November 4, 2000

Mr. Horst Köhler
Managing Director
International Monetary Fund
700 19th Street NW
Washington, D.C. 20431
U.S.A.

Dear Mr. Köhler:

The Pakistan authorities have held discussions with Fund staff for a Stand-By Arrangement until end-September 2001 in support of the government's economic program for 2000/01. Based on these discussions, the attached Memorandum on Economic and Financial Policies (MEFP) reviews economic developments and policies in 1999/2000, and discusses the macroeconomic framework for the program, as well as the underpinning stabilization and structural policies. In support of the policies set out in the attached MEFP, the government requests that the Executive Board of the Fund approve a Stand-By Arrangement in an amount of SDR 465 million.

The Government of Pakistan will provide the Fund with such information as the Fund may request in connection with Pakistan's progress in implementing the economic and financial policies and achieving the objectives of the program. The government believes that the policies set out in the attached MEFP are adequate to achieve the objectives of the program. However, it stands ready to take any additional measures appropriate for this purpose, and will consult with the Fund in accordance with the policies of the Fund on such consultations.

Attachment:
Memorandum on Economic and Financial Policies
Technical Memorandum of Understanding

2. Favorable performance of the agricultural sector boosted real GDP growth to an estimated 4.8 percent in 1999/2000, compared with 3.1 percent during 1998/99. Agricultural output expanded by 7 percent, with bumper cotton and wheat harvests more than offsetting a decline in sugarcane output. The bumper cotton crop gave a welcome boost to the textile industry after three years of lackluster activity in this vital sector. However, industrial activity was dampened by a collapse in sugar production. As a result, large-scale manufacturing output growth contracted by 0.8 percent, compared with an increase of 3.7 percent during the previous year.1 Notwithstanding increases in domestic petroleum products prices, the average rate of consumer price inflation eased further to 3.6 percent, from 5.7 percent in 1998/99. Food price inflation was even lower, aided by the decline in international nonoil commodity prices and the buoyant domestic output of food crops.

3. With the favorable supply conditions in the agricultural sector and the recovery in the textile sectors, Pakistan's external current account deficit narrowed from 3.8 percent of GDP in 1998/99 to 1.6 percent of GDP in 1999/2000 despite the sharp rise in world oil prices. Exports grew by 8.5 percent in U.S. dollar terms, as more favorable external demand conditions and the boost in textile production helped maintain buoyant export performance despite a decline in export unit values. The overall import bill was flat in 1999/2000, with the US$1.2 billion increase in oil imports caused by higher international petroleum prices offset by lower food, defense, and project aid-related imports. Kerb market purchases of foreign exchange by the State Bank of Pakistan (SBP) increased.² The capital account of the balance of payments turned sharply negative, however, driven mainly by a reversal in public medium- and long-term capital flows. As a result, gross official reserves declined from US$1.7 billion (equivalent to 7.4 weeks of imports of goods and nonfactor services) to US$0.9 billion (3.7 weeks of imports). The exchange rate of the rupee was held stable against the U.S. dollar through the year in an effort to maintain investor confidence amidst the uncertain outlook for external financing. In real effective terms, the rupee remained roughly stable on average in 1999/2000 in relation to the previous year.

4. The consolidated government budget deficit widened to 6.5 percent of GDP in 1999/2000, from 6.1 percent of GDP in 1998/99, adversely affected by the delayed adjustments in domestic petroleum prices, an increase in the government's interest bill, an overrun in defense expenditures, the settlement of accumulated tax refunds, and additional provincial transfers to municipalities in lieu of abolished local taxes. Interest payments rose by 0.4 percent of GDP, while petroleum surcharge revenue fell by 1 percent of GDP.³ These effects on the fiscal balance were partly offset by increased tax receipts of the Central Board of Revenue (CBR) by 0.2 percent of GDP; higher nontax revenue (0.4 percent of GDP); and lower development expenditure and net lending (0.4 percent of GDP). While a lapse in expenditure control mechanisms prevented the envisaged cut in defense spending from materializing, defense expenditure nevertheless declined by 0.2 percentage points in relation to GDP.

5. Broad money grew by 9.4 percent in 1999/2000, broadly in line with the pace of nominal GDP (9.2 percent). Deposits in the banking system, however, expanded by only 5.3 percent, with the expansion in rupee deposits exceeding somewhat the continued conversion of residents' frozen foreign currency deposits. Currency in circulation increased sharply, however, to almost 24 percent on a year-on-year basis in June 2000. This appears to have reflected an increased demand for cash following the launch of the intensified loan recovery and tax survey and registration drives. The decline in banks' deposit interest rates during the course of the year likely contributed to increased demand for cash. On the assets side, net bank borrowing by the government for budgetary support contributed to around one-third of the growth in broad money, as did a surge in bank credit towards the end of the fiscal year to finance the procurement of the bumper wheat crop. Private sector credit growth moderated to 2.5 percent in June 2000 (year-on-year basis), reflecting the dampening effect on net credit outstanding of the loan recovery drive; the associated cautious behavior of banks in approving new credits; rationalization of the Export Finance Scheme, which reduced outstanding credit under the scheme by over 10 percent; and increased self-financing by textile units, whose profitability benefited from the decline in raw cotton prices. The weak private credit growth and the continued moderation in inflation prompted the SBP to ease the monetary policy stance. Accordingly, treasury bill yields declined and reserve money growth picked up to 25 percent in June 2000. In the last quarter of 1999/2000, the rise in the government's budgetary financing needs, was lower than envisaged receipts of external financing, and reduced budgetary financing by commercial banks fueled reserve money growth.

