Pakistan Economy

An Overview, Prospects and Summary

Overview: Contrary to earlier fears, Pakistan's economy performed reasonably well in FY02. In particular, the tremendous improvement in Pakistan's external sector post-September 2001, either directly or indirectly, contributed to positive developments for many macroeconomic indicators during the year. The trade deficit turned out to be much lower than in FY01 as exports recovered in the second half of FY02 to reach the preceding year's level, while imports dropped; the current account was in surplus and underpinned the unprecedented 6.7 percent appreciation of the Rupee. An upsurge in workers' remittances, increased official transfers and savings in interest payments allowed the SBP to increase foreign exchange reserves to an all-time high; the Rupee liquidity injected through the foreign exchange purchases enabled the SBP to ease its monetary policy stance; inflation was down to 3.5 percent as the appreciating Rupee lowered the cost of imported inputs; external debt restructuring and lower interest rates on domestic debt led to a reduction in debt servicing, thereby aiding the Government's effort to contain the fiscal deficit. Still, there were several negative repercussions of the September 11 events on the domestic economy; there was a lower collection of tax revenues as the tax base was eroded due to a reduced level of imports in Rupee terms; the export target of US$ 10 billion could not be achieved, foreign investors remained hesitant in making new commitments; and the law-and-order situation became difficult as action was taken against terrorist groups.

While acknowledging the salutary impact of the external account improvement, however, it is worth stressing that the trend improvement was visible well before the seminal September 11 events. Interest rates were already on the way down; foreign currency reserves were edging up; the exchange rate was relatively stable; the inflation downtrend was well defined, and the government's continuing fiscal discipline and commitment to reforms had already set the stage for the IMF PRGF, and the subsequent re-profiling of external debt. Nonetheless, the pre-existing positive trends did gain invaluable momentum in FY02, post-September 11. However, despite these major positives, the economy was not unscathed in FY02.

Real GDP grew by a reasonable 3.6 percent, but the increase was concentrated in fewer sub-sectors. A third successive year of water shortages took its toll, as major crops recorded another decline. The overall 1.4 percent agricultural growth thus owed almost entirely to yet another impressive performance by the livestock sub-sector. The manufacturing sector presented, under the circumstances, a more creditable performance. Even though the 4.4 percent FY02 growth was considerably weaker than the 7.6 percent increase recorded in FY01, it must be remembered that the economic environment was shrouded in uncertainties through much of FY02, first due to the conflict in Afghanistan and then due to border tensions with India. While some sectors targeting the local economy (electronics, car manufacturers, sugar, etc.) performed reasonably well through most of the year, it was the increased access to key Western markets and a substantial decline in interest rates that catalyzed the textile sector recovery late in H2-FY02. As a result, it was the services sector that dominated the FY02 growth profile with a 5.1 percent growth. Yet, it is important to note that, here too, the structure of growth was highly skewed, with a single component, public administration & defense, accounting for a major portion of the total increase in sectoral value added during the year. In other words, while the growth rate recorded some improvement in FY02, the quality of growth retrained lackluster and shallow as the spread and spillovers to the rest of the economy remained highly limited. Thus the buoyancy and briskness in economic activity was not observed.

Table 1: Selected Macroeconomic Indicators

Focusing on the external account improvement, there were clearly some one-off inflows into the current account in FY02 that are unlikely to recur in future. The US$ 600 million grant from the US, the payments for logistics support provided to the US troops, and other bilateral grants, fall under this category and should be excluded in determining the trend of current account inflows.

A look at the external cash flows (see Table:2) depicts more insights on the external account improvement:

Table: 2 External Cash Flow Position

Million US Dollar

(1) While headline figures depict a narrowing is trade deficit to US$ 1.2 billion in FY02 the realized outcome was even better, with a deficit of US$ 360 million only.

(2) The role of exceptional financing is declining. In FY02 a notional inflow of US$ 1.7 billion on account of the Paris Club re-scheduling, was largely offset by maturities of earlier re-scheduled payments (of frozen FE-45 foreign exchange deposits, etc.). This is a positive development for Pakistan, reflecting that rescheduled loans and higher foreign currency inflows, allowed the termination of more expensive commercial liabilities (see Table: 3).

