Dec 28, 2009 - Jan 03, 20

Pakistan had enjoyed a relatively robust economic performance until the economic crisis broke out in 2008. Warning signs emerged in 2007 and early 2008, as inflation began to rise and external imbalances arose, though growth remained strong. Conditions worsened significantly in mid-2008 with the sharp increase in international food and fuel prices and the deterioration in the security situation.

Growing fiscal deficits, due in large part to energy subsidies, were financed by the State Bank through money supply. As a result, inflation reached as much as to 25 percent points by mid-2008, the rupee aggressively depreciated, and foreign currency reserves fell sharply. The high rate of inflation was particularly harmful to vast majority of people. Events urgently needed to be brought under control.

By the end of 2008, Pakistan approached IMF for financial support of nearly US$7.6 billion under a 23 month SBA. Again in August 2009, IMF raised the financial package to US$11.3 billion so as to address the increased risks and financing needs. Moreover the program was extended to 25 months.

IMF has recently declared that the program got off to a good start and Pakistan's economy has continued to stabilize. Macroeconomic imbalances have shrunk and inflation has fallen. The exchange rate has stabilized and foreign currency reserves have increased from $3.3 billion in November 08 (before the SBA approval) to over $13 billion in November 2009.

Over this period, demand for treasury bills has increased in response to an initial rise in interest rates by 200 basis points, allowing the government to retire some of its debt to the State Bank. State Bank is lowering the policy interest rates because of improvements in economic and financial situation.

Pakistan, a fragile economy, has been facing both economic and political crisis which predate the global financial crisis. Inflation, trade deficit, balance of payment, foreign exchange reserves, circular debt, poor performance of the banking sector and Karachi Stock Exchange and political instability have remained the key indicators of Pakistan's economic crisis. Political and economic stability complement each other. Pakistan is an interesting case since both are in crisis. The war on terror has become a hanging sword overhead-the rate of suicide bombing is sprouting alarmingly.

GDP growth rate is a significant indicator to assess the health of an economy; it has deteriorated since 2004-05 from 9.0% to 2.0% in 2008-09. Government of Pakistan spends approximately $26 billion per year based on the expected revenues of approximately $20 billion incurring a huge budget deficit. Last year it suffered huge Balance of Payment (BOP) crisis when the entire donor community was also going through financial collapse. IMF aided with $7.6 billion and with the first tranche of $3.1 billion Pakistan foreign reserve rose from $ 6 billion to $ 9 billion.

There has been 2.6 percent negative growth of exports, declining from $ 16.4 billion last year to $16.0 billion in July-April 2008-09. Imports also showed a negative growth of 9.8 percent in July-April 2009. Imports stood at $26.77 billion as against $28.715 billion in the comparable period of last year.

Continuous increase in the import bills due to higher oil prices has increased the current account deficit which significantly depleted the foreign exchange reserves thus enhanced the country's default risk. Given the unsafe investment climate and security situation the foreign direct investment inflows also fell more than 20 percent in calendar year 2009. Pakistan's total external debt is also increasing with the appreciation of dollar and continuous relying on the foreign debt. The national savings are also on decline.

The core inflation which represents the rate of increase in cost of goods and services excluding food and energy prices also went up to 18.0 percent and for a brief period it even crossed 20 percent.

Pakistan's local banking sector has shown resilience to the weak macroeconomic environment even though it experienced a decline in deposits. Circular debt is another critical issue which is still a potential indicator of the economic problem.

Government of Pakistan is unable to pay billions of rupees to Oil Marketing Companies (OMCs) and Independent Power Producers (IPPs). The long hour power failures have not only affected the common people, but also shut down many businesses.

There are no doubts that 2008 global financial crisis has not affected Pakistan with a huge blow though the government claimed entirely different. The country has seen some of the worst situations but survived. How can an economy survive or even flourish while continuously being hit by the corruption, short term policies and political instability? In all fairness, if the Pakistan wants to grow, it must have to show seriousness to address the problems with strict time lines.