6. Notable progress was made in 1999/2000 in implementing structural reform measures in certain areas. On the fiscal side, the GST was extended to petroleum, gas, and electricity, and all tax whitener schemes were withdrawn. However, tax amnesty schemes have remained in place to allow those who had previously evaded taxes to settle their tax liability with a one-off payment. A major tax survey and registration campaign was launched to widen the tax base and facilitate vigorous enforcement of the GST in the retail sector from next year. A price adjustment mechanism for petroleum products has been in place since December 1999 to pass through developments in international import parity prices; four quarterly adjustments in response to international price developments have already taken place. In addition, important liberalization measures have been taken in the areas of international trade, agriculture, and petroleum. Restructuring plans have been developed for key public enterprises, and the implementation of reforms has commenced. Corporate management structures have been put in place in the petroleum, gas, and power sector enterprises. In the financial sector, the loan recovery drive has helped improve banks' financial position and the integration of financial markets has been aided by reforms of the National Savings Schemes (NSS).

II. Macroeconomic Objectives and Policies for 2000/01

7. The principal objective of economic and financial policies is the achievement of sustained economic growth of around 6 percent over the medium term, together with low inflation and a viable balance of payments position. To this end, policies will focus on fiscal reforms, including improved monitoring of the budgetary position, and measures to enhance the openness of the economy and export competitiveness. The macroeconomic targets for 2000/01 include: (a) real GDP growth of at least 4.5 percent; (b) annual average CPI inflation of about 6 percent, with a somewhat lower rate of underlying inflation; and (c) a buildup in official foreign exchange reserves to US$1.74 billion, equivalent to about 7.3 weeks of imports of goods and nonfactor services.

8. Agricultural output is expected to remain strong in response to policy measures to liberalize this sector and improve its productivity on a sustained basis, although output growth is projected to slow somewhat from the pace in 1999/2000. The growth momentum will be sustained by a pick-up in manufacturing growth, as the textile sector is expected to remain buoyant with favorable domestic supply and external demand conditions. Moreover, strengthened confidence should lead to a recovery in private investment. Inflation is expected to pick-up with the pass through of exchange rate and petroleum and gas price adjustments and the carry over effects of structural price increases (fuel, wheat issue price, and medicines) in the second half of 1999/2000. The external current account deficit is expected to remain at about 1.6 percent of GDP in 2000/01, despite a projected further deterioration in the terms of trade, equivalent to at least 0.3 percent of GDP. The adverse impact of high world oil prices on imports would be offset by continued strong export performance, partly reflecting the export of last year's excess agricultural crops. Improved investor sentiment is expected to be reflected in an increase in private investment inflows. Nevertheless, the external outlook and the envisaged buildup in reserves is predicated on inflows of exceptional financing of around US$4 billion (discussed below).

9. A competitive, flexible, and market-based exchange rate will be critical in achieving the external sector objectives. Aided by the removal of the unofficial trading bands in the interbank market in July 2000, the interbank exchange rate of the rupee against the U.S. dollar depreciated by 12 percent between end-May 2000 and October 25, 2000. Henceforth, the exchange value of the rupee will be determined by market forces. The depth of the interbank exchange market operations will be enhanced by the withdrawal of the requirement that all interbank deals are backed by approved commercial transactions. In addition, nostro limits on banks' balances held abroad on account of trading activities will be relaxed, and the SBP's practice of dealing for same day or "ready" value in foreign exchange will be changed to two-day value for spot dealing, in line with the internationally accepted standard. These measures, which will be implemented in a phased manner starting in the second half of 2000/01, are expected to lower the premium in the kerb market, inducing some inflows to move from the kerb market to the interbank market. Developments in the foreign exchange markets will be reviewed on a quarterly basis, with a view to ensuring a competitive, market-based exchange rate and to moving toward the cessation of SBP purchases from the kerb market over the longer term.

10. The government recognizes that the existence of two foreign exchange markets (the interbank and the kerb markets) could potentially lead to multiple currency practices and the breach of Pakistan's obligations under Article VIII, Section 3 of the Articles of Agreement. However, all current account transactions are, and will be, allowed to take place in the interbank market. The diversion of current transactions to the kerb market through official actions, which occasionally took place in the past under exceptional circumstances, will no longer occur. In the past, occasional delays in the approval of payments and transfers for current international transactions took place mainly due to administrative requirements. Currently, no such restrictions exist and, under the program, the government will not delay approval of payments and transfers for current account transactions or hinder the free flow of funds for current account transactions.

11. In order to achieve the reserves targets and keep inflation in check, a tighter monetary policy stance is envisaged for 2000/01, as reflected in the target for reserve money growth of 3 percent. Indeed, the monetary stance has already been tightened to quell speculative pressure against the rupee and support the transition to a flexible exchange rate regime; treasury bill yields have risen by over 3 percentage points since June 2000. As confidence strengthens with an agreement on an external financing package, the effects of the rupee depreciation on trade flows begin to take hold, and provided that the reserve money and reserve accumulation targets are being met, some easing of the interest rates may be possible. As regards broad money, the special factors--including the loan recovery drive, the launch of the tax survey and registration campaign, and the tax amnesty scheme--that led to an increase in the currency-to-deposit ratio to 34 percent in May 2000 (from 29 percent in June 1999) should start to wear off during 2000/01. As a result, with broad money growing in line with nominal GDP (11.3 percent) and the envisaged buildup in net foreign assets of the banking system, the improvement in banks' liquidity position should be sufficient to finance roughly 11 percent growth in private sector credit together with a moderate reduction in net claims on government.

