that the chief short-run challenge facing the SBP is to rebuild criticallylow reserves, so a reversal of the exchange intervention policy was urgently needed. External competitiveness factors also suggest that a moderate weakening of the rupee would be appropriate (¶6, Box 1). Staff expressed concern about the SBP’s heavy reliance on short-term currency swap/forward contracts to boost gross reserves, and recommended that they be gradually scaled back to limit risk.

27. Independence of the SBP remains inadequate. Staff urged the authorities to amend the SBP Act in order to establish an independent, decision-making monetary policy committee, which is a pre-requisite for an optimal design and implementation of monetary policy. Staff stressed that full Independence would help pave the way for improved price stability, as SBP’s primary objective, and the elimination of future direct financing of fiscal deficits.

Authorities’ Views

28. The SBP argued that the recent cuts in policy rates were justified given declining headline inflation and the need to stimulate growth. While acknowledging that inflationary risks remain and stressing that it would adjust the rates if circumstances change, the SBP added that the impacts on private sector credit could have been severe, had the rates not been cut. The SBP stressed that in addition to other structural factors, the banking system has not fully played its role of financial intermediation in providing credit to the private sector, resulting in negative real rates of private credit expansion. In addition, the SBP argued that in evaluating monetary policy in Pakistan other factors, like law and order, and security concerns should be taken into consideration. The SBP disagreed that capital flows to Pakistan are sensitive to interest rates in the current circumstances and pointed to other structural factors that prevented direct and portfolio investment. On exchange rate policy, the SBP firmly believed that its intervention policy was necessary to ensure the stability of the foreign exchange market and in avoiding any disruption in market sentiments, particularly during the sensitive election period. The SBP agreed that the reserves situation was challenging but asserted that it was manageable.

C. Safeguarding Financial Sector Stability

29. Growth in banks’ lending to private sector continues to be weak, while banks’ holdings of government securities continue to expand. Financial intermediation to the private sector has declined significantly over the last few years. Despite strong domestic deposit growth, high capitalization and liquidity levels, and reductions of the policy interest rate and NPLs, lending to the private sector has been diminishing as a share of total lending from around 75 percent in 2005 to around 45 percent in 2012, as the fiscal deficit increased from less than 3 percent to around 8 percent. Staff emphasized the need to tackle this severe crowding-out of the private sector in a credible way in order to stabilize the economy and create the conditions for future growth. The envisaged reduction of the government’s borrowing requirement and addressing NPLs should help stimulate private sector credit from the supply side, while greater macro stability and broader structural reforms should boost demand for private credit. These in turn would support the recovery of private sector investment, and thus employment and growth.

30. Staff urged the SBP to address the undercapitalization of a few banks. The SBP has already identified the capital shortfall for each bank that falls below CAR, where there are four noncompliant banks (excluding one state-owned bank that is under liquidation)—representing around 7 percent of the banking sector assets (with a total shortfall of less than 0.1 of GDP). Moreover, there are nine banks (six private and three state owned) that fall below the minimum capital requirement (MCR) but meet the CAR, representing 7.8 percent of the banking system assets. The SBP has provided extension to some banks for meeting MCR, subject to maintaining healthy CAR and presenting a timeline to meet the shortfall. Staff advised the authorities to develop a welldefined time bound Action Plan to deal with banks that are either below CAR or MCR, and restructure or merge few state-owned banks. Continued forbearance may pose a financial threat to financial system and have fiscal implications (e.g., in case of a need to recapitalize a state-owned bank).

31. Staff supported financial sector reforms to enhance the resilience of the financial system. In particular:

  • Introducing a bankruptcy law: due to nonexistence of a bankruptcy law in Pakistan and the large volume of NPLs, staff underscored the need to complete the consultation with key stakeholders in order to finalize the draft Corporate Rehabilitation Act (CRA). At the moment, banking courts are understaffed, with years of long litigation and resolution process, as well as weak enforcement capacity of courts’ decisions. This is not a conducive environment for banks to extend credit to the eligible borrowers. Therefore, there is a need to revamp the recovery mechanisms by speeding up judicial process and filling up vacancies in banking courts with the necessary skills to handle outstanding cases.

  • Setting up a deposit insurance scheme: the SBP is preparing to introduce an explicit Deposit Protection Fund (DPF). Deposit protection is currently ambiguous in Pakistan, as under the Banks (Nationalization) Act of 1974, the government of Pakistan implicitly guaranteed the safety of all deposits, despite the fact that the Banks Act applies only to nationalized banks. Therefore, depositors widely anticipate that the government or the SBP will compensate their deposits in case of a bank failure. Banks also support the introduction of the DPF. As the draft DPF Act is being finalized, staff stressed the need to ensure that the necessary preconditions are in place before launching the DPF, such as achieving compliance of all banks with minimum capital requirements, appropriate regulation and effective supervision for a sound banking system, and a special resolution regime.

  • Enhancing consolidated supervision: the SBP and the Securities and Exchange Commission of Pakistan (SECP) recognize that consolidated supervision of financial conglomerates is critical for financial stability. The regulatory framework is similar to a “twin peak” model, where the SBP is entrusted with regulating the banking system and the SECP with regulating nonbank financial sector. Given ownership inter-linkages in the financial sector, however, there is a challenge to regulate these financial conglomerates. The SBP and SECP signed a Memorandum of Understanding (MoU) to share information and monitor the financial risks on consolidated basis. A joint task force on financial conglomerates was also established in 2010 and it meets periodically to discuss regulatory concerns pertaining to consolidated supervision.

  • Strengthening the regulatory and supervisory framework: the SBP has developed and introduced several prudential regulations (e.g., loan to value, loans to deposits, and exposure limits on individual borrowers and borrowing groups), aiming to address macro-prudential risk. It has also improved its macro stress testing framework substantially over the years; however, there remains no macroeconomic model that the SBP could use for generating baseline and adverse scenarios for the stress testing. The SBP has requested technical assistance from the IMF’s Monetary and Capital Markets to assess its overall framework for contingency planning and crisis management. In addition, the SECP has revisited its legal framework—by drafting legislation that is under consideration by the government—to enhance its supervisory and enforcement powers, and to regulate futures markets. Staff also recommended that the government restore the SECP’s budgetary autonomy.

