The outlook is facing increased uncertainty. In this global context, Pakistan’s economy continues to expand while vulnerabilities mount. Agriculture, industry and services supported GDP growth from the supply side. Consumption continues to drive growth, while investment demand remains sluggish. Accumulating macro imbalances point to vulnerabilities on the external front as well as on the fiscal front with implications on debt levels. Inflation remained within target, with the State Bank of Pakistan (SBP) tightening monetary policy in H2FY18. GDP growth is expected to decelerate in FY19. Structural reforms are needed for long term growth. A sustainable fiscal policy over the medium term requires a credible fiscal consolidation plan today. Allowing exchange rate flexibility will help create a buffer and reduce vulnerability to external shocks. Structural reforms conducive to better integration in the global economy are needed for increased productivity and resilience.
Global growth is expected to decelerate over the next two years, after reaching 3.1 percent in 2018. As the global sluggishness has dissipated and commodity prices have stabilized, major central banks have conduct contractionary monetary policies. Increase in interest rates leading to a rising US dollar is likely to dry up the liquidity that had been flowing to emerging markets in recent years, thus increasing rollover risks on foreign-currency denominated debt. Furthermore, trade tensions between the United States and China could add stress to emerging markets. By increasing uncertainty, these tensions could lead to a reduction in global investment demand and a re-shuffling of existing global value chains, with implications not only for trade flows but also for foreign direct investment (FDI).
Economic performance in Pakistan remains robust, with GDP growth in FY18 at 5.8 percent—its highest level in 11 years. While inflation remained below target, imbalances on the fiscal and external fronts mounted, increasing vulnerabilities that could compromise future growth. The fiscal deficit continued to expand on the back of weak revenue growth and large increases in recurrent spending. This, coupled with a large current account deficit (CAD), on the back of the largest trade deficit registered in Pakistan’s history, has accentuated the country’s vulnerabilities. Energy sector arrears have also been accumulating, as well as fiscal contingencies, due to investment guarantees mainly associated with projects for the China-Pakistan Economic Corridor (CPEC). Taken together, these imbalances imply increased risk and liabilities.
Growing macroeconomic imbalances have dampened the growth outlook. GDP growth is projected to decelerate in FY19 due to contractions in private and public consumption, as the authorities tighten fiscal policy and adjust other policy levers to correct the imbalances. Services, the main driver of growth in recent years, will lead this deceleration, albeit continuing to grow, but more in line with growth rates seen in the industry and agriculture sectors.
Immediate policy adjustments, entailing fiscal consolidation and increased exchange rate flexibility, are needed to restore and maintain macroeconomic stability. Renewed efforts are essential to advance medium-term structural reforms to shift the growth model away from being consumption-led to one led by investment and productivity.
The fiscal consolidation measures announced in the mini-budget are a step in the right direction toward short-term adjustments. However, for the fiscal consolidation path to be sustainable, additional interventions will be needed in the areas of tax administration and tax policy; fiscal decentralization; the legislative framework governing public finance; and measures to improve spending efficiency. With lower fiscal deficits, the private sector will have greater access to market borrowing for productive investments than it currently enjoys. To ensure these opportunities can be tapped into, innovative approaches may be needed to leverage private sector funds to maximize financing for development.
The context of increasing external financing requirements, rising interest rates and tighter global liquidity poses challenges, given that diminished reserves and elevated debt ratios have reduced Pakistan’s ability to withstand external shocks. The recent depreciation of the Pakistani rupee that resulted in an acceleration of exports and a deceleration of imports toward the second half of FY18 showed the importance of exchange-rate flexibility to rebalance the external accounts. The depreciation of the Pakistani rupee has helped to switch expenditure away from foreign goods and toward domestic goods, and could partially offset the dampening effect of fiscal consolidation on domestic demand. At the same time, the depreciation of the Pakistani rupee has increased the value of Pakistan’s portion of debt liabilities denominated in foreign currencies, and put upward pressure on inflation, mainly through increases in the prices of tradable goods.
Integration into the global economy provides opportunities for Pakistani firms to increase productivity—the fundamental driver of growth. However, on the export front, Pakistan has still to tap into the potential of greater integration. Despite the most recent export growth, the past decade’s export performance reflects the worsening competitiveness of Pakistan’s economy, particularly compared with the export performance of peer countries. High customs duties shelter Pakistani firms from competition, discouraging them from venturing into export markets. Also, recent increases in regulatory duties increase the costs of accessing key intermediates from abroad. On the investment front, a poor business environment, evidenced by Pakistan’s performance in international rankings such as the World Bank’s Doing Business indicators, affects private investment and discourages FDI inflows. In this area, reform efforts should be led from the Prime Minister’s office and supported by a coordinated federation effort.