RESOURCE CONSTRAINTS TO BITE
June 13 - 19, 2011
External financing has slowed down sharply as international financial institutions (IFIs) including the IMF have suspended disbursements on a sharp build-up of debt and the slow pace of reform.
Domestic financing is available but at appreciably higher costs: the government currently pays 13.76 per cent for its 6-month paper, compared with 12.3 per cent in June 2010.
The budget outlines measures to limit the fiscal deficit to 4 per cent of GDP, from an estimated 5.7 per cent of GDP in FY11. This is to be achieved through a reduction in food and energy subsidies and measures to raise tax revenue. Real GDP growth is targeted to pick up to 4.2 per cent YoY in FY12, from 2.4 per cent in FY11, as the economy recovers from last year's devastating floods and there is a 58 per cent increase in government investment spending. Inflation is targeted to come down to 12 per cent in FY12, from 14.5 per cent in FY11, on reduced money creation by the central bank for deficit financing, a cut in the sales tax (GST) rate to 16 per cent, from 17 per cent, and the removal of special excise duty.
However, the government's record on budget targets inspires little confidence: in the last four years every tax and spending target has been missed. A closer look at the FY12 budget measures indicates that there is a real risk that the targets will be missed once again in FY12, with the fiscal deficit likely to stay high at 5 per cent of GDP. While the tax collection target of 9.3 per cent of GDP in FY12 is very ambitious, it is not backed up by measures needed to boost revenues. A cutback in subsidies through a 12 per cent hike in power tariffs will be a difficult for the government.
Bank borrowing is likely to increase to Rs550 billion in FY12, against the budget target of Rs304 billion. Markets will demand a higher premium for the purchase of government debt, as banks already hold Rs2.1 trillion of government debt, against the stipulated regulatory reserve requirement of Rs980 billion. The higher supply of debt and higher risk premium should hold rates firm.
AMBITIOUS GROWTH TARGET
The government targets 4.2 per cent growth in FY12, from 2.4 per cent in FY11. Higher reconstruction spending in flood-affected areas and higher investment spending in the energy and transport infrastructure will accelerate growth. In the FY12 budget, the government has outlined plans to increase its investment spending by 58 per cent YoY to Rs730 billion (4 per cent of GDP) from Rs462 billion (2.7 per cent of GDP) in FY11. The biggest allocation is for the power sector, at Rs90 billion. This has been identified as the key bottleneck to growth, with the power crisis costing the economy the equivalent of 2 per cent of GDP.
The government plans to address the large shortfall between peak demand and supply, currently at a substantial 5,500 MWs, which is more than the total electricity demand of Karachi and Faisalabad combined.
Private investment spending is also targeted to rise in FY12, as the government reduces its borrowing from banks, creating space for banks to lend to the private sector. The government aims to reduce its bank borrowing in FY12 to Rs304 billion, nearly half of Rs633 billion borrowed in FY11. Private investment spending has been crowded out in the last four years as heavy government borrowing has kept lending rates high, declining sharply from 15.4 per cent of GDP in FY07 to 8.5 per cent of GDP by FY11.
The government targets a reduction in inflation to 12 per cent in FY12, from 14.5 per cent in FY11. This is to be achieved through reduction in the sales tax (GST) rate to 16 per cent, from 17 per cent earlier, and commitment to stop printing money for deficit financing. Inflation has remained high in the last four years, as the government has printed a record amount of money to finance its large deficit. This has fuelled inflation through money-supply growth, at 15.5 per cent in May 2011, up from 13.5 per cent last year.
However, a sharp reduction in subsidies will add to inflationary pressures in the short term. In the FY12 budget, the government aims to reduce subsidies to 0.8 per cent of GDP, from 2.2 per cent of GDP in FY11. The biggest component is the power-sector subsidies, estimated at 1.9 per cent of GDP in FY11. The government aims to raise power tariffs by 20 per cent in FY12 to reduce power subsidies to 0.24 per cent of GDP. The need for subsidies arises from an inefficient energy transmission network, with line losses of close to 30 per cent and rising energy-generation costs.