32. After the collapse in 2008, there has been renewed buoyancy in the stock market. The Karachi Stock Exchange (KSE-100) set new records over the last 12 months to June 2013, outperforming many other emerging markets (Figure 3). Staff recommended that the authorities closely monitor any speculation and market manipulation to maintain confidence in the stock market. Looking ahead, the SECP will continue with its reforms to develop stock exchanges through attracting strategic foreign investors, introducing Shariah-compliant investment products, and establishing a central counter party to provide protection to investors by reducing credit risk.

33. Steps should be taken to develop debt markets. The corporate debt market is underdeveloped and small. For the government debt market, measures have been taken to develop an efficient and liquid market, by consolidating benchmark securities, automating the auction process, and pre-announcing the auction calendar for the next quarter. To further deepen the government debt market, the authorities need to: (i) continue aligning rates of returns on the National Saving Schemes (NSS) to equivalent government securities;17 (ii) improve price discovery during the auction process by utilizing cut-off rates much less frequently and allowing market forces to determine the yield on government securities; (iii) build a more complete yield curve by extending maturities of government securities;18 (iv) issue Sukuk instruments beyond 3-year maturity; (v) continue to broaden the investor base to include institutional investors, and (vi) list government debt instruments in the stock exchanges to increase secondary market liquidity.

34. Over the medium-run, the authorities should seek to further deepen the financial markets and develop capital markets.19 The financial system of Pakistan remains shallow in terms of its inclusiveness, depth, efficiency, and stability. Though the system has grown over the last decade and is diversified, it remains small and largely bank-based. There is scope for further financial deepening by: (i) continuing to increase access to financial services through the Financial Inclusion Program and microfinance; (ii) stimulating credit to the private sector; (iii) addressing undercapitalization of a few banks; and (iv) developing capital markets to provide alternative means of financing investments and investment opportunities for investors. Financial deepening should, over the long term, sustain economic growth and increase the effectiveness of macroeconomic policies.

Authorities’ views

35. The authorities stressed that the banking system continues to show strong indicators of financial soundness, with high liquidity, capitalization, and comfortable profitability. They noted the increasing exposure of banks balance sheets to the government due to high financing needs. They also acknowledged that there are three noncompliant banks in both CAR and MCR which are a source of concern, and they have actively engaged with each bank for ensuring full compliance. They believe that raising additional capital for meeting MCR is quite challenging in the current domestic and global environment. Moreover, the authorities asserted that the recent policy rate cuts would help stimulate private sector credit and reduce the debt burden on borrowers, and thereby lower NPLs.

36. To enhance the stability of the financial system, the authorities emphasized the importance of introducing key reforms. They would finalize the consultation with key stakeholders on the draft bankruptcy law (Corporate Rehabilitation Act) and seek to pass legislation on a deposit protection fund over the course of the next two years. The SBP and SECP supported staff’s recommendations for reopening the issue of consolidated supervision, while noting the importance of the existing interagency coordination arrangements between them to stem any possible risks from the financial conglomeration.

D. Structural Reforms for Fiscal Consolidation and Economic Growth

37. Structural reforms, especially in the energy sector, are crucial for fiscal consolidation and economic growth. The energy sector is saddled with considerable problems that have led to unreliable electricity supply and large fiscal costs, including price distortions, insufficient collections, costly and poorly targeted subsidies, inadequate governance and low efficiency in energy supply and distribution, regulatory inadequacies, and insufficient investment in new energy production (Box 7). As a result the output level is estimated to be depressed by some 2 percent.20 Outside the energy sector, growth prospects are limited by the presence of loss-making public sector enterprises (PSE) in key economic activities, a poor business climate, and a distorted trade regime—all areas where Pakistan falls short of its peer countries.21

38. Initial actions on energy sector reform should concentrate on “quick wins” that contribute to fiscal adjustment and resolve energy sector bottlenecks to boost economic growth. Staff argued that the key to reform is making the energy system financially viable, including via clearance of circular debt, tariff adjustments, and a change to cheaper fuels. The mission welcomed the Prime Minister’s announcement of a new Energy Policy to relieve short-term bottle necks and encourage long-term increases in electricity supply. In this respect, out of the Rs. 503 billion of payment arrears identified as of end-May 2013, Rs. 342 billion were cleared at end-June 2013, with the residual slated for resolution by end-August 2013. The arrears reduction will allow cash-constrained power producers to bring additional electricity supply to the system in the short-run and reduce load shedding by around three hours per day. Tariff adjustments will improve resource allocation and efficiency, and will encourage conservation. Staff stressed that phasing out subsidies is also an important component of fiscal adjustment; however, targeted income support programs should be used to protect the most vulnerable members of the society. Cost-cutting, improved collection from nonpayers, and efficiency measures are needed to reach full cost recovery in the electricity sector.

39. A key shortcoming of the current electricity sector has been the limited ability to collect for energy supplied, due in part to a lack of specific real-time data on energy flows, and which also results in inadequate compliance with usage restrictions. To address this, strengthened performance contracts needs to be signed with all power sector companies to tackle losses, raise payment compliance, and improve energy efficiency and service delivery. Staff stressed that pending amendments to the Penal Code 1860 and the Code of Criminal Procedures 1898 need to be accelerated to strengthen the legal framework in cases of electricity theft by enhancing investigation, prosecution, and penalties. However, a new electricity act is still needed to modernize governance of the sector.

Overview of Pakistan’s Power Sector

Technical and financial problems in the energy sector have led to large-scale power outages which have depressed output. In the 2000–10 period, Pakistan increased energy supply by 11 percent in per capita GWh, lagging behind her peers1 by almost one fourth. Energy supply has also lagged behind growing demand at notified prices which fell behind the cost recovery levels. The total installed capacity as of end FY12/13 reached around 23.52 GW, however net electrical output has been declining in the last three years due to drags created by the growing payment arrears, derated power plants, and insufficient supply of gas. The current generation falls short of estimated demand by 4–5 GW leading to 8–10 hours of load shedding in the system. Delays in tariff determination and low collection rates contributed to increasing arrears in the sector, which further depressed supply.3 Transmission and distribution (T&D) losses hover around 22 percent of total supply triple high income economies and more than double the world average.4 Load shedding in this period led to declining capacity utilization which is estimated to cost around 10 percent of GDP.4, 5

Energy supply relies on costly fuel mix. Despite power sector’s heavy reliance on gas as a generating fuel, the insufficient supply of gas led to the substitution to costly imported fuel. Growing allocation of gas to domestic users further elevated the shortage in the power sector. Fuel imports reach 36 percent of the total energy mix,6 however it constitutes 70 percent of the total energy generation cost.

