Public Information Notice No. 05/157

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Pakistan

November 17, 2005

On November 2, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV Consultations with Pakistan.¹

Background

In 2004/05 (July/June), Pakistan's macroeconomic performance continued to be favorable, despite some inflationary and external pressures. Economic growth is estimated to have reached 8.4 percent in 2004/05, driven by manufacturing, and bumper harvests that benefited from timely rains. However, 12-month inflation reached 11 percent in April 2005, before easing to 8.4 percent in August. Strong growth, including in agriculture, combined with rising wages and employment according to some indicators, is expected to have yielded some reduction in poverty. Data from a household survey to be released later this year will provide further information in this regard.

Fiscal targets for 2004/05 were broadly met, with the overall deficit (excluding grants) at 3.3 percent of GDP. Government debt was reduced to just below 60 percent of GDP. The tax-to-GDP ratio fell because of the elimination of excises on petroleum products to offset the impact of rising international oil prices, and a number of tax relief measures in the 2004/05 budget.

Concerned with double digit inflation and high capacity utilization, the State Bank of Pakistan (SBP) has tightened monetary policy. Since the beginning of 2005, the SBP has raised the six-month treasury bill rate by more than 4 percentage points to 8 percent in May, but has kept it broadly unchanged since then; key interest rates remain slightly negative in real terms. Despite the tightening, reserve money growth has not slowed down because the SBP provided substantial budget financing during the year as the government's gross financing needs could not be fully met from the market at prevailing rates.

Despite higher worker's remittances, the current account moved into deficit in 2004/05. Exports, and in particular textile exports following the end of the textile quota system, have performed well in the first six months of 2005. But import grew even faster, reflecting higher oil prices and strong demand, including for machinery. Gross reserves fell somewhat in 2004/05, notwithstanding a continued increase in non-debt-creating inflows and substantial concessional financing. The real effective exchange rate has appreciated modestly over the last few months given the stable U.S. dollar-Pakistani rupee exchange rate and the substantial inflation differential.

The 2005/06 budget targets a deficit (excluding grants) of 3.8 percent of GDP. The budget shows little revenue buoyancy; again, a number of tax relief measures were introduced for exporters and the manufacturing sector. Nonetheless, even with the increase in the fiscal deficit, government debt would fall to 52 percent of GDP. The government has taken steps to offset pressures on fiscal policy from rising international oil prices and should be able to achieve the budget target. In particular, significant increase in domestic retail prices of petroleum products was implemented in September and October. Expenditures will be tightly controlled, but priority will be given to achieving the development expenditure target.

Progress has been made on the government's structural reform agenda, in particular in the area of privatization. In June 2005, the largest transaction so far in Pakistan's privatization program took place, with the sale of 26 percent, together with management control, of a large telecommunication company. The sale of several other major companies is underway. Energy sector reforms have again proven to take longer than envisaged. While the unbundling of the other large power utility is almost complete, the individual distribution companies cannot start to operate independently because regional tariffs have yet to be notified.

Cooperation with the Fund has been fruitful. In contrast to earlier experience, the 2000 Stand-by Arrangement and the 2001-04 Poverty Reduction and Growth Facility (PRGF) were in large part implemented steadfastly. Moreover, many recommendations made at the time of the 2004 Article IV consultations have been implemented. In analyzing policy implementation under the PRGF arrangement, it was noted that the correction of a tax anomaly that had not been previously discussed between the authorities and the Fund had resulted in an insignificant deviation from a structural performance criterion but without any effect on fiscal outcomes. This does not change the Fund's favorable assessment of policy implementation under the program.

Executive Board Assessment

Executive Directors expressed their sympathy and condolences for the loss of life and the large-scale destruction caused by the recent earthquake that hit the northern parts of Pakistan. They welcomed the pledges of support that have been made by the international community to address urgent needs and assist with the reconstruction, and called for substantial additional assistance, especially grants, to help the government overcome the crisis without adversely affecting implementation of broader economic policies. In this regard, several Directors noted that they would support a request for Emergency Natural Disaster Assistance from the Fund, if the Pakistani authorities were to make such a request.

