Press Release No. 10/435

Press Release: IMF Statement on the Occasion of the 2010 Pakistan Development Forum

November 15, 2010

An International Monetary Fund (IMF) staff team, led by Adnan Mazarei, IMF mission chief for Pakistan, participated in the 2010 Pakistan Development Forum in Islamabad. Mr. Mazarei issued the following statement on the occasion of the forum:

“IMF staff is very happy to participate in this Pakistan Development Forum. Our statement will cover three topics: recent developments in the Pakistani economy, the current macroeconomic framework, and Pakistan’s financing needs.

“Prior to this summer’s floods, although growth was picking up, inflation was high and persistent. The 2009/10 budget deficit target was missed by a significant margin and the end-June 2010 ceiling on government borrowing from the State Bank of Pakistan (SBP) was also exceeded. As a result, the fifth program review could not be completed on time.¹

“This summer’s floods have led to a sharp deterioration in the economic outlook. The agriculture sector—which accounts for 21 percent of GDP and nearly half of employment—has been hit particularly hard. There has also been substantial damage to infrastructure and private property. The floods will dampen economic growth significantly in 2010/11(July-June) and add to pressures on the balance of payments and public finances. Inflation, especially of food prices, has picked up, compounding the social pains of the recent floods.

“Asian Development Bank and World Bank staffs have estimated damages and losses from the floods at about US$10 billion. In 2010/11, the authorities plan to provide US$1.8 billion (1.0 percent of GDP) in cash transfers to flood victims, most of which is targeted to be spent on house reconstruction.

“The fiscal outcome in the first quarter of 2010/11 was weaker than expected, and the government continued to borrow from the SBP. With low revenues and large outlays for provinces and energy subsidies, the deficit reached about 1.6 percent of GDP. The borrowing from the SBP, together with the shock to food supplies following the floods, helped push inflation in October to 15.3 percent (year-on-year) from around 13 percent in August.

“The SBP raised interest rates in July and again in September on account of concerns about inflation, the external position, and the need to roll over government paper. Market interest rates have risen by 70–150 basis points since June 2010, reflecting both the increased policy rate and higher inflationary expectations.

“Despite the floods, the external position and the exchange rate have remained stable so far. The envisaged loss of reserves due to flood-related imports has not materialized; the external current account deficit was only 0.3 percent of GDP in the first quarter and the SBP reserves increased by US$200 million to US$13.2 billion. However, considerable risks to the external position remain.

“The authorities know that a swift and robust policy response is needed to manage the pressures existing before the floods, provide relief to flood victims, and contribute to reconstruction. They also recognize the need to manage the economy with considerable caution to preserve macroeconomic stability. Accordingly, they are adjusting economic policies.

“Public finances have been affected by lower revenue collections and higher outlays for humanitarian assistance. A revision of the 2010/11 budget will, therefore, be necessary. To this effect, the authorities have revised their fiscal deficit target for this fiscal year to 4.7 percent of GDP. Discussions of the required policy measures to attain this objective have started, but are not yet completed. Achieving the budget deficit target will be challenging, and will require an agreement with provinces on binding limits on provincial fiscal positions, consistent with the overall target.

“Structural reforms are needed to improve budgetary performance. Two areas stand out. One is the reformed general sales tax (RGST), including an effective input-crediting mechanism, reduced exemptions, and elimination of zero-rating and special rates. The other is electricity reform, where action is needed to eliminate untargeted subsidies while addressing load shedding and protecting the poor, and address the problem of circular debt. The authorities’ electricity sector reform plan will need to be reviewed by Asian Development Bank and the World Bank, which take the lead in this area.

“Adherence to the revised 2010/11 budget deficit target will be needed to bring government borrowing from the SBP down to the targeted level, which is essential for achieving a durable reduction in inflation, a major source of poverty. In this connection, the adoption of a flood tax is a welcome step.

“Financial sector reforms are also needed. Parliament has amended the SBP Act, which should help improve public financial management, and amendments to the banking and bankruptcy laws are being prepared. Nonperforming loans have increased through end-September, and are expected to increase further due to the floods. Also, several banks must increase capital to meet their statutory requirements, and there is a need to pass amendments to the banking law to strengthen the SBP’s supervisory powers.

“The balance of payments is expected to weaken in 2010/11, due in part to the impact of the floods. Imports will rise as food and other basic goods will need to be sourced from abroad and imports of capital equipment for reconstruction will increase. Although the major export plants have escaped physical damage, cotton and textiles exports may be lower. However, we expect that the higher trade deficit will be compensated in part by rising remittances from Pakistanis abroad. Even so, the current account deficit will likely widen by 0.8 percent of GDP to 2.8 percent of GDP. Overall, for 2010/11, we project an average inflation rate of 14 percent and real GDP growth of 2¾ percent. The medium-term outlook will be updated when discussions between the authorities and Fund staff have been completed.

“Given Pakistan’s large flood and development needs, additional donor financing would support the government’s efforts to finance flood relief and reconstruction as well as raise development and social spending. In this spirit, already in September, the IMF provided over $450 million in emergency assistance. This was new money (i.e., in addition to the current Stand-By Arrangement), which was made available quickly and unconditionally to help the authorities deal with the most urgent budgetary needs entailed by the floods. Additional financing would also reduce the risks to the economy, including from shortfalls in projected capital inflow. Specifically:

• Pakistan will continue to have large gross external financing requirements in the next few years. The floods have added to these needs.

• The Fund-supported program can accommodate additional foreign assistance during 2010/11. The macroeconomic effects would be generally favorable, including revived growth.

• Provision of external financing on concessional terms or, preferably, in the form of grants will reduce downside risks to debt sustainability. Reducing these risks will enhance investor confidence—and therefore increase the prospects for private external financing—and increase growth prospects for the Pakistan economy.

“The Fund has been providing Pakistan with policy advice and financial resources. We will continue to work together with the authorities toward putting the IMF-supported program back on track and completing the fifth review of the Stand-By Arrangement.”

¹ See IMF Staff Report “Pakistan: Use of Fund Resources—Request for Emergency Assistance” of September 10, 2010 (http://www.imf.org/external/pubs/ft/scr/2010/cr10295.pdf).