Power tariffs have been raised by over 100 per cent in the last three years, but growing line losses and rising oil prices have hampered government efforts to rein in subsidies.
Similarly, food subsidies on the procurement, import and sale of essential food items has been slashed as the government limits its intervention in the markets. This is positive, as government intervention has created distortions in the market, whereas the private sector is much more efficient and can improve the agriculture and food market supply chains, helping to bring food prices into line with international markets. However, in the short term, the removal of subsidies and higher taxes on agricultural inputs is likely to lead to an increase in the prices of sugar, wheat and rice.
The deficit target is based on ambitious revenue targets and the premise that the provinces will generate a surplus of 0.5 per cent of GDP in FY12, based on a higher share in the revenue pool as agreed under the 2010 National Finance Commission award. In FY11, the government budgeted for a provincial surplus of 1 per cent of GDP but ended up with a deficit. The same is likely to happen in FY12, with provincial governments keen to spend ahead of the parliamentary elections due in early 2013.
Military spending is budgeted at 2.3 per cent of GDP in FY12, down from 2.5 per cent of GDP in FY11, but could potentially rise if the army launches operations against militants in the border regions with Afghanistan.
AMBITIOUS TAX TARGETS
The focus of the FY12 budget is on tax measures, as total tax revenues declined to 9.8 per cent of GDP in FY11 from 10.2 per cent in FY10, with Pakistan having one of the lowest tax-to-GDP ratios in the world. The reform agenda outlined by the government in the budget aims to simplify the tax structure and broaden the tax base, in line with the recommendations of the World Bank's tax policy report. However, some of the more ambitious measures discussed prior to the budget, including a tax on agricultural income and a wealth tax, have not been included.
The floor on income tax has been raised: individuals with income of Rs350,000 and below are exempt from income tax, from Rs300,000 in FY11. These measures will result in significant revenue loss and the government's revenue target of 9.3 per cent of GDP looks highly unlikely to materialize.
SUPPLY PRESSURE TO CONTINUE
The government is seeking to reduce its FY12 borrowing from banks to Rs304 billion (1.4 per cent of GDP), from Rs633 billion (3.5 per cent of GDP) in FY11. However, there is a real risk that bank borrowing will be significantly higher due to a higher-than-targeted fiscal deficit and lower-than-targeted external financing. External financing has slowed sharply as IFIs, including the IMF, have suspended disbursements on the sharp debt build-up and slow pace of reforms. The IFIs will not release money unless they see tangible progress on reforms outlined in the FY12 budget.
In this scenario, the government's estimates that it will raise US$3.3 billion (1.4 per cent of GDP) in loans from IFIs look highly unlikely. Program loans of US$1.4 billion for budgetary support in FY12 are particularly at risk; the government received only US$450 million in FY11.
Hopes of early disbursement of US aid money have evaporated with the capture and death of Osama bin Laden a few miles from the capital city. The intelligence failure of security forces and the unilateral action taken by US forces have increased mistrust between the two allies. Unless relations improve significantly the money is unlikely to be released. The government has budgeted US$400 million under the Kerry Lugar Bill in FY12; last year it received only US$179 million. Similarly, US$800 million is earmarked in privatization receipts. No privatization has taken place since 2007 and it seems highly unlikely that the government will be able to push through the privatization of state-owned enterprises at this stage.
In the first 11 months of FY11, the government borrowed Rs633 billion (3.5 per cent of GDP) from the banking sector for deficit financing purposes, including Rs480 billion from commercial banks and Rs153 billion money printed from the central bank. Banks' appetite for holding government paper is limited; they already hold Rs2.1 trillion of government debt against the stipulated regulatory reserve requirement of Rs980 billion. Hence, markets will demand a higher premium to purchase government debt and rates should remain firm.
The writer is an Economist at Standard Chartered.