Energy Supply by source

Citation: IMF Staff Country Reports 2013, 287; 10.5089/9781484379615.002.A001

Sources: Pakistani authorities; and IMF staff calculations.

Energy Supply by Cost

Citation: IMF Staff Country Reports 2013, 287; 10.5089/9781484379615.002.A001

Sources: Pakistani authorities; and IMF staff calculations.

Pakistan consumes all of its domestic gas production, however due to lack of investment production is dropping. The current level of gas supply is just over one half of unconstrained demand due to low prices and insufficient investment.7 The lack of infrastructure also makes it difficult to import gas. At current regulated domestic gas prices, quantity based allocations divert gas from the power sector to households, transport, fertilizer production and industry. Nevertheless, low user prices discourage new investment, promote inefficiency in gas use, and have the potential to generate fiscal cost from the gas sector. The current level of un-accounted for gas losses reached 11 percent—way above international benchmarks.

Fiscal subsidies reached almost 2 percent of GDP per year. The sector generates direct and indirect fiscal costs through untargeted direct subsidies to energy users and repeated bailouts of the recurrent costs in the sector. Pakistan’s direct subsidies are more than double relative to median emerging market economy.8 The delays in determination and notification of prices also increase uncertainty on predicting the cost of subsidies on budget.

Until recently, the increasing stock of circular debt posed to limit energy supply. The stock was estimated to reach 4 percent of GDP as of end-FY13. The debt emerges due to the gap between the actual cost of production and the revenues, and delayed payments by distribution companies to the Central Power Purchasing Agency (CPPA). T&D losses, delays in price determination and notification, delays in pass through of fuel price changes, poor revenue collections, courts interference to power sector governance, delays in subsidy payments by the government to distribution companies all contributed to the growing circular debt. In June 2013, the government cleared large portion of the circular debt, about 1.4 percent of GDP, which should help elevate electricity supply. However, until the underline issues are addressed in a systemic way the problem will emerge in the future.

1 Median Emerging Market economy improved energy supply by 36 percent in the same period.2 NEPRA (2012) State of the Industry Report.3 DISCO losses reached 18.46 percent, 32.64 percent of losses at KESC (total 20.8 percent) from units purchased, and 2.8 percent of losses for NTDC from units received. The total losses of the system are around 22.37 percent of supply i.e. (NTDC+KESC+DISCO losses)/ Units received by NTDC +KESC purchased from own plants.4 Sahin, S. and F. Salman, (2013), “Pakistan’s energy issues in computable general equilibrium setting,” unpublished.6 Sources: Pakistani Authorities.7 At current prices, supply of gas is around 60 percent of total demand in the system.8 IMF (2013) “Energy Subsidy Reform: Lessons and Implications”9 Planning Commission of Pakistan and USAID (2013) “The Causes and Impacts of Power Sector Circular Debt in Pakistan,” March.

40. Conservation and energy efficiency are the cheapest and the fastest ways to alleviate the electricity shortage. Staff pointed out that pricing and other market based instruments to encourage energy conservation will significantly improve resource allocation and energy efficiency. Staff also urged authorities to promulgate the Pakistan Energy Efficiency and Conservation Act.

41. Current energy generation is tilted towards the use of costly fuel oil. Changes in the energy mix are required to decrease the production costs. The use of gas and coal rather than fuel oil needs to be prioritized. Moreover, the development of hydropower projects needs to continue for long-term sustainable supply.

42. Gas supply falls short of unconstrained estimated demand by half at current prices and investment is limited. To help tackle the gas shortages in the short-run, import of Liquefied Natural Gas (LNG) should be a priority, along with limiting further expansion of the gas distribution networks for domestic consumption and limiting the use of compressed natural gas to fuel vehicles. In the medium-term new investment in gas production should be a priority, both from existing fields and new exploration. Gradual price rationalization would encourage new production and would allocate gas consumption to the most efficient uses. Improvements in the business climate would also encourage new domestic and foreign investment in the sector.

43. Governance and regulatory improvements should be important components of energy sector reform. Half of current circular debt is caused by inefficiencies in tariff determination and notification. Staff urged authorities to minimize the time to determine and notify tariffs and to consolidate the process under the National Electric Power Regulatory Authority (NEPRA) while strengthening NEPRAs administrative capacity. Similarly fuel price adjustments need to be made on a timely basis. Finally, the institutional capacity of all energy sector PSEs needs to be strengthened to allow them to operate independently from the Government as efficient commercial entities.

44. Business climate reforms should initially tackle the major impediments to entry. Staff pointed out that liberalization of barriers to new business start-ups, simplification of legal and taxation requirements (such as a “one stop shop” for investors), strengthening anti-corruption efforts, and designing frameworks to improve contract enforcement would enhance the business climate and increase investment. Access to credit for small and medium enterprises (SME) remains very limited. In this respect, the State Bank of Pakistan’s Financial Inclusion Program makes an important contribution.

45. Trade policy reforms would stimulate competition, facilitate innovation and encourage foreign investment. A decade ago, Pakistan had a relatively simple and flat import regime, with four tariff rates from 0 to 25 percent and few exceptions. This system has been subjected to numerous modifications which have made it complex and riddled with special conditions. According to a study by the Customs Budget Wing in 2012, 84 percent of traded tariff headings were subject to SROs modifying rates or granting exemptions. In staff’s view, simplifying tariff rates, eliminating exemptions and SROs would deliver a much needed improvement in the competitive environment. Staff also suggested a return to the 2003 framework of 4 tariff “slabs” with 0 to 25 percent rates. Elimination of the negative list on trade with India and extending India most favored nation status, and shifting to “sensitive list” under SAFTA regime would increase regional trade. A strategy to take full advantage of trade preferences available from the EU—where currently autonomous trade preferences in 75 items is present—would also be advantageous.

46. Reforming public sector enterprises will limit poor performance and help lift economic growth by improving resource allocation. The authorities and staff agreed that comprehensive action was needed on some 65 PSEs. Initially, a stock taking of all major loss-making PSEs would be advisable to provide a diagnosis of the main problems. This could be followed by implementation of medium-term action plans to privatize firms, restructure those with prospects of profitability but which the government wishes to retain in the public sector, and close nonviable firms. Staff suggested that for those companies with shares already in private hands, privatization should go ahead with block sales, secondary public offerings for institutional and general public or international listings. On restructuring improved governance and corporatization should be essential components of reform.

