Program Performance

Program performance has significantly strengthened in 2015, reflecting the authorities’ strong commitment to the program, despite significant challenges from a less favorable international environment and unfavorable cotton crop. All end-December performance criteria (PCs) were met, in some instances with significant margins, as were two indicative targets (ITs) on social spending under the Benazir Income Support Program (BISP) and on accumulation of power sector arrears. The third IT on tax revenue was narrowly missed but only after recouping PKR 35 billion out of the shortfall of PKR 40 billion recorded at end-September 2015, thus putting the revenue collection on a strong path to meeting the end-fiscal year target.

Significant progress has been made in structural reform implementation. Five Structural Benchmarks (SB) were met, including adoption of comprehensive monitoring system for tax audits, submission of draft legislation against benami transactions to the National Assembly, amendments to the Penal Code 1860 and the Code of Criminal Procedures 1898, a new time-bound plan with specific measures to significantly improve the business climate, and determination of multi-year tariffs by the power distribution companies IESCO and LESCO, albeit with a short delay. Amendments to AML Act (SB) were no longer required as the law allows inclusion of tax crimes in the schedule of the AML Act without legislative action. As a modified SB, the authorities will now amend the schedule of the AML Act through notification in the official gazette to include offenses under the income tax law as predicate offenses under money laundering. However, the end-December SB on soliciting expressions of interest for strategic private sector stake in Pakistan International Airlines (PIA) was not met because of legal constraints, political resistance, and labor opposition. The authorities reiterate their strong commitment to completing this reform and are seeking Parliament approval of Amendments to the PIA Act by mid-May 2016 (new SB). The missed end-February SB on enactment of the Gas Ordinance has been implemented as a prior action for this review. The authorities have also agreed to five new SBs to monitor implementation of the structural agenda under the program.

Recent Economic Developments and Outlook

Strengthened program implementation has significantly improved macroeconomic stability, providing an environment more conducive to growth and improving the economy’s prospects. Economic activity has remained resilient, despite challenges, buoyed by uptick in the large-scale manufacturing, growing construction activity, recovery in private sector credit growth, and increased FDI inflows, reflecting positive effects of reduced outages as energy sector reforms start bearing fruit, despite a temporary setback to the power sector privatization process. Real GDP growth is projected to rise from 4.2 percent in FY 2014/15 to 4.5 percent this fiscal year (the highest in eight years), and after falling to historically low level of 1.3 percent in September 2015, y-o-y inflation has gradually increased to 4 percent in February 2016, while remaining well-anchored by prudent monetary policy. On the back of continued low oil prices and steady inflow of remittances, and notwithstanding the adverse impact of a decline in other export commodity prices, current account deficit is projected to close at around one percent of GDP in FY 2015/16. Gross international reserves have strengthened further to reach US$ 15.9 billion by end-December 2015, covering over four months of prospective imports.

The outlook continues to improve, as growth should strengthen as a result of enhanced investor confidence from improved macroeconomic conditions and business climate, further easing in the energy supply situation, investments in the China-Pakistan Economic Corridor, and prospects of strengthened economic ties with neighboring Iran after lifting of sanctions.

Fiscal Policy and Debt Management

Fiscal consolidation has been at the heart of the program. The authorities have made significant progress in strengthening revenue mobilization and containing expenditures, bringing the fiscal deficit (excluding grants) down from 8.5 percent of GDP in FY 2012/13 to 5.4 percent in FY 2014/15. They aim at reducing the fiscal deficit to 4.3 percent of GDP in FY 2015/16, with a further reduction to 3 ½ percent in FY 2016/17, putting public debt on a firmly declining path.

