Selected Issues

Abstract

Selected Issues

The Macroeconomics of Pakistan’s Quest for Energy and the CPEC1

Pakistan has embarked on a massive investment program in energy and infrastructure sectors, partly in the context of the China-Pakistan Economic Corridor (CPEC). This chapter discusses some of the expected benefits of these investments as well as their potential macroeconomic impact. The planned investments are expected to eliminate Pakistan’s energy deficit, improve the economy’s fuel mix, reduce energy costs, raise overall business productivity and trade connectivity, and provide a positive boost to output and exports. At the same time, the potential medium-term impact on the balance of payments—through higher loan repayments, repatriation of profits from FDI, and fuel imports—points to the need for a strong policy focus on boosting exports and building external buffers, bringing the distribution sector to full cost recovery, prudent management of project costs and fiscal incentives, as well as careful phasing in of new external commitments.2

1. Over the past decade, Pakistan has faced chronic energy shortages and substantial underinvestment in infrastructure. The authorities estimate the cost of these challenges to the economy at about 2 percent of GDP per annum. Excessive reliance on furnace oil amid rising oil prices combined with administrative and operational inefficiencies and inadequate tariff setting produced large and persistent losses in the power sector which, in turn, led to the accumulation of power sector arrears (so-called “circular debt”), underutilization of existing capacity, and underinvestment in new energy supply. The resulting gap between demand and supply of energy was manifested in power outages averaging 10–12 hours a day in FY2012/13. Alongside, public investment averaged only about 3.5 percent of GDP-substantially lower than the average of over 6 percent of GDP in other emerging economies.

2. The authorities’ reforms have led to notable improvement in recent years. Lower oil prices, combined with efforts to bring power tariffs closer to cost recovery as well as improved collections and reduced losses have helped bring power outages to about 6 hours a day on average in the residential sector and less than two hours a day in the industrial sector in FY2015/16. In parallel, accumulation of circular debt has slowed down and efforts to raise tax revenue and rationalize expenditure have created space to expand the public sector development program by 0.5 percent of GDP cumulatively over the last three years.

3. Alongside, Pakistan has embarked on a wide-ranging initiative to increase and diversify its energy supply and improve infrastructure to help realize the country’s growth potential. The China-Pakistan Economic Corridor (CPEC) is a large package of investment projects, potentially totaling about $55 billion (19 percent of FY2015/16 GDP) over the next decade, aimed at upgrading infrastructure, boosting and diversifying energy supply, and improving regional trade connectivity thereby stimulating investment. The estimated size of CPEC will likely change over time. The analysis below is based on realization of 19 CPEC projects ($17.7 billion in energy sector and $5.9 billion in infrastructure) and several non-CPEC energy sector projects ($25.4 billion), which are either in advanced planning stages or already in the process of implementation. Investments in the energy sector include a combination of generation projects based on coal and liquefied natural gas, hydro power stations, nuclear power plants, and several solar and wind farms. Substantial investment has already taken place and, going forward, inflows are expected to peak at about $12 billion, gradually declining in the following four years.

Summary of CPEC and Other Power Sector Projects 1/

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Source: Staff estimates based on discussions with the Pakistani authorities.

Includes only projects in implementation or advanced planning stage.

4. The authorities have facilitated a variety of financing modalities for the various investment plans. CPEC infrastructure and transport projects are financed by long term concessional government borrowing from China. CPEC projects in the energy sector involve foreign direct investment and commercial borrowing from Chinese financial institutions, either by majority foreign-owned joint ventures or Chinese investors.3 Financing of non-CPEC energy projects ranges from private domestic financing to private commercial as well as government concessional borrowing from international financial institutions.

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CPEC and Other Power Sector Investment Plans

(In billions of US dollars)

Citation: IMF Staff Country Reports 2017, 213; 10.5089/9781484309766.002.A004

Source: Pakistan authorities, NEPRA, news reports, and staff estimates.Based on projects in implementation or in advanced planning stages.
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Projected Power Sector Capacity and Demand

(In MW)

Citation: IMF Staff Country Reports 2017, 213; 10.5089/9781484309766.002.A004

Source: IMF staff estimates based on data from Pakistani authorities, NEPRA, and own assumptions.Based on projects in implementation or in advanced planning stages. Demand and supply during NTDC’s system peak hours.
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Projected Evolution of the Fuel Mix

(In percent)

Citation: IMF Staff Country Reports 2017, 213; 10.5089/9781484309766.002.A004

Sources: Pakistan authorities, NEPRA, news reports, and staff estimates.Based on projects in implementation or in advanced planning stages.

5. If implemented on schedule, these investments could help close Pakistan’s power deficit and significantly improve energy costs and the fuel mix. The current investment plans envisage an addition of about 24 GW in installed capacity, of which 8.6 GW owing to CPEC, over the next 7–9 years. Assuming annual growth in energy demand of around 6 percent and an average capacity utilization of 85 percent, this expansion will help eliminate Pakistan’s deficit of about 6 GW in 2016 to a surplus as early as end-2018. In the process, Pakistan’s reliance on furnace oil (30 percent of the fuel mix in 2015) would be significantly reduced, making the energy sector more independent and resilient to abrupt changes in international oil prices.