Authorities’ Views

47. The authorities broadly agreed with staff on the priorities for structural reform. They are committed to the elimination of subsidies, but stressed that they want to move gradually to match higher prices with increases in energy supply. To ease public resistance, they prefer initially to concentrate price increases on nonhousehold consumers. The authorities are pursuing projects to import gas, and recognize that bold actions on rationalization of gas prices are needed once they are able to tackle legal impediments. To improve electricity collections, the authorities are planning to introduce amendments to the penal and criminal codes before the end of the year. On PSE reform, the authorities proposed an even more ambitious agenda than that recommended by staff, while noting that sequencing should be calibrated to match market conditions and privatization IPOs and SPOs offered only after gauging investors’ appetite and global market conditions. The authorities noted that the EU is currently considering their request for receiving GSP plus benefits (zero percent duty) among other trade facilitation actions. Finally, they agreed to identify the legal and bureaucratic impediments to doing business and will build the capacity of the Board of Investment to undertake the necessary reforms.

Program Discussions

48. Program discussions focused on a package of adjustment measures to reduce short-term persistent vulnerabilities and promote robust inclusive growth by addressing Pakistan’s underlying structural problems. The authorities and staff agreed on strong fiscal consolidation measures to address the unsustainable government deficit problem and contribute to easing external financing needs, as they would ease demand-side pressures, facilitate increased donor inflows, and eventually allow for private external deficit financing. Such policies will address the large and persistent problems in the external sector by paving the grounds for foreign exchange inflows through increased FDI and portfolio investment. Staff and the SBP agreed that fiscal measures need to be combined with an independent monetary policy aimed at rebuilding reserves and controlling inflation in the medium-term. The policy mix also includes significant structural reforms to sustain the improved fiscal stance, boost investment and growth prospects and deliver better economic prospects for the poor through targeted support spending. The sizable fiscal consolidation should allow the government to transition to reliance on foreign and domestic private markets and normal project disbursements from donors to cover its future financing needs once the program ends. Structural reforms to improve growth, ease energy bottlenecks, and strengthen the investment climate should boost both foreign direct investment and portfolio inflows, making the balance of payments more sustainable.

49. The program has been designed with the lessons from Pakistan’s previous arrangements with the Fund in mind. Staff noted that the Ex Post Evaluation (EPE) report on the 2008 program recommended the following key points for future engagement: (i) Strong ownership and broad-based buy-in and political support to implement ambitious structural reforms; (ii) Striking a balance between including critical reforms and avoiding overreach; and (iii) Close collaboration with other development partners. Consistent with this, program discussions centered on upfront conditionality focused on a limited number of permanent measures clearly aimed at Pakistan’s longstanding challenges, and steps to secure broad political support for the program. Other donors were closely involved in program discussions, particularly in their areas of expertise and will be full participants in the overall reform program supported by the EFF. Structural conditionality will be focused on the most critical areas where the authorities themselves have strong ownership. Structural benchmarks are phased over time in recognition of constraints on the authorities’ administrative implementation capacity, and significant technical assistance will be provided by the Fund and other donors (¶76). While program design has been adapted to incorporate the lessons of previous programs, full and timely implementation of program conditionality is ultimately the crucial factor in determining program success.

Fiscal Policy

The Fund supported program contemplates around 4½ percent of GDP in fiscal consolidation over three years, of which 2 percent of GDP would be taken upfront.

50. Under the authorities’ proposed program, the fiscal deficit would be reduced to around 3½ percent of GDP by FY2016/17 (MEFP ¶7–9). World Bank studies suggest that aggressively broadening the coverage of General Sales Tax (GST) and key taxes (income taxes and import tariffs) could yield up to 4½ percent of GDP over time, and increases in tax rates (such as GST or excises) could be considered, in addition to other potential measures (table below). On the expenditure side, current spending—mostly electricity subsidies—could be reduced by 1½– 2 percent of GDP over the program period. Together, measures of this order of magnitude could deliver the desired deficit reduction while permitting increased spending on growth enhancing investment and social protection. Given the significant devolution of revenues to the provinces, the government will seek explicit agreement with the provinces to deliver the budgeted surpluses through saving additional revenue transfers.

51. The initial fiscal adjustment effort includes permanent deficit reduction measures of 2 percent of GDP, coming mainly from revenue increases and lower energy subsidies (MEFP ¶8). Tax measures included in the 2013/14 budget—including a one point hike in the GST rate—are expected to yield ¾ percent of GDP annually. Reduced energy subsidies will produce another ¾ percent of GDP in savings. The remainder will come from lower current expenditures (0.15 percent of GDP), savings of the PSDP budget, and (in the second half of the fiscal year) a new levy on natural gas expected to yield about 0.4 percent of GDP on an annualized basis. As a contingent strategy, the government will bring forward the measures identified for years two and three of the program.

52. The additional fiscal adjustment in years two and three of the program will be concentrated on efforts to broaden the tax base and to further reduce untargeted subsidies (MEFP ¶9, 10, and 13). On the revenue side, the authorities envisage measures yielding ¾ percent of GDP in each of the subsequent years. The focus will be on eliminating exemptions and concessions embedded in the Statutory Regulatory Orders (SROs) and in the law, as well as on eliminating the power of the executive to grant preferential tax treatment through SROs. These steps will facilitate gradually moving the GST to a full-fledged integrated VAT-style modern indirect tax system with few exemptions and to an integrated income tax by 2016/17. Tax administration reforms will also be critical to this revenue effort. On the income tax side, the authorities will focus on 300,000 potential taxpayers, through the national data warehouse. In addition to the 100,000 notifications for late return filing under section 114 envisaged for FY2013/2014, the authorities will pursue additional 100,000 in each of the following two years. If the tax payers fail to respond satisfactory, these notifications will be followed by a provisional assessment of income under section 122—which will become final if the taxpayer again fails to respond satisfactorily—and measures to collect the tax liability (including attachment of bank accounts). The authorities will also develop plans to strengthen the administration of customs, sales and excise taxes (structural benchmark). On the expenditure side, further subsidy reductions of around 0.4 percent of GDP per year are envisaged under the authorities’ comprehensive energy plan.