Table: 3 Commercial, Short-term and Foreign Exchange Liabilities Paid in FY02

Million US $

The striking improvement in the current account, and the massive Rupee liquidity injections resulting from the SBP foreign exchange purchases, also had important implications for the conduct of monetary policy. It may be recalled that a major factor behind the monetary tightening in FY01 was the need to support the Rupee. Thus, as the exchange rate stabilized, the SBP immediately signaled an easing by twice lowering the discount rate in successive months . The subsequent two, post-September, reductions however were aimed more at mitigating the impact of the prevailing uncertainties in the business environment.

Pakistan's debt profile also saw significant changes in FY02 reflecting the country's adherence to the Debt Reduction and Management Strategy (DRMS), as well as a one-off Rs 193 billion stock adjustment of the domestic debt. While the absolute decline in external debt and liabilities (EDL) was a marginal US$ 607 million, the re-profiling of Paris Club debt and the substitution of expensive commercial loans by cheaper IFI credits led to a significant drop in the net present value of outstanding EDL. Similarly, the domestic debt profile too saw a shift to longer tenors amidst a fall in interest rates. This said, it must be stressed that the changes, though welcome, only depict an improvement in the dynamics of Pakistan's debt profile; the country has still a long arduous road to travel before the debt ratios go down to international norms.

Medium-term Prospects

With prospects of a broad economic recovery looking bright, it becomes even more important that the FY02 improvements in the macroeconomic fundamentals not be frittered away. The key policy challenge for the government in FY03 therefore is to stay the course by remaining fully committed in implementing the on-going reform process, irrespective of gains such as the higher availability of external assistance, debt re-profiling, etc.

In particular, it is important to note the possibility (however modest) that the external account improvements could taper off in future; if this development emerges, it could have significant negative repercussions, not least the re-emergence of devaluation expectations and a jump in domestic interest rates. These concerns are particularly colored by the realization that domestic policy only set the enabling environment that allowed the economy to take better advantage of the positive exogenous shocks. It must be remembered that the catalyst (and, at least in part, continuing driver) for the rise in transfer payments into Pakistan was the policies of other countries, especially the international crackdown on informal flows that drove up remittances.

In fact, it is this concern that has led the SBP to opt for a gradual adjustment of its monetary and exchange rate policies despite a substantial improvement in the current account. It must also be noted that an abrupt shift in the exchange rate is not to be desired in any case, as an inadequate adjustment period for exporters could lead to the loss of hard-to-recapture export markets, and a consequent fall in economic activity and higher unemployment. Thus, the gradual adjustment policy is likely to continue. Also, despite a hardening consensus that the increase in foreign exchange in flows is probably sustainable, the SBP intends to guard against the possible re-emergence of the kerb market, by largely subsuming it into the mainstream financial system through the newly introduced exchange companies.

The outlook for inflation does not show any signs of concern despite the growth of monetary aggregates (M2) by 14.8 percent during FY02, well above the nominal growth rate. Most of the growth in M2 originated from the continuing rise in NFA and was substantially sterilized. Consequently, the reserve money growth was contained to 9.6 percent. The large FY02 increase was not too inappropriate in light of the need to support the economy during a period of considerable uncertainty. But, going forward, it will be prudent to limit reserve money growth consistent with the nominal growth rate of the economy, since excessive growth could fuel inflationary pressures. Within this constraint, however, the loose monetary posture could be extended further.

On the fiscal side, the government should see higher net tax receipts due to the impact of the recently introduced Self Assessment Scheme, lower tax refunds, an absence of a further cut in the maximum customs duty rate, and a return to normal imports in FY03. Non-tax revenues too, should see greater stability going forward, as the re-structuring of government-controlled entities (especially WAPDA) should allow them to service their debt.

Over the last few years, revenue shortfalls (by the CBR, in particular) have traditionally resulted in a curtailment of development expenditures. In FY03, however, the government has vowed to substantially increase developmental expenditures, and to insulate this spending from below-target revenues by, (1) incremental revenue measures and (2) reductions in non-development spending. It must be noted that higher development expenditures not only increase immediate aggregate demand, but also have substantial "crowding-in" effects on private investment. For far too long, the low development spending has effectively led to a deterioration of infrastructure, reducing the economy's growth capacity (lowering future government revenues). Thus, in essence, meeting the fiscal deficit targets through low development spending was equivalent to shifting the fiscal deficit to future generations. It is therefore essential that the government's promise be kept.