Revenue collection has improved during the program period, and the tax-to-GDP ratio is projected to exceed 12 percent in FY 2015/16 from 10 percent at the start of this program. After increasing by 15.8 percent on average for the period FY 2012/13 to FY 2014/15, FBR collection strengthened further in the first eight months of this fiscal year, growing by 18.3 percent, reflecting the impact of the measures that the authorities have taken since the start of the program. The authorities are cognizant that despite this marked improvement, much more needs to be done, and are targeting a tax-to-GDP ratio of 14.5 percent of GDP by FY 2019/20. To achieve this goal, in addition to the full year effect of recent revenue measures and to enhance tax compliance, a comprehensive monitoring system for tax audits has been instituted, with quantitative performance criteria of number of risk-based audits as well as qualitative audit indicators (SB). By improving audit practices, not only have the number of cases selected for audit increased six-fold between 2011 and 2015, but the resulting claims from the FBR and actual collections have increased even more. The authorities are also improving coordination and information exchange between revenue agencies. Some of the other important measures include among others: i) removing distortions and discriminatory tax exemptions (MEFP, ¶11), ii) submitting draft legislation to the parliament against benami transactions (SB), and iii) improving governance in tax administration (¶17). Moreover, in implementing the voluntary tax compliance scheme for traders, the authorities will ensure that it does not create moral hazard or discriminate against law-abiding taxpayers.

Budget spending has remained prudent, and the authorities are committed to meeting the deficit target for the fiscal year, including some nonplan loans and agriculture expenditure which were not part of the budget. They have continued to reduce energy subsidies and improve their targeting, and are on course to bringing them down to 0.4 percent of GDP in FY 2015/16 (including 0.1 percent of GDP for arrears clearance) from 1.4 percent in FY 2012/13. They are strengthening fiscal policy coordination between federal and provincial governments to rebalance the devolution of revenues and expenditures. The authorities will prepare contingency measures to protect against any potential deviation from the fiscal deficit target. To provide a coherent institutional framework in line with best international practices for engaging the private sector in public infrastructure projects and create greater fiscal space for pro-growth spending, the authorities are preparing a Public-Private Partnership law to be submitted to the National Assembly by end-April 2016 (SB).

To improve debt sustainability, the authorities are focusing on reducing rollover risks, lengthening the maturity profile, and creating an appropriate balance between domestic and external financing. They have also continued to strengthen the institutional framework for debt management, including enhancing staffing of the Debt Policy Coordination Office. The Medium-Term Debt Strategy for the period FY 2015/16 to FY 2018/19 was also published in March 2016. To further strengthen debt sustainability, the authorities, with Fund TA support, are amending the 2005 law on Fiscal Responsibility and Debt Limitation (new SB) to ensure sound management of public finances and reduce debt-to-GDP ratio gradually from 63.2 percent of GDP in FY 2015/16 to 60 percent in 2017/18 and to 50 percent over a 15-year transitional period.

The authorities are strengthening the social safety net. They have enhanced the coverage and stipend of the BISP to improve the conditions of the marginalized segments of society. The authorities are also expanding the conditional cash transfer program for students to 1.3 million beneficiaries and are including more districts under the program.

Monetary and Exchange Rate Policies

Monetary and exchange rate policies remain geared towards building external buffers and maintaining price stability. Consistent with the program goals, the authorities have maintained a prudent monetary policy stance setting the policy rate in a forward-looking fashion to anchor low inflation expectations. Benefitting from continued low international oil prices, the authorities are building external reserves, including through market purchases.

In line with the objective of increasing SBP’s autonomy and ensuring transparency in monetary policy, the recently-established Monetary Policy Committee held its first meeting in January 2016, after approval of the amendments to the SBP law by the parliament in November 2015. To further strengthen SBP’s autonomy and to give effect to the remaining recommendations of the 2013 Safeguards Assessment, a time-bound legislative action plan is being prepared. In the meanwhile, the authorities, through an executive order will: i) provide financial guarantee for losses that are not covered by SBP’s general reserves, and authorize recapitalization of the bank if required and, ii) delegate power to the SBP Board to establish profit distribution rules, allowing it discretion in building reserves, and prohibit distribution of unrealized gains (SB). Further work is ongoing to strengthen SBP’s analytical capabilities in the transition to inflation targeting in the medium-term, including by strengthening the interest rate corridor and disseminating information about inflation expectations and forecast.

Financial Sector

The banking sector remains well capitalized and profitable. Although the Capital Adequacy Ratio (CAR) declined marginally to 17.3 percent in the quarter ending December 2015, reflecting strong growth in private sector credit, it remained much higher than the minimum requirement of 10.25 percent under Basel III. The asset quality of the banking sector improved, with NPL ratio declining to 11.3 percent and improved provisioning. Moreover, the SBP continues to monitor compliance with regulations: two banks which recently became CAR noncompliant will soon meet the statutory ratio, one of which by end-December 2016 after privatization, while the other will have to meet the minor shortfall through capital injection by March 2016. Another two banks which are CAR compliant but remain below the minimum capital requirement (MCR) will be made MCR-compliant by June and December 2016, respectively.