Annualized Yield of Key Measures under the Program (In percent of GDP)

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53. The provinces will contribute to the consolidation effort (MEFP ¶14). In 2013/14, the provinces—through the Council of Common Interests—have agreed to deliver the required fiscal surpluses through saving the additional revenue transfers. To encourage compliance, the SBP will begin to pay interest on deposits held by the provinces. However, stronger institutional arrangements will be needed in the future to ensure the sustainability of the envisaged fiscal consolidation. In 2014/15 and beyond, negotiations will take place on a new NFC award which the authorities plan to use to adjust the revenue sharing arrangements to provide a better balance between revenue and spending responsibilities.

Federal and Provincial Fiscal Balances (In percent of GDP)

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54. Targeted assistance schemes will be expanded significantly during the program to protect the most vulnerable members of society 22 (MEFP ¶13). The main program, the Benazir Income Support Program (BISP), reaches 4.8 million families in the two poorest quintiles of the population.23 For FY2013/14, the budget allocated to BISP has risen so as to increase the level of benefits from PRs.1000 to PRs. 1200 per family per month and expand coverage to 5.7 million families. Additional resources will also provide conditional cash transfers (CCTs) to primary education, supporting 560,000 families with a benefit of Rs. 200 per child per month attending school. Coverage of the BISP and CCTs would continue to rise under the program, reaching 6.6 million families by 2015/16 with benefits scaled up to cover inflation.

Quintile Share of Aggregate Spending or Transfers

(In precent)

Citation: IMF Staff Country Reports 2013, 287; 10.5089/9781484379615.002.A001

Sources: Pakistani authorities; and IMF staff calculations.

Monetary Policy

Rebuilding reserves will be the priority short-term policy objective, with maintaining low and stable inflation taking on greater importance later on. Enhanced SBP independence and ending SBP direct financing of the fiscal deficit will be crucial.

55. Staff and the SBP agreed that monetary and exchange rate policies should be adjusted to address declining reserves and a projected rebound in inflation (MEFP ¶17). In the short-term, monetary and exchange rate policies should focus on rebuilding foreign exchange reserves. As a first step, to signal a shift in policy and to begin attracting capital inflows, the SBP has begun net purchases of foreign exchange in the interbank spot market. Reserves accumulation will be guided by a tight NIR target under the program. The SBP will allow greater exchange rate flexibility, limiting intervention in the exchange market to that needed to build reserves, cushion major shocks, and strengthen competitiveness over time. The authorities also agreed to gradually reduce the SBP’s short swap/forward foreign exchange position to a more sustainable level. Inflation will be contained to around 8 percent in 2013/14, aided by the effects of fiscal consolidation in limiting domestic demand growth and easing fiscal pressures on the money supply.

56. Beginning in 2014/15, monetary policy should aim to reduce inflation while continuing to rebuild foreign exchange reserves (MEFP ¶16, and 18). To guide inflation reduction efforts, a target on NDA of the SBP envisages a reduction in money supply growth over time to rates consistent with the inflation objective of 6–7 percent. Monetary accommodation of fiscal deficits will be scaled back considerably, while maintaining a positive real policy interest rate will help anchor inflation expectations. The SBP has also halted further direct lending to the government, reflected by a continuous ceiling on total SBP credit to the government (which will fall over time and will help lowering the reserve money growth).

57. Enhanced central bank independence will improve monetary policymaking (MEFP ¶19). In the near term the authorities agreed to work toward approval of amendments to the SBP law to give greater operational independence in the central bank’s pursuit of price stability as its primary objective. Among other things, the amendments will establish an independent, decision-making monetary policy committee to design and implement monetary policy and will prohibit any form of new direct lending to the government from the SBP.

Financial Policies

58. The SBP will prepare detailed plans to assure that all banks come into compliance with minimum capital adequacy requirements (structural benchmark, MEFP ¶21). The plan will cover both state-owned and private banks and will include contingency measures in case of slippages, indicating clearer alternatives in case banks are unable to raise expected capital.

59. Consultations are already underway with key stakeholders on the new bankruptcy law (Corporate Rehabilitation Act) to revamp the recovery mechanisms (MEFP ¶22). The new law will facilitate the legal framework for rehabilitating viable corporate and financial entities while speeding up the process of liquidation of unviable entities. The authorities also plan to approach key stakeholders to address the concerns regarding creditor and debtor protection.

60. A deposit insurance scheme will be introduced once preconditions are in place (MEFP ¶23). The scheme is expected to boost confidence in the banking system, which will encourage additional growth in deposits. The authorities agreed to pass legislation on deposit insurance scheme and fully implement this legislation over the course of the next three years where necessary preconditions are met such as capital adequacy, effective supervisory and regulatory framework, and a special resolution framework.

61. Revising the regulatory and supervisory frameworks is critical for financial stability (MEFP ¶24). The Securities and Exchange Ordinance, 1969 “SEO 69” lacks a proper structure and suffers from numerous inconsistencies and gaps due to several amendments made over years. The authorities will undertake several initiatives during the program period:

  • The draft Securities Bill will enhance the supervisory and enforcement power of the regulator.

  • Regulatory power of the Securities and Exchange Commission of Pakistan (SECP) will be enhanced with a new draft bill.

  • A comprehensive framework for the futures markets will be prepared.

  • Better coordination between SBP and SECP will be implemented to effectively regulate and supervise banking groups.

Structural Policies

Critical structural measures in the energy sector together with targeted transfers to protect the most vulnerable will be a priority under the new Fund-supported program. Other reforms will also be important components of the arrangement, such as trade liberalization, reforms of public sector enterprises (PSEs), and improvements to the business climate, which will kick start growth.

62. The authorities have launched a comprehensive energy policy (MEFP ¶26). The policy to be implemented during the program will cover all elements of the energy supply chain, demand management, and pricing policies for better functioning of the sector:

  • Electricity sector (MEFP ¶27, and 32). Tariff rationalization has already begun, and the elimination of payables arrears in the power sector is a positive development. However, more is needed to limit the recurrence of arrears in the future. During the program period Tariff Differential Subsidies (TDS) will be phased out and tariffs will be brought to cost recovery levels. Tariff adjustments will improve resource allocation and efficiency, and will encourage conservation. Cost-cutting and efficiency measures will also be undertaken in both generation and distribution companies. Legal changes will be undertaken to tackle electricity theft by enhancing investigation, prosecution, and penalties. High priority will be given to improve energy sector governance and transparency. Additional electricity production projects will be accelerated.

