Pakistan and the IMF
News Brief: IMF Completes Last Review Under Pakistan's Stand-By Arrangement, Approves US$135 Million Disbursement
Country's Policy Intentions Documents
Intent, Memorandum of Economic and Financial Policies
Mr. Horst Köhler
Dear Mr. Köhler:
Based on discussions with Fund staff in late August 2001 for the third review under the Stand-By Arrangement, the attached Supplementary Memorandum on Economic and Financial Policies (SMEFP) reviews economic developments and policy implementation in fiscal year 2000/01 (July 2000-June 2001) and during July-August 2001, and discusses a few measures to be taken in the coming weeks to ensure the program for 2001/02 remains on track. As you know, we are discussing with Fund staff a three-year program to be supported under the PRGF, and with negotiations well advanced, expect to provide you soon with a Memorandum on Economic and Financial Policies (MEFP) for the next three year.
On the outcome for the structural performance criteria through end-June 2001 we had already reported in our letter dated June 27, 2001. All structural performance criteria for July-September were observed, except that passage of the revised income tax law has been delayed to early September 2001 to allow more public debate and scrutiny of the published draft, and the elimination of the export credit subsidy (for which a waiver of nonobservance was granted in July). With one exception, all quantitative performance criteria for end-June 2001 were met with comfortable margins. The performance criterion on Central Board of Revenue (CBR) revenue was missed, as already anticipated in our June letter, but by a larger-than-expected margin as explained in the attached memorandum. To ensure that the 2001/02 deficit will be achieved, we have implemented additional fiscal measures as outlined in the attached SMEFP, along with measures designed to deepen the interbank foreign exchange market. This will allow to gradually reduce reliance on the kerb market purchases to strengthen official reserves. On this basis, we request a waiver for the nonobservance of the structural performance criterion on passage of a reformed income tax law by end-July 2001. On the basis of performance and policies set out in the attached memorandum, the government requests the completion of the third review.
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 memorandum 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.
I. Developments During FY 2000/01 and the First Quarter of FY 2001/02
1. Macroeconomic performance in 2000/01 suffered from an unprecedented drought, a weakening external environment, and higher oil prices. As detailed in our earlier memoranda, rainfed agriculture was most severely affected, and the need for additional petroleum imports to substitute for hydropower weakened already vulnerable external balances. Preliminary estimates put real GDP (at factor cost) growth in FY 2000/01 at 2.7 percent, slightly better than the program target of 2.6 percent. We expect some slowdown of industrial growth for 2001/02 given weakening foreign demand, but despite poor rainfalls in August (after good rains in June/July), some recovery of agricultural output. Accordingly, the economy is so far on track to realize the targeted real GDP growth of around 4 percent for 2001/02. Reflecting prudent financial policies and favorable food supply conditions, inflation as measured by the CPI slowed to 2.5 percent in the year through June 2001, and 4.4 percent for the annual average, better than programmed. This trend continued in July 2001, with the CPI increase year-on-year again at 2.5 percent. With the exception of the target for Central Board of Revenue (CBR) revenue, as discussed below, all quantitative performance criteria for end-June 2001 were observed (Table 1).
2. External balances for FY 2000/01 were somewhat stronger than programmed. The external current account deficit (excluding grants) declined to 3.3 percent of GDP, compared to 3.6 percent the preceding year. The trade balance turned out better than projected, reflecting largely lower imports, while workers' remittances (including through the kerb market) were higher than projected. Exports grew by 9 percent, reflecting strong growth in nontraditional exports, such as petroleum products, pharmaceuticals, chemicals, and leather goods. Cotton manufacture exports stagnated due to lower unit values, reflecting a softening of world demand, whereas volumes increased as programmed. Import growth was contained at 6 percent, reflecting weaker domestic demand and external financing constraints.