It is worth noting that the positive developments in the country's economy do not appear to be fully reflected in Pakistan's current sovereign rating, possibly due to the impact of political uncertainties (general elections are scheduled for October 2002). The continuation of current economic polices (as promised by the President) would thus be expected to result in an upward re-rating, attracting greater investments.

In short, if the global economy does not see a major dip, Pakistan appears well placed to meet its economic targets in FY03. In fact, the FY02 developments provide a rare opportunity for Pakistan to accelerate the improvement in the country's economic fundamentals.

Economic Growth, Savings & Investment

Water shortages constrained the growth of the agriculture sector for the second year running. As a result, despite improved management and increased use of tube wells to alleviate the shortages, the major crops saw a marginal decline. However, the impact of the dismal performance of the crops was greatly moderated by the positive momentum of another encouraging performance by the livestock sub-sector. This enabled agriculture to record a positive growth of 1.4 percent for FY02.

The weak performance of the manufacturing sector, especially large-scale manufacturing (LSM) was the major factor behind slower growth in industrial value added. LSM grew by only 4 percent in FY02, much lower than the 8.6 percent growth recorded in FY01; however, this was still commendable given that the business environment through most of FY02 remained uncertain. The performance of the remaining three sub-sectors i.e. mining & quarrying, construction, and electricity & gas distribution, remained subdued.

During FY02, the services sector grew by 5.1 percent, higher than the 4.8 percent seen in FY01 The emergence of the services sector has imparted resilience to the economy, particularly at times when the commodity-producing sector is struggling.

In overall terms, while the 3.6 percent FY02 growth of the economy was reasonably good, it was narrowly based on a few sub-sectors.

With regard to investment, provisional estimates for the FY02 suggest that the pace of investment has not picked up, and the declining trend witnessed over the last decade persists. This is reflected in the 5.9 percent decline in (nominal) gross fixed investment in FY02 against an increase of 7.9 percent last year. As a ratio to GNP, it declined to 12.2 percent from 14.5 percent last year. Although, overall investment fell short of the target, the growth in foreign direct investment is encouraging - it increased to US $ 484.7 million compared to US $ 322.4 million in FY01.

While the share of both the public and the private sector declined, the deceleration in the investment by the public sector was more pronounced. This is reflective of government's budgetary constraints and the increasing emphasis on the role of the private sector. As a result, the share of the private investment in total investment reached 61.5 percent in FY02.

Annual average rates of inflation in terms of all three price indices as well as the GDP deflator went down during FY02 from their levels last year. The rate of inflation in terms of the Consumer Price Index (CPI) came down to 3.5 percent in FY02 from 4.4 percent in the previous year despite the uncertainties following the September 11 events, continued border tensions and persistent drought-like situation in the country. Better availability of essential commodities due to a reasonable production of both food and non-food items, and availability of stocks from previous years had a moderating influence on inflation. The appreciation of the Rupee by 6.7 percent also helped, by reducing the cost of imports.

As the SBP was able to substantially limit the growth of reserve money, it is hoped that inflationary pressure will be contained.

PUBLIC FINANCE AND FISCAL POLICY.

Introduction

In FY02, overall budget deficit swelled to 6.6 percent of GDP, significantly higher than both the budget target as well as that in the previous year. This was largely driven by increased defense spending (Rs.17.4 billion), and three one-off expenditures - a grant to CBR to clear accumulated income tax refunds (Rs.22 billion), a substantial investment in KESC to prepare it for privatization (Rs.30 billion) and a settlement of WAPDA arrears (Rs 5.billion). These FY02-specific expenditures not only pushed up the overall budget deficit, but also masked the benefits of lower interest payments realized on account of (1) rescheduling and re-profiling of external debt, and (2) low interest rates on domestic debt instruments. Adjusted for the FY02-specific spending, the "baseline" budget deficit was lower than the FY02 target.

Although total revenues posted a reasonable growth on the back of a large rise in non-tax revenues, overall tax collections were well below the FY02 target. The poor tax collections were largely attributed to a decline in imports, an appreciation of the Rupee against US Dollar, unusually high tax refunds, and a decreasing trend in domestic inflation during FY02.

The easing of monetary policy in FY02 had its roots in the macroeconomic discipline achieved in FY01 and was initiated well before the post September developments took over. The monetary easing not only brought down the benchmark 6-month T-bill rates to an all-time low but also led to a 1.9 percent drop in the weighted average lending rates.