Extensive reform efforts are underway to reinforce regulatory and supervisory framework to protect financial stability. These include: i) revision of Securities Exchange Commission of Pakistan (SECP) Act to enhance its regulatory role; ii) establishment of a framework for consolidated supervision of banking groups and financial conglomerates by SBP-SECP; iii) amendments to foreclosure clauses in the Financial Institutions Ordinance 2001 to improve recovery of NPLs without intervention of banking courts, along with preparation of draft Corporate Restructuring Companies Act to facilitate timely resolution of NPLs, and preparation of a concept note for development of a Corporate Rehabilitation Act; and iv) progress toward developing a contingency planning framework for SBP and identification and monitoring of domestic systemically important banks. Moreover, to strengthen the stability and resilience of the banking system, a modern deposit insurance scheme is being instituted, and a Deposit Protection Corporation Act is expected to be enacted by end-March 2016, with the Corporation to be operational by June 2016. Progress is also made in transition to Basel III capital and liquidity standards. The authorities will continue strengthening effectiveness of the AML/CFT frameworks in line with international standards.

Structural Reforms

Structural reforms are a key element of this program and are designed to improve efficiency and service delivery in the public sector enterprises (PSEs) and reduce fiscal burden and risks through restructuring and privatization, reforming the energy sector to strengthen its performance and eliminate shortages, and enhance competitiveness and the business climate to achieve higher and more inclusive growth.

The authorities are firmly committed to the privatization program. The government has divested shares in three banks and a petroleum company, and has completed strategic sale of a construction company. Despite the temporary setback in strategic private sector stake in PIA as explained above, the authorities are firmly committed to completing this reform and are seeking parliament approval of the Amendment to the PIA Act by mid-May 2016. Unfortunately, the social tensions that hindered the private sector stake in PIA will likely delay the bidding process for shares of the power distribution company FESCO. The authorities are determined to seek broad consensus with stakeholders in order to put the privatization program back on track.

Continued progress is being made in Public Sector Enterprise (PSE) reform. The power sector companies are being required to commit to stringent reform measures so as to prevent further losses, reduce arrear accumulation, and to eliminate shortages and bring necessary improvements in service delivery. It is in this vein that the monitoring of arrears is being strengthened, and following over performance in reducing arrears accumulation at end-December, the indicative target for end-March and end-June has been tightened at the authorities’ request. Moreover, energy sources are being diversified away from fuel oil, the tariff setting system is being improved, collection is strengthened, and governance of power companies is being enhanced, including as a result of the amendments to Penal Code 1860 and the Code of Criminal Procedures. Progress is also made in strengthening the financial position of the gas companies, including through semi-annual notification of gas tariffs and by improving governance, revenue collection, and gas supply conditions. In this regard, following a short delay, the Gas Ordinance 2014 Act, which should reduce theft and improve cost recovery and governance in the sector, has been enacted.

To improve the business climate, a comprehensive and country-wide reform is being undertaken, in cooperation with development partners, to remove constraints to private sector development and enhance competitiveness. In this regard, procedures for starting businesses, enforcement of creditor rights, and tax payment and trade have been streamlined, with further steps planned in these areas, including simplification of the tariff structure by July 2016, and reduction in outstanding GST refund claims. Access to finance has been improved, including for women, SMEs, and marginalized segments of society, and the authorities are committed to continue enhancing financial inclusion. The authorities are cognizant of improving gender equality in education and raise female participation in the labor force. They conducted a gender-responsive analysis in FY 2015/16 and plan to incorporate gender equality in the budget-making process from FY 2016/17 with the ultimate objective of unlocking growth potential and achieving more inclusive growth.

Conclusion

The authorities’ overarching objective is to strengthen the economy’s performance further to reduce unemployment and improve the standards of living of the population. They also attach high priority to reducing inequality and addressing the needs of the most vulnerable segments of society through enhanced and broadened safety nets. They remain committed to maintaining sound policy implementation and strengthening the reform momentum to achieve their objectives under the program and over the medium-term. They request completion of the tenth review and modification of performance criteria, as stated in their MEFP. They are grateful for the guidance and support from management and the Board throughout this EFF-supported program.