12. Fiscal consolidation will be a critical component of macroeconomic policies in 2000/01. The target for the budget deficit has been set at PRs 185.7 billion (5.2 percent of GDP), an improvement of 1.3 percentage points from the estimated outturn for 1999/2000. The target is to be achieved primarily through increased tax collection built on a widening of the tax base and strict containment of current spending. On the revenue side, an increase in tax receipts by 1.1 percentage points of GDP relative to 1999/2000 will come from higher sales and direct tax receipts and gas surcharge revenue. Sales tax revenue is projected to rise on account of the full-year effect of the extension of the GST to petroleum, electricity, and gas, the amalgamation of various excise taxes into the GST net, and various legislative/regulatory changes and administrative improvements. Direct taxes will also expand as the tax base widens and documentation is enhanced. Revenue from the gas surcharge will benefit from the 15 percent increase of gas tariffs in June 2000. (Details of tax reforms are discussed below.) Nontax revenue is expected to decline by 0.6 percentage points of GDP, owing mainly to a decline in SBP profits.⁴

13. On the expenditure side, current spending will fall on account of lower interest expenditure,⁵ reduced outlays on subsidies, and lower defense spending in relation to GDP. Development spending has been budgeted to increase by 0.4 percent of GDP. The budget also provides for one time expenditure of PRs 7.0 billion for the settlement of arrears from provincial governments, Federally Administered Tribal Areas (FATA), and agricultural tubewells in Baluchistan to the Water and Power Development Authority (WAPDA) as well as for some of the billings of Baluchistan and Azad Jammu and Kashmir (AJK) in FY 2000/01.

14. The 2000/01 budget takes into account the need to increase social expenditure and protect the poor from the impact of the economic stabilization measures under the program. To this end, social expenditures and poverty reduction programs under the Public Sector Development Program plus current expenditures for Social Action Program (SAP) and Food Support Program have been increased by 28 percent. As a result, these expenditures would account for 12.6 percent of total expenditures in 2000/01, compared with an average of 10.6 percent in the previous three years. With Zakat disbursements, which are outside the budget, social and poverty related expenditures are targeted to increase to 2.8 percent of GDP, from 2.5 percent of GDP in each of the previous two years.

15. Following the overrun relative to the target for defense spending last year, adequate expenditure control mechanisms have been put in place to ensure that the defense budget remains within the agreed limit. This has been done after due consultation with the relevant departments, who will liaise closely with the Ministry of Defense on a regular basis, and progressive monthly expenditures will be monitored closely. The outcome of this exercise will be reported on a quarterly basis to the Fiscal Monitoring Committee of the Ministry of Finance. In addition, any virements (transfers of allocations across line items) will not be permitted without Ministry of Finance approval. Furthermore, to prevent underestimation of interest payments, detailed accounts related to NSS instruments have been used in calculating forthcoming obligations. In addition, various cushions have been included in the budget numbers to ensure the achievement of overall budgetary target in 2000/01 and to safeguard the budgeted social and poverty-related expenditures from cuts during the course of the year.

16. In view of the uncertainty surrounding the projected increase in tax revenue in 2000/01, contingency measures have been identified that will involve cuts in public spending (excluding social and poverty related-expenditures) if revenue falls short of program targets. The Ministry of Finance has issued instructions to line ministries to limit actual expenditures to PRs 5 billion below the level envisaged through end-December under the program.⁶ A mid-year expenditure review exercise will be conducted in January 2001. This will entail bringing forward the revised estimate exercise to January, which is normally conducted once a year in May in the context of the annual budget preparation. On the basis of this review, if revenue performance is found to be in line with expectations, the amounts withheld would be released in the second half of the fiscal year. If, however, data on CBR revenue performance through December indicate that a shortfall is unavoidable, necessary expenditure cuts would be announced in consultation with line ministries. Potential cuts amounting to PRs 7 billion in the PSDP have been identified in the areas of infrastructure (PRs 3 billion), sports and culture (PRs 0.2 billion), corporations (PRs 3.5 billion), and others (PRs 0.4 billion). To ensure that social and poverty-related expenditures are protected, quarterly quantitative targets for this type of spending have been established under the program, and the Ministry of Finance will issue quarterly expenditure authorizations that are in line with these targets.

17. The overall financial performance of the seven large public sector enterprises--as measured by net operational revenue including interest charges--is expected to remain roughly unchanged at about 0.8 percent of GDP. Except for the Karachi Electricity Supply Corporation (KESC) and the Pakistan Railways, all enterprises are profitable. However, the net borrowing requirements of the seven large public sector enterprises are projected to rise because of increased capital expenditures in the energy sector, which are needed to improve and expand the distribution network in line with production capacity.

III. Medium-term Outlook

18. Real GDP growth is expected to improve gradually to around 6 percent by 2003/04 and CPI inflation is envisaged to moderate steadily to 3.5 percent. Notwithstanding the projected pickup in private investment as confidence returns, the tight external financing constraint and the limited room to expand public investment imply that the overall investment rate is unlikely to increase much beyond 17-18 percent of GDP by 2003/04. Realization of the growth target would be predicated on enhanced productivity stemming from the redirection of investment to export-oriented sectors through structural reforms being implemented under the program. On the external side, the macroeconomic framework is built around a further narrowing of the current account deficit (excluding official transfers) to 0.1 percent of GDP and an increase in official reserves to the equivalent of 12 weeks of imports of goods and nonfactor services.

19. The achievement of these objectives will hinge on the achievement of further fiscal consolidation and the maintenance of a competitive and market-based exchange rate to ensure that the reserve target is met. The medium-term budgetary projections envisage a budget deficit of about 3 percent of GDP by 2003/04, supported by a steadily rising revenue-to-GDP ratio reflecting improved tax administration and a simpler, broad-based tax system. At the same time, further saving in interest payments and containment of defense outlays should allow increased social expenditures consistent with the objective of reducing poverty. The envisaged reduction in the budget deficit will result in a decline in net public debt from about 94 percent of GDP in 2000/01 to about 86 percent of GDP by 2003/04.

IV. Structural Reforms

20. Since taking office in October 1999, the new government has developed a comprehensive structural reform plan through a broad consultative process involving participation of business leaders, professionals, academics, nongovernment organizations, as well as government officials from the federal, provincial, and district levels. The main objectives of the program are rebuilding confidence of domestic and foreign investors, alleviating poverty, and promoting good governance. A number of key steps have already been implemented, signaling the government's resolve to break from the past and put the economy on a sound footing.