6. Alongside, these investments will provide a boost to Pakistan’s GDP. This boost will likely come in three stages: construction, power generation once the installed capacity becomes operational, and-over time-second-round effects on broader economic activity owing to increased productivity, lower costs, and improved trade connectivity owing to improved infrastructure. The first two stages (direct contribution) will likely materialize in the next several years, while the second-round effects will likely accrue more gradually and could lead to a significant contribution in the long run, although the exact impact will depend on many other supportive factors.

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Direct Contribution to GDP from CPEC and other Energy Projects

(In billions of US dollars)

Citation: IMF Staff Country Reports 2017, 213; 10.5089/9781484309766.002.A004

Source: IMF staff estimates based on data from Pakistan authorities, NEPRA, and own assumptions. Based on projects in implementation or in advanced planning stages. Direct contribution includes impact from construction phase as well as value added in electricity generation (using NEPRA-determined tariffs), and does not include potential second-round effects. Assumes 70% import content during construction. Value added is estimated by subtracting the import content of investment, and the cost of imported fuel.

7. At the same time, Pakistan’s investment initiatives will likely create long-term balance of payments outflows. In the medium term, the operation of these projects will require balance of payments (BoP) outflows in the form of loan repayment, profit repatriation, and imports of input fuel. These outflows- which will be moderated by the expected savings from phasing out of the oil-based electricity generation -are expected to rise in the next several years, peaking at about $3.5–$4.5 billion by FY2024/25 (1.2–1.6 percent of FY2015/16 GDP) and gradually declining in the long run. A slower growth of energy demand or a faster phasing out of oil-based energy generation capacity, among other factors, will help lower these outflows.

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BoP Flows Owing to CPEC and non-CPEC Energy Projects

(In billions of US dollars)

Citation: IMF Staff Country Reports 2017, 213; 10.5089/9781484309766.002.A004

Source: IMF staff estimates based on data from Pakistani authorities, NEPRA, and own assumptions. Based on projects currently in implementation or in advanced planning stages. The range of estimates corresponds to different plausible assumptions about the rate of displacement of furnace oil-based electricity generation, rate of profit repatriation, energy demand growth, fuel prices, and capacity utilization.

8. Exports will need to increase substantially to meet the increased foreign currency financing needs. A positive impact of these projects on exports will further offset the expected outflows in the medium term. However, the effect of these investment initiatives will likely accrue gradually over time given the time required to build up additional export capacity from productivity improvements.

9. These considerations warrant policymakers’ attention to two priority areas in order to realize the transformational potential of Pakistan’s investment program while maintaining external stability:

  • Generating export revenue and further building the external buffers. Taking advantage of the still low oil prices to substantially augment the foreign exchange reserves of the State Bank of Pakistan (SBP)will be important to cushion the period of increased BoP outflows. Strong and sustained reform efforts aimed at raising exports by improving competitiveness and the business climate will be critical to maintain long-term external sustainability and realize the potential benefits of CPEC from improved energy supply and transport infrastructure.

  • Bringing the distribution sector to full cost recovery. Routing the increased generation capacity through a loss-making distribution sector could result in faster accumulation of circular debt and fiscal costs, as well as undermine long-term financial sustainability of the new energy projects. Therefore, despite the recent progress, a significant acceleration of energy sector reforms, including strengthening of governance in the distribution companies (DISCOs), attracting private investment to reduce line losses and improve metering and collection, and maintaining a strong and enabling regulatory framework will be important in the period ahead.

10. Looking ahead, containing fiscal costs, maintaining a supportive environment for all investments, and a gradual phasing in of new external commitments will help maintain macroeconomic stability and strengthen growth sustainability. In this context, it would be important to rationalize and limit tax incentives and exemptions; maintain uniformity of the tax regime with respect to all investments; and synchronize phasing in of new external commitments with the expected balance of payments trends.

References

1

Prepared by Hiba Zaidi and Tokhir Mirzoev.

2

Medium-term projections presented in this note represent a preliminary assessment which is likely to change over time. These projections have already been incorporated in the IMF staff’s macroeconomic framework balance of payments projections. The calculations are based on available information and, where applicable, staff’s own assumptions.

3

Energy sector projects will operate as independent power producers (IPPs) with guaranteed sales through power purchasing agreements or guaranteed rates of return through energy tariffs.

Pakistan: Selected Issues
Author: International Monetary Fund. Middle East and Central Asia Dept.
  • View in gallery

    CPEC and Other Power Sector Investment Plans

    (In billions of US dollars)

  • View in gallery

    Projected Power Sector Capacity and Demand

    (In MW)

  • View in gallery

    Projected Evolution of the Fuel Mix

    (In percent)

  • View in gallery

    Direct Contribution to GDP from CPEC and other Energy Projects

    (In billions of US dollars)

  • View in gallery

    BoP Flows Owing to CPEC and non-CPEC Energy Projects

    (In billions of US dollars)