Pakistan: Request for an Extended Arrangement Under the Extended Fund Facility—Press Release; Staff Report; and Statement by the Executive Director for Pakistan

Request for an Extended Arrangement Under the Extended Fund Facility-Press Release; Staff Report; and Statement by the Executive Director for Pakistan

Abstract

Request for an Extended Arrangement Under the Extended Fund Facility-Press Release; Staff Report; and Statement by the Executive Director for Pakistan

Context and Recent Developments

1. Over the past year, Pakistan has faced challenging financial conditions on the back of unbalanced policies and unfinished reforms. While economic growth has been relatively fast— averaging close to 5 percent over the past five years—macroeconomic vulnerabilities have rapidly increased on the back of weak policies supporting a consumption- and import-driven growth model. In particular, procyclical fiscal policies led to a surge in the FY 2018 fiscal deficit to 6.5 percent of GDP, 2.5 percent of GDP higher than budgeted, pushing public debt to 75 percent of GDP. The fiscal stimulus, together with an accommodative monetary policy and, crucially, the defense of an overvalued exchange rate, fueled the current account deficit to 6.3 percent of GDP last year. Lackluster progress in structural reforms continued to hamper investment, allowed inefficient SOEs to linger, and a large informal economy to expand. While the macroeconomic deterioration that eroded the stability gains achieved during the 2013–16 EFF has been largely due to homemade factors, the increase in oil prices and more limited capital flows have added to this difficult picture.

2. The authorities’ gradual policy measures have not been enough to stabilize the economy. While some adjustment policies were adopted since the start of 2018, these fell short of the comprehensive reforms needed to ensure macroeconomic stability. Despite some exchange rate depreciation and significant monetary policy tightening, sizeable foreign exchange interventions continued through April 2019. Similarly, fiscal slippages in the first half of the fiscal year have been significant despite the adoption of two budget amendments. Finally, increases in power and gas tariffs have not been sufficient to stem the accumulation of quasi-fiscal losses. Sizable short-term financing from bilateral creditors provided critical financing relief, but also deferred the urgency to tackle the underlying problems while increasing the maturing debt obligations due in coming years.

3. On the back of weakening confidence, economic activity has slowed considerably, and inflation accelerated. High-frequency indicators, including the large-scale manufacturing index, domestic cement dispatches, and motor vehicle sales, have continued to deteriorate, confirming a marked slowdown in economic activity. In addition, agriculture, including cotton production, has been impacted by water shortages, while public investment and construction have contracted owing to cuts in government development spending. Growth is estimated to decline to 3.3 percent this year, from 5.5 percent a year ago, as policy uncertainty and limited financing heavily weigh on confidence and investment. Consumer inflation has accelerated to a near five-year high of 9.1 percent in May 2019, more than doubling from 4.2 percent a year ago. It is expected to remain elevated in FY 2019, reflecting the pass-through from the recent exchange rate devaluations, power and gas tariff increases and an ongoing food price normalization.

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Key High Frequency Indicators

(y-o-y percent change; 3-month moving average)

Citation: IMF Staff Country Reports 2019, 212; 10.5089/9781498324496.002.A001

Source: State Bank of Pakistan, Pakistan Bureau of Statistics, All Pakistan Cement Manufacturer Association, and IMF staff calculations.
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Contribution to CPI Inflation

(In y-o-y precent change)

Citation: IMF Staff Country Reports 2019, 212; 10.5089/9781498324496.002.A001

Sources: SBP; and IMF staff calculations.

4. Fiscal imbalances have continued to build. Despite the adoption of two supplementary budgets, the overall fiscal deficit (excluding grants) is expected to widen to over 7 percent of GDP against a budget target of 5.1 percent in FY 2019. This deterioration is largely driven by a significant revenue shortfall, equivalent to 1.4 percent of GDP relative to the budget target, and is mainly the result of the three-fold increase of personal income tax thresholds, stalled collection of withholding taxes on mobile services due to Court decisions, losses from Petroleum Development Levy (PDL) and sales tax on petroleum products, and weaker domestic demand. The tax to GDP ratio is estimated to have declined to below 13 percent of GDP, among the lowest in the region. Weak revenue collection also impacted provincial surpluses, expected to be 0.5 percentage point lower than envisaged in the budget. Expenditures also increased somewhat, despite the cuts in Public Sector Development Program, reflecting higher interest payments, subsidies, and defense related spending. Borrowing from the State Bank of Pakistan has financed a large part of the deficit.