A. Fiscal Reforms

21. An important element of structural reforms in the fiscal area is the tax registration drive, which is aimed at increasing the documentation of the economy and improving tax compliance. Businesses and households in the most prosperous parts of the 13 largest urban areas in Pakistan have been required to complete a tax survey; 13 more are to follow. At the same time, a campaign is underway to issue the new National Taxpayer Number (NTN) to be used for all taxes. Audits will be conducted for up to 20 percent of all tax returns; a computerized process has been established for selecting businesses and individuals for audit.

22. The tax registration drive is expected to result in a significant expansion in the tax base and yield a substantial increase in tax collection over the medium term. Nevertheless, it is difficult to estimate the increase in tax revenue that will stem from the unprecedented drive; this will depend on whether or not it improves long-term confidence in the integrity and effectiveness of the tax administration. Consequently, the budgetary projections for 2000/01 incorporate an increase in tax revenue of PRs 30 billion (0.9 percent of GDP) in conjunction with complementary measures. These would comprise PRs 10 billion from increased income and wealth tax receipts and PRs 20 billion in higher sales tax collection. Complementary measures include the introduction of audits and minimum accounting requirements under the self-assessment scheme; subjecting agricultural wealth more fully to wealth tax; legislative/regulatory changes that will curb spurious and fraudulent GST refunds in the textile sector; procedural changes to prevent the underpayment of GST by steel mills; full exploitation of the newly available audit management information system; and collection from the increased stock of collectible GST arrears. The government expects that 50,000-100,000 new taxpayers would be brought under the GST/Income Tax net in 2000/01.

23. A fundamental overhaul of income taxation is to be undertaken. A reform committee has been established and a new law will be promulgated in the context of the 2001/02 budget. The aim of the overhaul is to move to a simple legislation based on genuine self-assessment, with minimal exemptions, less distorting rate structures, and limiting the number of withholding taxes to a few key ones. To ensure that the new law is ready for promulgation with the next budget, the income tax reform committee will submit its preliminary recommendations to the Minister of Finance by end-2000, and the final report, with a draft law, will be submitted to the cabinet by end-March 2001.

24. In the meantime, the direct tax base has been expanded through reform of agricultural income and wealth taxation. Agricultural wealth has been subjected to taxation together with nonagricultural wealth in 2000/01. In addition, the provincial budgets for 2000/01 included ordinances that introduced a two-tier agricultural income tax consisting of: (a) a fixed land-based tax; and (b) an income tax for an estimated 30,000 large farmers. Revenue from both components will accrue to the provinces, and the rates and schedules pertaining to both components have been fixed by the respective provincial governments. While recognizing that the efficiency of the land-based tax would be enhanced by extending the tax to all landholdings regardless of size, most provinces have opted for minimum thresholds due to high administrative costs associated with levying the tax on small landholdings. As regards the income tax component, the exemption limit for agricultural income has been set by all provinces at a level twice as high as that for nonagricultural income, in view of the higher volatility of agricultural income and the larger number of dependents per household. However, agricultural income will be clubbed with nonagricultural income for rate purposes. The agricultural income tax will be levied on income earned in 2000/01, and although the date for filing tax returns has not yet been fixed, filing will commence this fiscal year. The budget projections for 2000/01, however, incorporate a modest amount (PRs 4 billion, about the same nominal level as last year) in revenue from agricultural taxes.

25. On the sales tax side, the GST has been extended to various services that were previously subject to excise taxes, which have been withdrawn, as well as additional services that were previously not taxed. As the Constitution confers the right to tax most services to the provinces, this extension has required the enactment of provincial legislation. While the ordinances issued by each of the provinces with their 2000/01 budgets are identical, there is a risk that the coverage or the tax rates may deviate across provinces in the future. As such a deviation could compromise the viability of the tax, consideration will be given, at the time of the next National Finance Commission (NFC) award, to enhancing the legal framework to ensure that tax rates and coverage remain identical across provinces. Moreover, as revenue from the GST extension to these services accrues to the provinces, a workable revenue-sharing arrangement across provinces has been devised. Under the arrangement, the tax is administered by the Central Board of Revenue (CBR) across all provinces and territories in exchange for a 2 percent collection fee and the balance of 98 percent is transferred to the provinces on the basis of the current NFC award based on population. As the Constitution confers the right to tax transportation and telecommunications services to the federal government, but does not allow the federal government to impose a sales tax on these services, excise taxes in VAT mode have been levied on these services with the 2000/01 budget.

26. To realize the tax revenue benefits of enhanced documentation associated with the GST and to strengthen incentives for upstream registration, the extension of the GST to retailers with annual sales of over PRs 5 million will be enforced from the beginning of the 2001/02 fiscal year. In the meantime, to ease the transition of large retailers (those above the threshold) to the GST, the option to pay a 2 percent turnover tax instead of registering for the GST has been given for one year. The one-year transition period will ease the pressure on the administrative capacity of the CBR. To facilitate the meaningful extension of the GST from 2001/02, record-keeping and filing requirements under the turnover tax have been enhanced and a vigorous GST education campaign for retailers is being launched.

27. While the agricultural sector has already been subjected to enhanced direct taxation from this year, the favorable performance of agricultural output over the past year should facilitate the extension of the GST to agricultural inputs. This extension will be implemented in two phases, starting from March 2001. In the first phase, the GST will be extended to pesticides and urea fertilizers. In the second phase, which will be implemented by September 1, 2001, the GST will be extended to all agricultural inputs. The timing of the two phases has been chosen to coincide with the crop cycle, thereby minimizing the effect on farmers' liquidity position.

28. Exemptions in the areas of GST, income tax, and customs duties have been reduced considerably in recent years. Customs exemptions, which were granted through 49 Statutory Regulatory Orders (SROs), were reduced by 13 in the context of the 2000/01 budget. Time-bound SROs will be allowed to lapse and the timetable for exemptions under the deletion policy will be strictly followed. Furthermore, income tax exemptions, including those related to income from financial instruments, will be rationalized or eliminated in the context of the income tax and civil service reforms.