In order to avoid a major economic crisis, Pakistan government should solve two top problems; war on terror, and heavy debt burden.

War on terror cost Pakistan more than $6 billion economic losses during 2007-08 and $10 billion losses alone in 2008-09. In July 2009, Shah Mahmood Qureshi, Foreign Minister of Pakistan claimed that the war on terror thus far cost Pakistan more than $35 billion. The insurgency resulted in massive capital outflow to Middle East. Every one is paying a heavy price for this trouble and instability. Government is trying to eliminate terrorism, military operation in Swat and Waziristan is part of those efforts. We need to re-assess our plans and strategies. We must overhaul our diplomatic front and make a very strong case on the basis of this to get aid, grant in the shape of investment and access to their foreign markets for Pakistani goods. It is difficult to fight against terrorism unless Pakistan eliminates Taliban's financial channel. Therefore, it is required to strictly control and monitor the financial flows sponsoring these activities.

Circular debt problem increased, and is seriously impacting the operations of Pakistan's whole energy value chain. Current account deficits, getting new loans to pay old debts, defense expenditure and non developmental expenditures have pushed the country to economic crisis. As per recent transparency international's report, Pakistan lost almost $10 billion on tax evasion in 2008. If there is improvement in tax collection, it will greatly offset the national debt and deficit.

For past few years, Pakistan is facing unprecedented energy crisis. There is a shortage of about 3,500 megawatt in electric power. The energy consumption of Pakistan's per capita is only 15 MMBtu, according to the Energy Year Book issued by Hydrocarbon Institute of Pakistan, as compared to the world average of 68 MMBtu. It is essential for Pakistan to increase its per capita energy availability and consumption to at least 50 percent of the world level to about 35 MMBtu in the medium term (2012- 2020). To meet the growing demand of energy and the target of 9700 MW generation by the year 2030, the government should speed up work on alternative sources of energy which are (i) Mega Wind Power Projects, (ii) Bio-diesel, (iii) Biogas, and (iv) Small Hydro projects.

The government needs to focus on green energy initiatives and energy saving technologies. It should hold itself accountable in making payments to IPPs, and encourage solar energy panels for houses and businesses.

The current account deficit narrowed beyond the set target of 5.9 percent of GDP to 5.1 percent of GDP in 2008/09 driven by deceleration in imports which exceeded that of exports, and growing workers' remittances. Exports contracted by 6 percent as external demand declined owing to the global recession. Imports in turn declined over 10 percent as international oil and commodity prices sharply fell, rupee depreciated and aggregate domestic demand contracted.

The narrowing of the current account deficit continued during the first two months of 2009/10. Exports continued contracting at 19 percent which was sharper than anticipated, but imports decreased even more, by 23 percent. Strong remittance inflows continued, with about 25 percent year-on-year growth. While remittances increased, financial inflows dropped sharply in 2008/09 over 37 percent owing to macroeconomic instability, deteriorating security situation and global recession.

Net foreign direct investment declined to approximately US$3.7 billion, and there was a net outflow of US$1.1 billion in foreign portfolio investment during 2008/09. However, net capital inflows started recovering during the first two months of 2009/10.

Workers' remittances continued growing for the fifth consecutive year in 2008/09, and registered 21 percent growth during 2008/09. Given global economic recession, this strong growth was somewhat surprising. One option is that these inflows reflected past savings of migrants which they brought back as they returned to Pakistan. If true, sustainability of the current account would be at risk.

FBR tax collection during July-August 2009 increased only 3.6 percent. While direct and sales taxes grew 2.9 percent and 9.7 percent, respectively, excise and custom duties collection contracted 4.3 and 14 percent, respectively, compared to the corresponding period last year.

In light of the shortfall in revenues, the federal government is attempting to reduce the fiscal deficit in 2009-10 by reducing spending, but its attempts are thwarted. First, as power shortages increase, the government greatly dilutes increases in power tariffs for political reasons. As a result, power subsidies remain high. Second, large overruns in provincial development expenditures compromise federal efforts. While federal development spends are below the target, provincial development expenditures exceed the target.