  • Gas sector (MEFP ¶34). The authorities will prepare a gas price rationalization plan to accompany the electricity price rationalization already underway. In the short-run, they will administratively allocate gas to uses with higher economic value (e.g., energy production) while preparing to let price mechanisms take over the allocation function in the future. They will develop facilities to import gas, and will increase incentives for higher domestic production.

63. The authorities agreed to move forward with business climate reforms to help increase foreign and domestic private investment (MEFP ¶36). The Corporate Rehabilitation Act, Alternative Dispute Resolution (ADR) Mechanisms, setting up a one-stop shop (including the human resource and funding needs), and identifying the required changes in the regulations and administration will be required to tackle the impediments to doing business. In this respect, the Board of Investment, in coordination with SECP, Federal Bureau of Revenue, provincial governments, and other concerned agencies, will develop a plan to further simplify procedures and reduce costs for setting-up businesses in Pakistan.

64. Trade policy and PSE reforms will be important components of the program (MEFP ¶37). These reforms will increase consumer welfare, stimulate growth via increased competition, and improve public resource allocation. The authorities will prepare a three-year program to return to a simplified import tariff regime, with 4 tariff rates ranging from 0-25 percent with few exceptions. The elimination of SROs will also remove the source of many distortions to the trade regime. The authorities will embark on a stock-taking of all major loss-making PSEs. This shall be followed by implementation of medium-term action plans to privatize firms, restructure those with prospects of profitability but which the government wishes to retain in the public sector, and close nonviable firms.

65. Enhanced and better-targeted assistance for the poorest households is necessary (MEFP ¶13). The poor and most vulnerable segments of the society will be protected from the direct and indirect impacts of fiscal consolidation and tariff adjustments. The Benazir Income Support Program (BISP) is the largest targeted social assistance mechanism directly reaching 4.8 million families (16 percent of the population) within the two poorest quintiles. As savings from tariff adjustments and fiscal space are realized, the authorities agreed to expand its coverage and increase the benefit amount to protect the real purchasing power of the beneficiaries.

Program Modalities

66. Access, Duration, Phasing: An extended arrangement under the EFF would be appropriate to meet Pakistan’s medium-term financing needs, build reserve buffers from their current level of US$5.4 billion, and put the economy on a sustainable, higher-growth path. Access of 425 percent of quota (SDR 4,393 million, equivalent to US$6.68 billion) is based on Pakistan’s external financing needs (Box 8). The required fiscal adjustment, outstanding credit, and record of using Fund resources are also used to determine access. The proposed arrangement will be within normal access limits for an extended arrangement under the EFF, even after the implementation of the 14th quota review and possible changes to normal access limits.24 Even phasing over the program would imply net repayments to the Fund in the first four quarters of the program. The first disbursement would be at program approval and the remaining purchases would be contingent on completing quarterly reviews.

67. Support from other donors. Staff has worked in close coordination with the World Bank, the Asian Development Bank, and key bilateral donors in developing policy recommendations (particularly for structural reforms). There are firm commitments from donors to fill the entire financing gap for the first 12 months of the arrangement, and good prospects that there will be adequate multilateral and bilateral financing for the remainder of the program. Financial support from these partners is expected to reach US$6 billion during the program period, with strong technical assistance also provided, particularly in tax administration and the energy sector.

68. Prior actions: The following prior actions were undertaken by the authorities to kick start reforms and signal commitment to the necessary adjustment policies:

  • Implementation of a series of fiscal adjustment measures (including those in 2013/14 budget) totaling 2 percent of GDP on an annualized basis.

  • Elimination of tariff differential subsidies in industrial, commercial and bulk users and reduction of subsidies to high levels of consumption totaled 0.75 percent of GDP in annualized savings.

  • Sustained purchases of foreign exchange by the SBP.

  • An agreement at the Council of Common Interest on respecting the 2013/14 fiscal balances for the provinces under the program.

  • Issuance of 10,000 collection notices to individuals not registered to pay taxes based where indirect methods suggest large potential income tax liabilities.

69. Quantitative and Continuous Performance Criteria: The program will be monitored with quarterly performance targets on the general government fiscal balance (consolidated federal and provincial), net foreign assets, net domestic assets, SBP lending to the government, the SBP’s forward/swap position, the accumulation of domestic arrears, and the standard continuous performance criterion on the nonaccumulation of external arrears.

70. Structural Benchmarks: Beyond the prior actions in the structural area, benchmarks on structural reforms are also set. Benchmarks in the fiscal sector are designed to secure the fiscal consolidation and distribute the burden to wider groups of tax payers. Monetary policy benchmark is aimed at bringing more independence to the SBP through changing the composition of the Board, extending the tenure of the Governor and eliminating SBP lending to the Government. Financial sector benchmarks focus on initially to mitigate short-term risks posed by undercapitalized banks and ensure that necessary institutions are set up to protect medium-term financial stability. Finally, benchmarks in the structural policies are intended to address the long-standing problems in the energy sector and loss making public sector enterprises which constitute critical constraints on growth and have generated or have the potential to generate large fiscal cost.

71. Risks: Program implementations risks are high given Pakistan’s track record, particularly political constraints and the limited technical capacity to implement reforms simultaneously across a wide range of activities. These risks are mitigated by critical upfront actions as well as the strong electoral mandate and commitment to reform of the new government. Strong technical assistance support from the international community should help ease risks that implementation will lag due to weak technical capacity. The recent record of interventions by the Supreme Court in economic and administrative issues may be another source of uncertainty. The governing party may lack political support in provinces outside of Punjab, complicating provincial-federal financial agreements. Endorsement of the 2013/14 budget parameters and medium-term program objectives from other provinces is expected to mitigate this danger. Delays or shortfalls in financing from public or private sources are another program risk. Public funding risks should be eased by the strong commitments of support from the World Bank, ADB, and key bilateral partners. Private financing risks may be reduced by the authorities’ strong privatization program (flows from which have been very conservatively estimated).

BOP Projections and External Financing Requirement

The BOP position is sustainable with significant adjustment and new financing. While the current account deficit is not particularly large, foreign exchange reserves are under downward pressure from three factors: (i) weak gross financing inflows; (ii) large expected financing outflows (including repayments to the Fund); and (iii) the possible unwinding of the SBP’s short forward position (currently at US$2.2 billion). Fiscal measures of 2 percent of GDP and Fund financing will stop reserve loss and maintain the stability of the external position.