Directors commended Pakistan's impressive macroeconomic results in recent years—in particular, the acceleration of economic growth—which have laid the ground for a decline in government debt, financial market stability, and the recent re-access to international capital markets. Directors noted the significant improvement in various health and education indicators. At the same time, they observed that poverty remains widespread, and that achieving the Millennium Development Goals will be a challenge, particularly given the added need to rebuild northern Pakistan. Going forward Directors considered that the key challenge for the medium term will be to sustain the high growth rate and reduce poverty in the context of price stability. Directors therefore welcomed the Pakistani authorities' determination to maintain macrostability in the face of the earthquake. They also emphasized the importance of continued structural reforms, particularly the need to create a business climate conducive to investment.

Directors noted that, in light of the earthquake, some widening of the budget deficit in 2005/06 might be unavoidable. However, they did not expect this to alter significantly the declining trend of Pakistan's debt indicators. They cautioned, however, that the overall debt burden continues to be high and needs close monitoring, and welcomed the adoption of the Fiscal Responsibility Law that requires a further reduction of the debt burden. Directors commended the authorities for having passed on much of the increase in international oil prices to consumers to help contain fiscal pressures, and recommended a continuation of this policy.

Directors stressed that meeting the authorities' medium-term fiscal objectives will require a marked improvement in revenue performance. In this regard, they were disappointed by the lack of progress made over the last five years in raising the ratio of tax revenue to GDP. A few Directors expressed concern that the authorities have returned to the past practice of granting exemptions and zero ratings. While agreeing that improving compliance by existing taxpayers is important to increase tax collections, Directors urged the authorities to extend the tax net to the services sector and to work with provincial governments to have the agricultural sector pay its fair share of taxes.

Directors expressed concern about the increase in inflation in the last two years and the widening of the current account deficit. They cautioned that relief and reconstruction efforts could add further pressures on both prices and the balance of payments. Directors commended the State Bank of Pakistan for raising interest rates sharply in the first half of 2005, and some urged the central bank to raise interest rates further if inflationary pressures persist. Directors stressed the need to sterilize effectively central bank financing of the budget. Directors welcomed the continuing improvement in the health of the financial sector. While noting that the strong credit growth currently appears in part to be the encouraging outcome of financial liberalization, Directors cautioned that this could be a source of vulnerability in the future. They advised the State Bank of Pakistan to monitor credit development carefully. Directors generally considered that the current exchange rate regime has served Pakistan well.

Directors were impressed by the overall progress made in privatizing state-owned enterprises, and welcomed the authorities' plans for further sales. However, they expressed concern about the electricity sector's sizable drain on the budget and urged stepped-up reform in this sector. They urged the authorities to complete the new tariff framework so that the successor companies of the Water and Power Development Authority could start functioning independently. Directors were encouraged by the prospects of the Karachi Electric Supply Corporation being transferred into private hands. More generally, Directors urged the authorities to continue with structural reforms aimed at improving the business environment and governance.

Directors encouraged the authorities to further improve the quality and timeliness of data, including data on the domestic debt, in order to allow better analysis and policy formulation, and with a view to subscribing to the Special Data Dissemination Standard.

Directors welcomed the ex post assessment of the Fund's involvement in Pakistan. They noted the dramatic change in ownership of economic policies compared to much of the 1990s. While acknowledging the importance of international support, Directors emphasized that steadfast implementation of sound policies and broad-based structural reforms were mainly responsible for the economic recovery. Directors agreed that conditionality under the 2000 Stand-By Arrangement had been extensive; nevertheless, the authorities demonstrated commendable perseverance in the implementation of strong policies and established a strong track record that paved the way for the 2001 arrangement under the PRGF. Directors note that Pakistan's program performance since 2000 compared favorably to the average Fund-supported program, and even though Pakistan had a larger number of structural conditions, the waiver rates were lower than the Fund-wide average, some of which involved minor or temporary deviations from program targets.

Directors supported management's recommendation to waive the nonobservance in 2002 of the performance criterion precluding new tax exemptions, stemming from a minor sales tax adjustment that has had no revenue impact and which had not been previously discussed between the authorities and the staff. Many Directors, although not representing a majority of the vote, questioned, however, whether there had been a breach of a performance criterion, since the sales tax exemption was immaterial as it had no revenue implication, and saw no need for the Board to grant a waiver.