June 25 - July 1, 20

If one looks objectively at Pakistan's economy, it is clear that the system is facing serious challenges. The list is familiar: fiscal pressures that require an increasing volume of domestic financing; an energy shortage that entails economic and social costs; low investment that is undermining future growth; law and order issues; and the war in the neighboring Afghanistan.

The report on state of economy of the State Bank of Pakistan (SBP) on third quarter of the financial year 2012 said that at the risk of making too fine a point on the matter, Pakistan's economic data appear to suggest two things: first, that Pakistan has fallen behind its neighbors in South Asia; and two, even this below-potential growth is quite impressive when seen in the context of the challenges mentioned above.

There is a growing sense that Pakistan's undocumented economy is vibrant, and that official data understate the level of economic activity that can be seen. In effect, there seems to be a disconnect.

This disconnect becomes more obvious when one observes the economic plight of EU countries, which are barely able to contain the debt crisis fallouts that could threaten the very existence of the Euro. Since countries like Greece, the UK, and Spain are now officially in recession, the telltale signs of a recession are worth noting.

'The economic growth of 3.7 per cent during FY12 is higher than the three per cent realized in the previous year, but less than the target of 4.2 per cent. Nevertheless, this performance is notable, given the considerable damage to the cotton crop due to floods in August 2011, ongoing energy shortages, the rise in international oil prices, and security concerns,' the SBP said in its report.

This growth has also been more broad-based with a larger contribution from the commodity producing sectors compared to FY11.

Moreover, as in the past, growth has been driven by domestic consumption (both private and public), which was partially offset by a decline in domestic investment and external demand, the report said and added that the continuous decline in investment since the macro instability in 2008, is a source of growing concern as it will stifle the long term growth of the economy.

It observed that although Pakistan's economy has shown some recovery in terms of GDP growth, the key macro indicators still remain weak. Persistent inflation and pressure on the fiscal and current accounts remain the key challenges for the economy, it added.

While low investment and energy shortages have direct growth implications, the persistently high fiscal deficit remains a major risk to the macro-economy. Current information suggests a budget deficit of 4.3 per cent of GDP for Jul-Mar FY12, and it appears that the budgetary gap for the full year will exceed the revised target of 4.7 per cent, it said, adding that overall revenues are lower than expected.

Though the growth in current expenditure is lower compared to the previous year, the government has enhanced its development spending, it said and added: 'While such spending should improve the country's long-term growth prospects, this also creates financing pressures.'

At the same time, despite efforts to reform public sector enterprises (PSEs), the operational efficiency of key PSEs has not improved, it said adding that this continues to add to the country's fiscal burden. The report said that in terms of financing this gap, the government relied more on domestic sources as external financing dried up. The government borrowed Rs847.5 billion in Jul-Mar FY12 from domestic sources compared to Rs700.1 billion in the corresponding period of FY11, it said and added that lately this has been increasingly skewed towards borrowing from the central bank.

Such borrowing is inflationary and a risk to macro-stability. Currently, two Acts - namely the Fiscal Responsibility and Debt Limitation (FRDL) Act (2005) and the newly amended SBP Act - provide guidelines on overall debt stocks and borrowing from the central bank, respectively, the report said.

The large fiscal deficit has resulted in a sharp increase in Pakistan's debt. The report said that government domestic debt recorded an increase of Rs1.2 trillion during Jul-Mar 2012 to reach Rs7.2 trillion. There is greater reliance on short-term borrowing, which is creating liquidity management problems for the central bank, and rollover and interest rate risks for the government, it added.

With the government's growing appetite for funding, banks have little incentive to finance the private sector. At the same time, demand for private sector credit is likely to be dampened this year, as loans to private businesses increased by only 1.8 per cent in Jul-Mar FY12 - the lowest growth rate in the past 10 years, it said, adding that the slowdown is concentrated in working capital and trade financing. 'However, there are indications that fixed investment loans have bottomed out,' it added.

Developments in third quarter of the fiscal 2012 in external sector were less adverse than we had expected, the SBP report said, adding that larger inflows of remittances and a lower trade deficit, explain this relative improvement.

The current account deficit during Jul-Mar FY12 was $3.1 billion, compared to a deficit of $10 million in the corresponding period last year, it said, adding that more importantly the expected inflows under coalition support fund (CSF), the auction of 3G licenses, and arrears from PTCL privatization did not materialize during the quarter.

While these challenges will continue to shape the outlook for the economy, it is important that GDP data should reflect the changing nature and composition of the country's economic activities, the report said, and added that Pakistan Bureau of Statistics (PBS) is already in the process of rebasing the national income accounts.

'We expect that PBS would also consider releasing GDP estimates on a quarterly basis, which is now a norm in emerging markets. It will help to get a more accurate and timely picture of the real economy, which will allow for more proactive policy corrections.