29. The structure of provincial taxation has been streamlined with a reduction in the number of provincial taxes and rationalization of the remaining taxes. On balance, this is expected to result in a modest revenue gain for the provinces, particularly from improved property tax collection. In addition, several of the structural tax reforms--including the extension of the GST to petroleum products, electricity, and services as well as the agricultural income tax--will result in an improvement in the provinces' budgetary position. To prevent a loss of fiscal discipline at the provincial level, many of the expenditure responsibilities related to development spending--including components of the urban/rural development and poverty alleviation programs as well as some smaller projects under the Public Sector Development Program (PSDP)--have been devolved to the provinces. As a result, provinces' share in spending under the PSDP will rise from 36 percent in 1999/2000 to 39 percent in 2000/01 (equivalent to an increase of 0.2 percent of GDP). If necessary, provinces can also be required to accelerate repayments of federal government loans. To further enhance provincial fiscal discipline, public accounts committees have been established at the provincial level, along the lines of the Federal Public Accounts Committee.

30. Measures are also being taken to improve the quality of tax administration. The process of assigning NTN to all taxpayers is expected to be completed by December 2000. Revised procedures, personnel improvements, and increased reliance on computerization will underpin the establishment of a more integrated, client-oriented, and functional tax administration. The audit capacity of CBR has been enhanced with the induction of an additional 350 auditors over the past year, and will be further increased with the hiring of at least 300 more auditors during 2000/01. To further increase audit capacity and to ensure fair treatment, taxpayers subject to audit have been given the option of choosing an external auditor from an approved list (subject to meeting half the cost). Special units that focus on large taxpayers will be created to enhance tax administration. In addition, the audit capacity of the CBR will be steadily increased. A special committee has been formed to look into these issues; it is expected to complete its report by end-2000, including a proposed implementation schedule. It is envisaged that a modern income tax administration based on genuine self-assessment will be in place by April 2002.

B. Public Enterprise Reform and Privatization

31. A major program to streamline, restructure, and corporatize public enterprises is underway either to reduce the burden associated with enterprises that place a drag on budgetary resources and complicate budget execution, or to enhance their revenue potential.⁷ More generally, the program also aims at improving the efficiency and services of public sector enterprises and preparing some of them for privatization. Starting in 1999/2000, the program has focused on the power sector, the Pakistan Steel Mill, and the Pakistan Railways. In the medium-term, the restructuring process will also be extended to the major companies in the gas sector.

32. The financial position of the power wing of WAPDA has improved substantially with the ongoing operational and financial restructuring supported by the World Bank. Nevertheless, the liquidity situation has remained difficult because of large overdue receivables from public and some private sector entities and the increase in furnace oil prices, which has eroded profit margins. After a long impasse, all involved parties have agreed on the modalities for the settlement of public sector arrears. For the large overdue receivables of Sindh, arbitration is required as Sindh disputes WAPDA's billing; the dispute is expected to be settled by end-November with the Finance Minister acting as the arbiter. Decisions on the settlement of arrears from other provincial governments, FATA, and agricultural tubewells in Baluchistan were reached recently and are now being implemented. The federal government will ensure that federal agencies and provinces will remain current on their electricity bills, including through deduction at source from the provincial share in tax revenue where necessary. To ensure financial viability and adequate working capital, WAPDA's electricity tariffs will need to increase in 2000/01. To this end, WAPDA submitted a filing for an automatic fuel and power purchase price adjustment clause to the National Electric Power Regulatory Authority (NEPRA) in August 2000 and will file for a structural price increase to address cost increases relating to exchange rate adjustment and the settlement with independent power producers (IPPs) during the fiscal year. In accordance with policy principles guiding NEPRA decisions, a notification of the tariff increase is expected to be issued in November 2000. In the meantime, NEPRA accorded a temporary tariff award to WAPDA.

33. The weak financial position of the KESC, which for many years has been running operational deficits that have eroded its equity capital, is also being addressed. The severe deterioration in corporate governance and the difficult law and order situation in Karachi, which have led to electricity theft, billing fraud, and collection problems on a large scale, are the main reason behind losses and liquidity problems, including large overdue payables to WAPDA, other suppliers, and the government. Financial control as well as operational and administrative efficiency will be strengthened through a corporate restructuring while the provision of army support to KESC will support the efforts to address the governance and collection problems. In addition, a sequence of tariff increases, the first of which is also to be approved by NEPRA in November 2000, will be needed to turn around the financial situation and improve the cash flow situation. Nevertheless, with overdue payables, upcoming amortization payments, and operational deficits in 2000/01 and 2001/02, KESC will be faced with a cumulative cash shortfall of about PRs 22.4 billion during 2000/01-2001/02, even if debt service liabilities are converted into equity (government) or rolled over and restructured. The shortfall is to be met through commercial bank borrowing with a government guarantee; bank borrowing of up to PRs 7.5 billion by KESC has been built into the monetary program for 2000/01. With the financial turnaround and a final financial restructuring to be supported by technical and financial resources from the AsDB, the privatization of KESC is targeted for December 2002.

34. The Privatization Commission (PC) has drawn up a timetable for the privatization of banks as well as enterprises in the gas, petroleum, power, and industrial sectors. Enterprises and banks are to be sold through competitive bidding and through listings on the stock exchanges. The PC estimates that privatization receipts could amount to US$4 billion over the medium term. The actual timing of privatization of each entity, however, will depend on a number of factors, including investor appetite. In the gas sector, for example, existing tariff policies at the consumer and the wellhead levels must be amended before the privatization process can be undertaken. This would involve a substantial increase in existing tariffs; the 15 percent increase in end-user gas prices effected in June 2000 should be seen as a step toward achieving the necessary tariff level. In all cases, some noncore assets would be divested prior to restructuring and privatization of the major entities; the LPG business of the Sui Southern gas distribution company (SSGCL) was sold to a foreign investor in September 2000, fetching about US$6 million.