Most of the additional expenditures at the provincial level are financed by borrowing from the banking system, mainly from the State Bank of Pakistan, which unchained adverse implications for money supply and inflation. Developments in 2009-10 suggest that these worrisome trends continue. First, continued government inaction on power tariffs implies that electricity subsidies will remain high in 2009-10. Second, the subsidy bill is increasing significantly at the provincial level, as Sindh has followed Punjab in launching a provincial income support program. In addition, Punjab has doubled its wheat procurement target, implying a large increase in wheat subsidy. Moreover, large subsidies are allocated to the provision of wheat and wheat flour to poorer segments of the society at substantially reduced rates.

Similarly, subsidies are being provided both at federal and provincial level for agricultural tractors and fertilizers. Finally, the federal scheme of providing loans to people for starting small business is also likely to have a significant impact on the fiscal situation.

Progress with structural reforms has been mixed, with progress in key areas lackluster. On the positive side, the automatic fuel price adjustment mechanism, which was re-introduced in early 2009, has been operating and domestic prices of fuel products have been adjusted monthly consistent with the changes in import parity price. Also, the pilot of the Benazir Income Support Program (BISP) with the new targeting instrument-the poverty scorecard-has been introduced and a full rollup of the new targeting methodology is expected to start next, albeit with a substantial delay due to resources constraints.

Steps to strengthen government's debt management have also been taken. However, progress with revenue reforms in the past months, owing to resistance from vested interests and lack of political will, has been weak, as demonstrated by declining tax revenues as a share of GDP.

Reforms to strengthen financial sustainability of the electricity sector have stalled. The authorities committed to raise electricity tariffs and introduce monthly and quarterly tariff adjustment mechanisms so as to eliminate tariff differential subsidies by end-June 2009. However, the government failed to follow through on this commitment. The authorities recommitted in July 2009 to a tariff adjustment schedule and to the introduction of automatic tariff adjustment mechanisms with a view to eliminating tariff differential subsidies by July 2010. But the implementation of the agreed measures has so far failed again.

While substantial steps were taken to establish a Treasury Single Account (TSA) in early 2009, since then the authorities have made limited progress to complete the transition. One of the key remaining steps would be to transfer the balances held by various government ministries and agencies in commercial banks (amounting to about US$10 billion) to TSA and then close those accounts. However, owing to strong vested interests, progress on this area has also stalled for the time being.

While the economy has started to stabilize, the macroeconomic situation remains fragile and the medium-term outlook uncertain. As mentioned above, progress with the implementation of reforms has been uneven, with inadequate measures taken to boost revenue mobilization and control spending. Also, while the acute phase of the global financial crisis seems to be ending, global recovery will be gradual and take time. Thus the downside risks remain significant, and the fiscal year 2009/10 looks difficult.

Pakistan's real GDP growth is projected to start slow recovery in 2009-10, and increase gradually from 3.0 percent in 2009/10 to 5.0 percent by 2012/13. Aided by increasing public investment-planned among other things in power and transport-gross capital formation is projected to rise and contribute to growth recovery and facilitate private sector activity gradually over time.

Agriculture and services are showing good growth prospects, while manufacturing is still contracting and expected to recover only slowly over time as the domestic aggregate demand picks up and the availability of power improves as a result of planned investments in power generation. Exports are projected to continue contracting in 2009/10. Thereafter, with the global recovery, exports are projected to improve gradually and reduce Pakistan's external vulnerability over time. However, longer-term projections are particularly uncertain in view of the volatile global and domestic economic environment.

Stabilization efforts together with a decline in international commodity prices have succeeded in reducing external imbalances, rebuilding foreign exchange reserves, and lowering inflation. However, owing to global economic recession, there are significant risks to exports, remittances and external financing. Also, there are significant risks to the fiscal framework. This highlights the need for a rigorous implementation of reforms. Stringent implementation of the economic program will be critical to success, and timely responses of fiscal and monetary authorities to emerging risks will be essential to ensure that it remains on track.