5. Quasi-fiscal losses increased further and represent a significant fiscal risk. Following several years of steady decline in the flow of circular debt1 in the power sector, new arrears were accumulated over FYs 2018 and 2019, reaching close to PRs 800 billion (around 2 percent of GDP). Delays in adjusting tariffs, reversal of policies—such as revenue-based load shedding—and the nonpayment of implicit subsidies by the government2 have been the main contributors to the increase in arrears. As a result, the stock of circular debt stood at over 4 percent of GDP as of March 2019. Moreover, arrears in the gas sector have now emerged, with the stock totaling over ½ percent of GDP, coming mostly from delays in tariff notifications and increasing technical losses. Beyond the energy sector, losses in the three largest State-Owned Enterprises (Pakistani International Airlines, Pakistan Steel Mills, and Pakistan Railways) have continued to accumulate, now totaling over 2 percent of GDP.

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SOEs Losses and Government Guarantees

(Percent of GDP)

Citation: IMF Staff Country Reports 2019, 212; 10.5089/9781498324496.002.A001

* FY19 or latest data available. Includes PIA, PSM, Railways, and DISCOS.

6. The external position remains fragile and substantially weaker than suggested by fundamentals (Box1). Although the current account deficit has narrowed in recent months reflecting the exchange rate depreciation (19 percent in real effective terms in FY 2019) and tightening of monetary policy by a cumulative 650 bps, it is still expected to remain large at around $13 billion in FY 2019 (4½ percent of GDP) due to higher oil imports and tepid export growth. The SBP continued with significant foreign exchange interventions, and gross reserves stood at $8 billion (1.7 months of imports or around 30 percent of the APIA metric) at end-May, notwithstanding large financing from Saudi Arabia and UAE ($8.2 billion in total; $5 billion already disbursed) and China ($2.2 billion disbursed).3

uA01fig04

International Reserves and Exchange Rate

Citation: IMF Staff Country Reports 2019, 212; 10.5089/9781498324496.002.A001

Source: State Bank of Pakistan.

7. The banking sector has been broadly stable, but increasingly reluctant to provide credit to the government. Amid sustainability concerns, banks have been demanding very short maturities, accentuating the government’s difficulty to finance its large deficit and roll over maturing domestic debt. Although the banking sector remains broadly stable, vulnerabilities have emerged. System-wide capital adequacy (16.1 percent in March 2019) remains well above the regulatory minimum, but there are five instances of small banks violating the minimum absolute capital and/or minimum capital adequacy ratio. Nonperforming loans (NPL) declined to 8.2 percent by March 2019 (from 8.3 percent a year ago) reflecting still strong private credit growth (16.1 percent yoy in March 2019), though NPLs in the SME sector and agriculture remain high (15 and 17 percent, respectively).

8. Pakistan lags regional peers on inclusive growth and social conditions (Table 11). While the unemployment is less than 6 percent, participation is low (around 30 percent) and informality remains high at over 70 percent of all economic activity. While declining, poverty remains high, at around 30 percent of the population. Moreover, literacy rates remain low relative to peers (60 percent vs. 80 percent), especially among women. Finally, Pakistan must also grapple with the demographic challenges from a population boom, with 2/3 of the population under the age of 30, underscoring the need for improved education and job creation.

Table 1.

Pakistan: Selected Economic Indicators, Program Scenario, 2014/15–2019/20 1/

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

Fiscal year ends June 30.

Including changes in inventories.

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

Excludes one-off transactions, including asset sales.

Table 2.

Pakistan: Medium-Term Macroeconomic Framework, Program Scenario, 2016/17– 2023/24

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Sources: Pakistani authorities; and IMF 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.

Excludes one-off transactions, including asset sales.

Table 3.

Pakistan: Balance of Payments, Program Scenario, 2016/17–2023/24

(In millions of U.S. dollars, unless otherwise indicated)

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

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

Excluding foreign currency deposits held with the State Bank of Pakistan (cash reserve requirements) and gold.

Table 3a.

Pakistan: Gross Financing Requirements and Sources, Program Scenario 2017/18–2023/24

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

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

Includes banks and non-bank private sector.

Includes privatization receipts.

Includes equity and debt portfolio inflows, and borrowing by banks and other sectors.

Includes syndicated loans and Euro bonds.

Includes capital account, financial derivatives, errors and omissions.

Table 4a.

Pakistan: General Government Budget, Program Scenario, 2016/17–2023/24

(In billions of Pakistani rupees)

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

Additional spending on security and internally-displaced people is recorded under transfers (“grants”) instead of development

Excludes one-off transactions, including asset sales.

Table 4b.

Pakistan: General Government Budget, Program Scenario 2016/17–2023/24

(In percent of GDP, unless otherwise indicated)

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

Additional spending on security and internally-displaced people is recorded under transfers (“grants”) instead of development expenditure as reported in the original FY2015/16 budget.

Excludes one-off transactions, including asset sales.