C. Financial Sector Reforms

National Savings Scheme (NSS)

35. Reforms of the NSS have been launched in an effort to reduce financial market segmentation, encourage the deepening of the capital market, and reduce the cost of government borrowing. Institutional investors have been barred from purchasing NSS instruments from March 2000, and interest rates on NSS instruments have been reduced by an average of 5.5 percentage points since May 1999. A special audit of, and intensive reconciliation, at the Central Directorate of National Savings (CDNS) and its regional directorates is underway by the Central Audit Department, and is expected to be completed by end-October 2000.

36. Professional management of the CDNS has recently been put in place and its autonomy from the Ministry of Finance will be enhanced. The terms of reference for the new management of the CDNS include computerization and streamlining of NSS operations, and replacing the entire line of NSS instruments with new instruments that carry market-based rates of return by the start of the next fiscal year. The new NSS instruments will be designed to ensure consistency with the requirements that are adopted in this regard. In view of the recent rise in treasury bill yields and the envisaged upward pressure on banks' deposit rates, the differential between return on NSS and other financial instruments is expected to narrow further in the coming months. Thus, further cuts in NSS interest rates during 2000/01 are not envisaged, except perhaps at the long end of the maturity spectrum. Indeed, under current macroeconomic circumstances, it is important to maintain the attractiveness of rupee denominated assets to help avert the emergence of pressures on the rupee.

37. Meanwhile, progress is being made in developing the necessary supporting infrastructure for linking the new NSS instruments to market-based rates of return. Tradable long-term government bonds of 3-, 5-, and 10-year maturities will be launched in November 2000. These new bonds, which are aimed at the institutional investors that may no longer invest in NSS instruments, are to be sold through auctions to primary dealers. It is envisaged that the market-determined yields on the new bonds will serve as a benchmark from January 1, 2001, for the returns that will be offered on new Defense Savings Certificates (DSCs), which account for about two-fifths of the outstanding stock of NSS instruments. The linked DSC rates will subsequently be adjusted on a semi-annual basis in response to movements in the benchmark yields. Returns on all other new issuance of NSS instruments will become market related by July 1, 2001, either by a link to the benchmark bond or by removing their "on tap" status. For the latter, the government will set targets for the mobilization of funds at the beginning of each fiscal year and adjust returns as warranted by market conditions.

38. The tax-exempt status of NSS instruments will be removed from the start of the 2001/02 fiscal year. From that point onwards, any new investments in NSS instruments will be taxed in the same manner as other financial instruments. The proposed change in the tax treatment of NSS instruments has been set to coincide with the envisaged promulgation of the new income tax law and the introduction of the new line of instruments.

39. Over the longer term, further rationalization of NSS operations--including through allowing retail investors access to the benchmark instrument--will be undertaken to facilitate the reintermediation of funds into the banking system and the capital market. Indeed, the outstanding stock of NSS instruments is expected to decline as the instruments held by institutional investors, which account for about one fourth of the total, mature. NSS operations will be focused more narrowly on the targeted client base of small savers in rural and poor urban areas; in this context, a survey to assess the socioeconomic profile of current NSS instrument holders is being undertaken. As the availability of commercial banking facilities and capital market instruments to these savers is limited, the absence of secure vehicles for saving could result in the re-emergence of unregulated pyramid saving schemes. Thus, NSS instruments are likely to continue to have a useful role to play in mobilizing their savings, similar to government-run saving schemes in operation in many countries, including several industrialized economies.

Banking sector and nonbank financial institutions

40. The financial health of the banking system has improved in recent years as a result of measures to enhance banks' commercial orientation and upgrade the banking supervision system. In addition, the intensified loan recovery drive, which has been in effect since mid-November 1999, has already yielded some PRs 22 billion in collections, equivalent to 11 percent of the outstanding stock of nonperforming loans of the banking system. The cleaning up of banks' balance sheets will be further aided by the newly established Corporate and Industrial Restructuring Corporation (CIRC), whose principal objective is to dispose of the nationalized commercial banks' (NCBs') nonperforming assets through industrial restructuring, mergers, and, if necessary, liquidation. A plan to restructure and consolidate the development finance institutions (DFIs) has also been formulated, with a view to improving their financial health, rationalizing and commercializing their operations, and paving the way for their eventual privatization.

41. To further enhance the commercial orientation of the banking system, the preparatory process for privatizing banks has been accelerated. It is envisaged that the remaining government stakes in Allied Bank and Muslim Commercial Bank will be sold by end-2000, and that one of the remaining NCBs will be privatized by end-March 2001.

Export Finance Scheme (EFS)

42. The scope of the EFS has been narrowed considerably over the past year with the reduction in the list of items that are eligible to receive financing through the scheme. In particular, exports of yarn and low count fabrics ceased to be eligible for financing under the EFS from end-1999, and exports of grey cloth are presently under a transitional arrangement by which financing under the EFS will be available at a rate of 10 percent (in comparison with 8 percent for other eligible exports).⁸ The subsidy element of the EFS has narrowed considerably over the past two years as lending interest rates have declined. To avoid any widening of the subsidy in the near term, the EFS interest rate will be raised in line with developments in the average 6-month treasury bill yield during the previous quarter, starting from end-2000.

43. Recognizing the need for an integrated approach to trade finance with an emphasis on mitigating risk while enhancing credit access of small- and medium-sized enterprises, a new dollar-based window will be introduced by end-2000. This window, which will be known as the Foreign Currency Export Facility (FCEF), will be supported by a loan from the AsDB. The FCEF will address a number of problems that exist under the EFS, including the absence of effective risk mitigation mechanisms and a banking culture that does not accept export payment instruments (such as letters of credit) as adequate collateral, thereby impeding the private sector's provision of funds for developing new exporters, markets, and products. In order for the FCEF to catch on, the subsidized export finance through the EFS will be eliminated by end-2000/01.