Reserves are projected to reach adequate levels within the program period to handle unforeseen shocks (see Table below). Under the program scenario, reserves are projected to reach to around US$15.5 billion by the fourth quarter of 2015/16 (three months of imports). This projection incorporates the following assumptions: the latest WEO assumptions on commodity prices and external demand; additional inflows from the Coalition Support Fund (US$3 billion), PTCL privatization (US$0.85 billion), and sales of 3G licenses (US$1.2 billion); and Fund financing of US$6.6 billion to close the remaining financing gap. The program is expected to stabilize the economy and catalyze external official (US$6 billion) and private financial inflows. FDI is expected to return gradually to its former levels as a share of GDP, driven by privatization revenues and improved business climate.

Medium-term projections are subject to significant downside risks. First, Pakistan’s BOP is very sensitive to volatile commodity prices. A US$10 per barrel increase in the oil price raises the import bill by about US$600 million. Second, some capital inflows that are expected in 2013/14 may not materialize. Third, the program scenario assumes that Pakistan will regain modest access to international capital markets in 2015/16. Finally, SBP’s short forward foreign exchange positions may unwind faster than envisaged in the program.

Pakistan: Gross Financing Requirements and Sources, 2011/12–2015/16

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

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

Excludes program related budgetary grants

72. Capacity to Repay the Fund: Pakistan’s capacity to repay the Fund is strengthened by the new program as it will help Pakistan restore its external stability and should catalyze new capital inflows from donors and from the private sector. With an extended arrangement under the EFF, the net repayment profile to the Fund eases significantly, while still lowering the Fund’s exposure to Pakistan during the first two years of the program. The new program will enhance the capacity to repay in two main ways: (i) the balance of payments is expected improve significantly (Box 8) due initially to consolidation and official inflows, but later due to higher private capital inflows; and (ii) reserves will be significantly higher under the program scenario, reducing the Fund’s exposure to only around 1/3 of reserves by the end of program period despite new disbursements.25 In the absence of a new program, the repayment burden would constitute a substantial strain on Pakistan’s balance of payments. While the authorities’ determination to repay is not in doubt, at end-June 2013 the Fund’s exposure to Pakistan stood at roughly US$4.5 billion (74 percent of gross official reserves). Repayments are concentrated in the remainder of 2013 and during 2014 (roughly US$4 billion). In addition, baseline risks to the balance of payments are tilted to the downside, and Pakistan’s ability to regain access to international capital markets is limited without reforms. Materialization of these risks would further erode Pakistan’s capacity to repay the Fund. While sensitive to real depreciation shocks, Pakistan’s total external debt remains broadly sustainable (Table 10).

Reserves under Baseline and Program Scenarios

(In billions of U.S. dollars)

Citation: IMF Staff Country Reports 2013, 287; 10.5089/9781484379615.002.A001

Sources: Pakistani authorities; and IMF staff calculations.

Net Purchases from the IMF

(In millions of U.S. dollars)

Citation: IMF Staff Country Reports 2013, 287; 10.5089/9781484379615.002.A001

Sources: Pakistani authorities; and IMF staff estimates.

73. Safeguards: A safeguards assessment update will be completed no later than the first review under the new extended arrangement under the EFF.

Other Issues

74. Outreach. As part of the Article IV consultation discussions, the mission held meetings with business and banking leaders in Karachi and Lahore and with journalists and opinion leaders in Islamabad. Meetings were held with the diplomatic community and with key multilateral and bilateral donors. At the conclusion of the mission, a joint press conference was held with Minister of Finance Dar. While direct meetings with civil society are somewhat circumscribed by security concerns, Pakistan is a pilot case for outreach via social media, with an active twitter account (@imf_pakistan). Further outreach efforts are planned upon Board approval of the program.

75. Although the authorities have taken steps toward improving Pakistan’s AML/CFT regime in the context of the Financial Action Task Force (FATF) initiative against noncooperative jurisdictions, some strategic deficiencies remain. The amendments to the Anti-Terrorism Act enacted earlier this year have addressed part of the concerns expressed by the FATF. However, the authorities still need to further amend the Act, in particular with regard to the identification and freezing of terrorist assets. Pakistan’s current listing by the FATF creates costs on financial intermediation because of heightened due diligence requirements by international financial institutions. In addition, the effective implementation of the AML/CFT framework could support the authorities’ efforts in fighting against tax evasion and corruption.

76. Exchange rate regime. Pakistan has accepted the obligations of Article VIII, Sections 2, 3, and 4. Pakistan’s exchange rate regime has been classified as floating since January 2008.

77. Data quality. Macroeconomic statistics are broadly adequate for surveillance and program monitoring. The authorities are progressing towards closing gaps in the real sector and strengthening the quality of fiscal and social (especially poverty) data to better inform policy decisions and monitor outcomes. Recently, the authorities have rebased the national account statistics and will publish quarterly national accounts starting from November 2013 in line with the Special Data Dissemination Standard (SDDS). Before the end of the year, they are also planning to extend the new series back to FY1999/2000.

78. Technical Assistance. A comprehensive solution to Pakistan’s fiscal problems will require technical assistance from the Fund and other donors. The highest priority is a tax administration diagnostic mission, followed by support on public financial management and on federal-provincial fiscal arrangements. Staff also pointed out that SBP can benefit from technical assistance on foreign exchange auctions, citing Turkey and Mexico as good examples. TA is also required to help improve banking supervision. The authorities have also requested assistance for applying BPM6.

Staff Appraisal

79. Pakistan is facing serious economic challenges. Overall vulnerabilities and crisis risks are high, with subpar growth and unsustainable fiscal and balance of payments positions. Lack of reliable electricity supply and a difficult security situation in large parts of the country have contributed to the deterioration.

80. The risks to the outlook are on the downside and strong policy action is required. Domestic risks emanate from the fiscal imbalance with the attendant high government debt rollover requirements, a worsening energy crisis, and security problems, all of which could seriously damage growth prospects. On the external side, there are significant downside risks to the balance of payments. Besides international oil and food price volatility, the economy also remains highly vulnerable to adverse global spillovers through trade and remittances channels.