The increased external inflows, improved liquidity in the market due to SBP interbank purchases, and lower net credit requirement by the private sector brought about a change in the behavior of both, banks and the government. While banks were anxious to lock-in their funds- in government paper, anticipating further interest rate cuts, the government used this opportunity to retire its more inflationary debt from SBP 'and borrowed afresh from scheduled banks. This had two implications: (1) it helped the SBP achieve limits on its NDA targets; and (2) it effectively sterilized the effect of SBP market purchases of foreign exchange. Also, while the actual government borrowings for budgetary support stood at Rs 12.5 billion for FY02, when adjusted for the waiver given by IMF for the KESC re-capitalization and tax refunds to the banks, the borrowings are well within targets.

Higher retirements, write-offs & deletions, and availability of fund from other sources, kept the net credit to private sector figure deceptively low (gross disbursements figures in FY02, remained higher than FY01, almost throughout the year). In overall terms lower interest rates, higher refunds and better availability of internal financing, and improved access to export markets greatly mitigated the adverse impacts of the uncertain business environment during FY02.

The overall impact of monetary easing and build-up of foreign exchange reserves resulted in an exceptional growth of 14.8 percent in monetary assets, which is the highest in the last five years.

Money Market

During FY02, the money market saw a relative improvement in liquidity as reflected in a decline in the volume and frequency of banks' use of the SBP discount window. This was, in part, a result of the SBP's pro-active liquidity management.

On the other hand, as interest rates declined due to the SBP monetary easing, and deposits began rising very strongly (with a relatively lower increase in private sector demand), banks increasingly preferred to invest in government securities to lock-in assets at higher rates.

The change in the monetary stance is reflected well in the downward shifting yield curves. However, the shape of the yield curves has become steeper, depicting a relatively lower decline in returns at the longer end of the curve.

Capital Markets

During FY02, capital market exhibited better performance compared to the previous year. Although the country underwent various economic and non-economic shocks, both the equity and fixed income securities markets remained buoyant.

The benchmark KSE-100 index gained 29.5 percent, in sharp contrast to a 10.1 percent fall during the previous year. The market gained resilience from the overall betterment in economic fundamentals, a consequent improvement in corporate profitability prospects, and the financial market liquidity prevalent in the economy. Similarly the fixed income market kept the momentum generated during the previous year on the back of reforms in National Saving Schemes and the easy monetary policy of the SBP. As a result, 17 new TFC issues were launched during the FY02 as compared to 10 during the preceding year.

Banking

The main developments in the banking sector in FY02 were the remarkable growth in deposits and the substantial increase in lending of foreign currency. Both developments largely owe to the improvements in Pakistan's external account in the aftermath of 9/11. The double-digit growth of 14.0 percent in deposits would have been even higher, had FCAs not declined by 13.7 percent. The phenomenal surge in the former was on the back of Rupee injections by SBP against foreign exchange purchases and higher remittance through banking channels. The fall in the latter reflects the decreasing attractiveness of foreign exchange holdings as the Rupee appreciated.

Besides the apparently subdued growth in credit, an important development in FY02 was the US$ 338.1 million (Rs 20.1 billion) surge in foreign currency loans. Although the banks were allowed to give credit in foreign currency (for trade related activities) since the introduction of FE-25 deposits in June 1998, it was only in FY02 that banks extended large volumes of foreign currency loans. Borrowing in dollars has become increasingly attractive in view of the lower rates (which range between 2 to 5 percent) and future expectations of a stable Rupee.

Unlike FY01, lending rates declined, especially in H2 FY02. This was in line with the easing of monetary policy. A lower fall in the weighted average deposit rates resulted in a narrowing of the banking spread by 111 basis point. It is important to note that foreign currency loans are not included while computing the weighted average lending rates. Incorporating these, it is evident that weighted average lending rates, and the banking spread, would have fallen further by at least 25 basis points.

Performance indicators (based on annual audited balance sheets) in CY01 showed a mixed picture when compared with CYOO. Efforts made to improve banks' assets quality started showing progress. The pace of NPLs from fresh lending has slowed down and together with increased emphasis on recoveries, has put a break on the growth of bad loans. In addition, to account for the historically bad portfolio (most of it in lost category) of public sector banks, the need for appropriate provisioning has been emphasized.