Transition to Islamic financial system

44. The government is in the process of making the necessary preparations to implement the Supreme Court's December 1999 decision requiring the transformation of Pakistan's financial system to conform with Islamic financial principles. In this connection, a Commission on the Transformation of the Financial System has been established to formulate a transformation plan and suggest amendments in contracts and operations of financial institutions. Once the transformation is completed, all new domestic borrowing will be in accordance with Islamic financial principles; new instruments and institutions, as well as a legal framework, will need to be put in place for this purpose. All international debt obligations will continue to be serviced.

Foreign currency deposits (FCDs)

45. The requirement that banks place with the SBP their foreign currency funds (excluding those that have been lent domestically) mobilized through new foreign currency deposits (FCDs) will be liberalized. This requirement had been put in place in June 1999, in response to concern over the quality of banks' investments in assets abroad. Prudential regulations governing such investment are being finalized. It is envisaged that the placement requirement will be withdrawn by end-March 2001, after financial assistance from the international financial institutions (IFIs) has resumed.

Recapitalization of the SBP

46. A shortfall in the SBP's capital and reserves related to revaluation losses on its net credit from the IMF was completely covered in June 2000. The shortfall had emerged as the result of not revaluing the outstanding stock of IMF credit (related to disbursements under SAF and ESAF) in the SBP's rupee balance sheet in previous years. Thus, a revaluation of PRs 18.9 billion was effected in stages during the period June 1999-June 2000. Of this, PRs 15.5 billion was covered through the retention of SBP profits earned in 1999/2000, while the remainder was covered through the retention of profits earned in 1998/99. For the purpose of preparing the monetary accounts, all foreign assets and liabilities of the SBP--including its net IMF position--are being revalued on a monthly basis from the start of the 2000/01 fiscal year.

D. Trade Liberalization

47. A number of measures have been taken in recent months to liberalize trade. In particular, effective tariff rates that were in excess of the maximum tariff of 35 percent have been reduced to no more than 35 percent. Effective tariffs, measured as the import tariff rate plus the differential in excise taxes applied to domestically-produced and imported goods, previously had exceeded the maximum rate for some 40 items. The differential excises applied to these 40 items were adjusted in June 2000 for all items except the 8 on which differential excises had been applied as an anti-dumping measure in the absence of the relevant legislation in Pakistan. Once the WTO-consistent anti-dumping law is in place--envisaged by end-December  2000--the differential excises for these items will be withdrawn. Any remaining differential excises (for items where the effective tariff is within the maximum) will be removed by July 2001.

48. A number of other steps have also being taken to liberalize the trade regime. Exports of all agricultural products except wheat have been liberalized by August 2000 through the elimination of annual administrative approval requirements and minimum export prices. At the same time, the government has scaled down its interventions in agricultural products markets. In addition, all remaining margin requirements on import letters of credit have been removed. A number of sectoral studies have also been commissioned to come up with recommendations to improve sectoral performance by identifying and addressing structural weaknesses in the economy.

49. The government is firmly committed to further trade liberalization over the medium term in order to promote competitive and efficient industry, and boost investment in high value-added sectors in which Pakistan has a comparative advantage. It is recognized that reducing rates of effective protection and the anti-export bias of existing tariff policies will enhance industrial performance and investment efficiency. In order to convey a strong signal regarding the government's policy intentions and give the private sector some time to adjust to increased competition, the overall tariff reduction plan was publicly announced on October 25, 2000. In particular, this will involve a reduction in the maximum tariff rate to 30 percent from July 2001, and to 25 percent from January 2003. Moreover, the number of tariff slabs will be reduced from 5 at present to 4 in July 2001 and 3 in January 2003.

V. Governance and Transparency

50. Measures aimed at improving governance and enhancing transparency constitute a key element of the reform agenda. These include the formulation of a devolution plan to redistribute the balance of activities and responsibilities across the various tiers of government; measures to enhance the quality of public spending; reform of the civil service, police, and judiciary, with increased accountability of public officials; and improvements in financial management and the quality of the public and national accounts statistics.

51. The National Devolution Plan to decentralize the delivery of government services and enhance the role of local citizens' groups in setting priorities for government spending has been launched. The program envisages the creation of elected district level authorities and local councils. A review of revenue authority and expenditure responsibilities at each tier of government has recently been initiated. The decentralization plan will be supported by a strong framework to ensure that it does not lead to a loss of fiscal control as revenues are transferred to lower tiers of government ahead of expenditure responsibilities.

52. Economic governance is being improved through a wide-ranging program to enhance the quality of economic decision making and public spending. This is expected to curb wasteful spending, particularly under the Public Sector Development Program, and raise the accountability of officials responsible for public projects.

53. A program to reform the civil service and enhance its accountability has been formulated and will be implemented over the next two years. The autonomy of the Federal Public Services Commission (FPSC) is being strengthened. In addition, government officials' training programs are being revamped and the performance evaluation system is being revised to ensure that promotions are on a strict merit basis. Restructuring of government departments has commenced with the CBR, where 1,000 employees have been shed. Restructuring of the CBR has been entrusted to a task force, which will submit its recommendations by end-December 2000. This is to be followed with the restructuring of federal economic ministries by March 2001 and of the rest of the federal secretariat by 2002/03. An ordinance empowering the government to retire civil servants with more than 25 years of service has been promulgated, and a new ordinance to deal with corruption and inefficiency is also in place. A review of government employees' salary structure is expected to be completed by June 2001. Under the judicial reform program, which was launched in 1998, the training of judges is being improved and automation of the judicial system is being enhanced. A Tax Ombudsman's Office has recently been established. A report on police reforms has been completed, and its recommendations are to be implemented during 2000/01.