81. Pakistan’s newly elected government has a strong mandate to stabilize the economy and address critical constraints on growth. The authorities have made in important start in their first months in office. They have approved a FY2013/14 budget with measures to boost revenues, reduce energy subsidies, and cut the fiscal deficit. To prepare for a new extended arrangement under the EFF with the Fund, they have undertaken additional fiscal measures. They have implemented significant energy price adjustments and launched a comprehensive energy reform policy. They are also preparing important reforms in the gas sector, trade policy, PSEs, and the business climate. They have launched a new enforcement program to improve tax collections and have appointed new senior staff in the FBR. Together, these steps to mitigate near-term vulnerabilities and foster inclusive growth over the medium term will generate a turnaround in the economy once fully implemented. The extended arrangement under the EFF support from the Fund is aimed at providing sufficient resources and traction to help the authorities to pursue this homegrown program.

82. To ensure fiscal sustainability further consolidation is needed. While the reduction in the headline deficit from 8.8 percent of GDP in 2012/13 to 5.8 percent of GDP in 2013/14 is an important achievement, further efforts will be needed in subsequent years to secure medium-term fiscal sustainability. In particular, the tax-to-GDP ratio must be raised significantly to allow for needed social and investment expenditures while lowering the deficit. This must involve broadening the tax base via an ambitious reduction in exemptions and concessions, and efforts to extend taxation to areas currently not fully covered by the tax net. It will also require an overhaul of tax administration, including by boosting training, transparency, and enforcement capabilities. Full fiscal sustainability can only be achieved if the provinces are full partners in the adjustment effort.

83. Monetary and exchange rate policies must be geared to rebuilding external buffers and to maintaining price stability over time. In the short-run, the SBP must prioritize stabilizing its foreign exchange reserves, making use of program disbursements, financial support from other donors, foreign exchange intervention, and exchange rate flexibility. The net international reserve targets under the program reflect this objective. Once reserves cushions begin to be restored, the SBP should increasingly focus its attention on maintaining low and stable inflation (in the 5-7 percent range). To achieve this objective, direct lending to the government must cease and liquidity injections should be exclusively through open market operations calibrated to achieve the program’s NDA targets. In the medium-term, full operational independence will help the SBP improve monetary policymaking and achieve the needed inflation reduction.

84. Continued financial sector stability and steps to deepen financial markets will contribute to boosting economic growth. While systemic risks to the banking sector are not particularly high at this time, the authorities need to promptly address those banks below the minimum CAR or below the MCR to avoid future dangers. Development of additional tools to strengthen the financial health of the system, such as deposit insurance, consolidated supervision, and enhanced legislation on nonbank financial activities are important. Steps to deepen financial markets will facilitate increased private investment and growth over time.

85. Structural reforms are key to sustained and inclusive growth. The authorities’ energy policy is geared to address the long-standing problems in the sector which constitute the most critical constraint on growth and have generated large fiscal costs. Staff anticipates a boost in GDP on the order of 2 percentage points over the coming years as the energy crisis is resolved. Reforms in other areas are also critical for higher growth. As the authorities liberalize the trade regime, restructure or privatize public sector enterprises, and take measures to improve the business climate, rent-seeking behaviors will decline and productive investment—both foreign and domestic—will rise sharply, boosting medium-term growth prospects.

86. Protecting the most vulnerable from the direct and indirect impacts of fiscal consolidation and price adjustments should be a priority. Staff welcomes the authorities’ firm commitment to boosting targeted income support programs, as signaled by the inclusion of an indicative floor on such spending in the program targets. Coverage and benefits of these programs are slated to gradually increase as savings from tariff adjustments and fiscal space are realized.

87. While there are implementation risks under the proposed extended arrangement under the EFF, the authorities’ commitment is strong. Pakistan’s track record is spotty on sustained adherence to IMF programs, and this will be a relatively high risk arrangement. Possible external shocks will continue to pose risks to Pakistan’s fragile balance of payments until well into the second year of the program when reserves will finally rise above critical levels. The delicate security situation could also pose risks. The authorities may also encounter constraints on their legal, administrative, or technical abilities to implement such an ambitious reform agenda simultaneously in several governance areas. However, the new government has demonstrated considerable political will in undertaking as a prior action around 45 percent of the total 4½ percent of GDP fiscal adjustment required in the three-year program. They have also taken increases in sensitive energy prices upfront. These early steps bode well for success in implementation of future program conditionality. Ownership of the program is strong, as emphasized by the authorities’ own reform initiatives even before program discussions began, and the government has a majority in the national assembly to take needed actions.

88. The proposed level of access of 425 percent of quota is consistent with medium-term external and debt sustainability provided the program is implemented as envisaged and any unforeseen shocks are addressed swiftly. However, additional resources from donors will be an important component of program financing. There are firm commitments from donors to fill the remaining financing gap for the first 12 months of the arrangement, and good prospects that there will be adequate multilateral and bilateral financing for the remaining program period beyond those first 12 months. Donors are expected to provide around US$6 billion of additional resources over the next three years.

89. In view of Pakistan’s balance of payments needs and the comprehensive package of adjustment measures proposed by the authorities, staff supports the authorities’ request for an extended arrangement under the EFF in the amount equivalent to SDR 4.393 billion (425 percent of quota). Staff recommends that the next Article IV Consultation with Pakistan take place on the 24-month cycle.

Figure 5.
Figure 5.

Pakistan: External Debt Sustainability: Bound Tests 1/2/

(External debt in percent of GDP)

Citation: IMF Staff Country Reports 2013, 287; 10.5089/9781484379615.002.A001

Sources: Pakistani authorities; and IMF staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ For historical scenarios, the historical averages are calculated over the ten-year period, and the information is used to project debt dynamics five years ahead.3/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.4/ One-time real depreciation of 30 percent occurs in 2013/4.
Table 1.

Pakistan: Selected Economic Indicators, 2009/10–2013/14 1/

Population: 178.9 million (2011/12)

Per capita GDP: US$1,228 (2011/12)

Poverty rate: 17.2 percent (2007/08)

Main exports: Textiles ($9.9 billion)

Unemployment: 5.95 percent (2010/11)

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

Fiscal year ends June 30.

Inflation after 2009/10 based on new CPI weights, recalculated in September 2011.

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

Excludes military debt, and commercial loans.

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

Table 2.

Pakistan: Medium-Term Baseline Macroeconomic Framework, 2009/10–2017/18

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

Difference between the overall balance and the current account balance.

Including privatization.

In months of next year’s imports of goods and services.

Including grants.

Table 3.

Pakistan: Medium-Term Program Macroeconomic Framework, 2009/10–2017/18

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

Difference between the overall balance and the current account balance.

Including privatization.

In months of next year’s imports of goods and services.

Including grants.