Balance of Payments & Exchange Rate

Although, the current account has been steadily improving over the last three years amid higher kerb purchases, FY02 surplus of US$ 2.7 billion is the first that is broad-based - all the sub-categories contributed to the out-turn.

The trade deficit narrowed mainly due to falling imports on the back of lower fuel and food imports. Also, while exports did decline in FY02, a portion of the fall is attributable to lower unit prices for Pakistani exports. The improvement in the services account reflects the receipts against logistics support for international forces in Afghanistan as well as the savings following the re-profiling of external debt. However, the most valuable improvement seems to be the sharp increase in workers remittances; FY02 receipts were more than twice the FY01 collections.

Despite lower SBP purchases from the kerb market and lesser inflows realized in resident FCAs, the current transfers registered a phenomenal growth during the current fiscal year. In this regard, the major contribution came from the workers' remittances, which registered an extraordinary growth of 129 percent (on a cash basis) during FY02. In fact, an international crackdown on hundi networks changed the dynamics of current transfers, as incentives to use the informal channels largely disappeared.

In terms of the capital account, the completion of the IMF Stand-By Arrangement not only paved the way for successful negotiations for a medium-term PRGF but also led to a higher non-food aid from the World Bank and ADB, as well as a generous re-profiling of Paris Club debt,

FY02 was also an unusual year for the foreign exchange market. The global crackdown on hundi networks led to: (1) the collapse of the kerb premium, (2) an end to market expectations for devaluation; and (3) a U-turn in the direction of exchange rate management of SBP. All of these developments provided grounds for liberalizing the foreign exchange market, particularly the removal of segmentation between the interbank and the kerb markets, which has been one of the key structural problems in Pakistan's external sector.

The pressures on the kerb market not only outweighed the traditional downward stickiness of the kerb rate, but also reversed the traditional market expectations for devaluation of the Rupee. In terms of exchange rate management, SBP net purchases from the interbank market showed a dramatic shift from negative US$ 1,126 million to positive US$ 2,483 million.

The higher purchases in FY02 were aimed at providing support to exporters who had already suffered on account of an appreciating Rupee, loss of export orders and imposition of a risk premium. In overall terms, the Rupee strengthened by 6.7 percent against the US Dollar in the interbank market during FY02.

Although at the start of the fiscal year reserves already stood at US$ 3 billion, post-September 11 developments accelerated reserve accumulation, taking Pakistan's foreign exchange reserves to US$ 6.4 billion by the end of FY02. This surge in reserves was mainly shaped by lumpy inflows from International Financial Institutions (IFIs) and SBP purchases. The build-up of reserves allowed SBP to settle expensive and short-term liabilities, which will improve the creditworthiness of the country.

Domestic and External Debt

There is a distinct improvement in Pakistan's total debt profile during FY02. Specifically, the total debt burden declined from Rs 3,866 billion to Rs 3,761 billion and debt to GDP ratio improved to 102 percent. This note worthy achievement mainly shows Pakistan's adherence to the Debt Management and Reduction Strategy (DMRS) formulated in March 2001.

On the external front, the successful completion of IMF Stand-By Arrangement (SBA) restored Pakistan's credibility with International Financial Institutions (IFIs) and reaffirmed the government's commitment to reforms. This in turn paved the way for successful negotiations for a medium-term IMF assistance program (PRGF) as well as increased aid from other IFIs. Moreover, Pakistan also obtained a stock re-profiling of bilateral debt from Paris Club creditors on very generous terms, which will result in an implied reduction in the net present value of EDL of between 28 to 44 percent, depending on the interest rate negotiations with individual creditors.

Pakistan also retired commercial debt by US$ 0.9 billion and at the same time contracted soft loans from IFIs, which improved the term structure of external debt. Furthermore, the stock of external liabilities declined significantly by US$ 1.9 billion during the course of the current fiscal year. This decline is mainly driven by the hard currency payments of FCAs (FE-45 and FE-31) and retirement of Special US Dollar bonds, NBP deposits placed with SBP and swaps.

As far as domestic debt is concerned, it also reflects similar improvement. A one-time adjustment in floating debt substantially reduced the stock of short-term debt (reducing the stream of future interest payments). Additionally, the increased long-term borrowings through PIBs and NSS instruments also facilitated the lengthening of the maturity profile. The appreciation of the Rupee also eliminated the upward pressure on interest rates considerably, which led to a sharp reduction in the cost of domestic debt.