54. Following the discovery of discrepancies in the fiscal accounts in late 1999, a number of measures have been put in place to improve financial management and enhance the transparency of economic and financial policies and data. A Fiscal Monitoring Committee (FMC) has been established at the federal level to track fiscal developments and direct efforts for improving the quality of fiscal data, and similar committees are being formed at the provincial level. The Accountant General Pakistan Revenue (AGPR) is now fully involved with the Budget Wing of the Ministry of Finance in the preparation of fiscal reports, which will henceforth be published on a quarterly basis with commentary on data quality. In addition, the implementation of the Pakistan Improvement of Financial Reporting and Accounting (PIFRA) project is being accelerated and a centralized debt management unit with a computerized debt management system will be put in place by end-2001.

55. A number of measures are underway to improve the transparency of economic and financial policies and data dissemination. The fiscal module of the IMF's ROSC has been completed, and its main recommendations are being implemented. In particular, efforts will focus on: (a) strengthening the core fiscal accounting and reporting procedures; (b) widening and deepening fiscal information provided in the budget process; and (c) defining more clearly the roles of different levels of government and the relationship between government and commercial activities. The government will also participate in the Financial Sector Assessment Program (FSAP) and take part in the production of related financial sector ROSCs during 2001. Moreover, in recognition of the weakness in the coverage, accuracy, and timeliness of national accounts statistics at present, a timebound plan to improve the quality and frequency of national accounts statistics has been developed. The plan envisages the completion of 22 sectoral reports by end-March 2002; the plan will culminate in the production of new national accounts statistics with the base year 1999/2000. The new national accounts will be completed by end-June 2002.

56. Stage one of the Fund's safeguards assessment has been completed, in collaboration with the Fund's staff. The principal recommendation emerging from this exercise was that the SBP's financial safeguards (audit, legal structure and independence, financial reporting and financial internal controls) need to be strengthened. Specific steps in this regard, as well as a timetable for their implementation, will be agreed during a stage two of the assessment, which is expected to be completed by end-January 2001.

VI. Financing Issues

57. The financial program outlined above is built on the assumption that about US$4 billion in gross exceptional financing would be available during 2000/01. It is envisaged that such financing could come from the private sector, the IFIs, and official bilateral creditors.

58. Regarding financing from the private sector, an agreement with commercial banks on the restructuring of commercial loans totalling US$929 million was reached in 1999. Of this total, US$777 million involves a rolling over of trade finance facilities on an annual basis for three years (concluding in June 2002), and includes a step-up in the margin over LIBOR from 100 basis points in the first year to 125 basis points and 150 basis points in the second and third years, respectively. Of the remaining amount, US$102 million was rescheduled with a grace period of up to end-December 2002 and repayments thereafter in six equal annual installments. In addition, a US$50 million loan from an investment bank, which was contracted in September 1998, has been rolled over beyond 2000.

59. Pakistan's three Eurobond obligations worth a total of US$608.3 million were voluntarily restructured in December 1999. Under the restructuring terms, previous bonds were exchanged for a new issue with six-year maturity, three-year grace period, and four equal annual repayments starting in November 15, 2002. Around 99 percent of bondholders opted for the new debt instrument. The government does not intend to repay the remaining old bonds on terms more favorable than the new issue.

60. New private sector financing is also being arranged. At this stage, two loans totaling US$145 million from commercial banks to public enterprises are being arranged; both loans are for 300 days. In addition to the US$413 million in loans from the Islamic Development Bank (IDB) that was already in the pipeline, financing of US$130 million from the IDB has been arranged (US$50 million with two-year maturity and US$80 million with a six-month rollover basis). Moreover, the government will seek rollover of US$500 million deposits from the Bank of China at the National Bank of Pakistan and of 75 percent of US$1.1 billion foreign currency deposits of nonresident institutional investors, which fall due in 2000/01.

61. The reform program in the power, gas, and banking sectors, and in the areas of privatization and governance, will be forcefully implemented to fulfill the conditionalities linked to the Structural Adjustment Loan from the World Bank. The government hopes that the World Bank could then disburse US$350 million in 2000/01 in support of these reform efforts. Expeditious steps will also be taken to allow the disbursement of some US$525 million from the AsDB during the current fiscal year in the form of program loans covering agriculture, trade, energy, legal system, microcredit and small- and medium-sized enterprises.

62. The government assured the rolling over for two years of US$250 million deposit from the Kuwait Investment Authority at the SBP initially falling due in August 2000. The government will also seek further rolling over of US$150 million deposit from the Central Bank of the U.A.E. at the SBP falling due in December 2000.

63. To close the remaining financing gap, the government intends to approach the Paris Club and other bilateral creditors for a rescheduling of public and publicly guaranteed pre-cutoff debt on terms similar to the last rescheduling, including arrears and excluding amounts due under the last rescheduling.⁹

VII. Program Monitoring

64. The government is aware that purchases under the stand-by arrangement would be contingent on the observance of quantitative and structural performance criteria and the completion of reviews. The monitoring of the program by the Fund staff will also take into account indicative targets and structural benchmarks.

65. For purposes of monitoring the program for 2000/01, quantitative performance criteria and quantitative indicative targets that have been agreed are presented in Table 1, and structural performance criteria and benchmarks are set out in Table 2. The government has also implemented a number of measures as prior actions for the Board's approval of the arrangement; these are listed in Table 3. Purchases under the Stand-By Arrangement shall be subject to reviews to be completed in March 2001, June 2001 and September 2001. Quarterly external financing assurances reviews will also apply, as part of the regular reviews under the program. Definitions of each of the monitoring variables and, where necessary, of the qualitative performance criteria and benchmarks, together with reporting requirements and monitoring mechanisms are detailed in the attached Technical Memorandum of Understanding.

66. The government believes that the above described policies are adequate to achieve the objectives of the program and, on this basis, hereby requests approval of the stand-by arrangement. Moreover, the government stands ready to take any additional steps that may be necessary and will consult with the Fund on this matter in accordance with the Fund policies on such consultations.

PAKISTAN