3. Reserves targets and the performance criterion on net foreign assets (NFA) of the State Bank of Pakistan (SBP) for end-June 2001 were met with comfortable margins. Gross official reserves (excluding FE-25 foreign currency deposits and short-term swaps and forwards) were maintained close to or above the projected end-June level, and are on track to meet the target (US$1,757 million) by end-September. However, given the timing of debt service payments and of foreign exchange inflows it will not be possible to observe daily the indicative continuous floor as set out in our June letter. The interbank market exchange rate remained broadly stable during July-August 2001, with the premium on the kerb market also stable in a daily range of 4-5 percent. Kerb market purchases by the SBP were reduced to US$88.5 million during July, compared to US$266.3 million during June. The government has ensured, and remains committed to ensure, that all current account operations can be transacted on the interbank market free of any restrictions or undue delays in the approval of payments and transfers for such transactions, and ensure compliance with Pakistan's obligations under Article VIII of the Articles of Agreement.
4. The consolidated government deficit (excluding grants) for FY 2000/01 amounted to 5.2 percent of GDP, lower than programmed. Unexpectedly large shortfalls in tax revenues from programmed levels were compensated by expenditure restraint. The revenue shortfalls on CBR taxes were mostly in income and sales tax collections as well as gas surcharges. The shortfalls on CBR taxes reflect a variety of factors, such as perhaps overly ambitious targets, weaker-than-expected growth, and excessive focus on the tax survey and documentation drive at the detriment of audit and collection enforcement earlier in the fiscal year. Despite release at the federal level of all budgeted appropriations for social and poverty-related expenditures at the beginning of the year, as envisaged in the program, such outlays fell short of program objectives by PRs 13 billion (as per provisional accounts) mainly due to limited absorption capacity. Nonetheless, such outlays rose by 11 percent (somewhat faster than GDP) over the last year and probably more as some of the expenditure that has yet to be classified (reconciliation is typically completed by end-September) may fall in this category. Military expenditure was contained at the programmed level. In addition, government net lending was reduced by the unexpected early repayment of PRs 8 billion onlent debt by the telecom company. Lower current and especially capital spending at the provincial levels resulted from deliberate expenditure restraint and better enforcement of accountability and governance standards. In the circumstances, the end-June performance criterion on CBR revenue was breached with a larger margin (0.7 percent of GDP) than was anticipated in our June letter. However, the performance criterion on the fiscal deficit was observed with a comfortable margin (0.2 percent of GDP). The performance criterion on net bank borrowing was also met comfortably, as both external and domestic nonbank financing turned out somewhat higher than expected. The unfavorable tax revenue trends continued in July, despite an encouraging performance of sales tax, with CBR revenue falling again short of the target, making it unlikely that the end-September indicative target would be met. More comprehensive budgetary data for July are not yet available although continued compression especially of provincial expenditures is likely to have occurred.
5. Monetary policy remained tight to keep inflation on target. A sharp tightening of monetary policy (six-month treasury bill rates were raised to 12.9 percent in late June) helped achieve the reserve target and helped slow reserve money growth to 3.4 percent in the year through end-June 2001, well below the program target. The performance criterion on central bank net domestic assets (NDA) at end-June was met with a comfortable margin, and without any exceptional operation. Broad money growth slowed to 7.1 percent in the year through June 2001, below the program target, reflecting a sharp reversal of the previously observed shift to cash. We are analyzing the reasons for this change in money demand, which does however reflect a return closer to the historically observed levels of the cash/deposit ratio from the unusually high levels observed through much of 2000. Private credit growth slowed to 6.4 percent over the year, reflecting mostly the impact of high interest rates. By contrast,
the growth of NFA of both commercial banks and the SBP was much larger than expected. With inflation well under control, and reserves targets for September within reach, we have cautiously started to reduce interest rates, but stand ready to reverse these steps if needed.
6. Structural reforms are broadly on track. The structural performance criteria for the period April 2001- July 1, 2001 were all observed, with the exception of the elimination of the interest subsidy on export finance (Table 2). The latter was nonetheless substantially implemented through a sharp increase in the export credit rate (to 13 percent), which, however, fell slightly short of the programmed level as the relevant benchmark rate (the six-month treasury bill rate) rose to exceptionally high levels in late June. The auction rate on six-month treasury bill subsequently declined rapidly, to 11.4 percent in early August and thus below the export finance rate by a margin exceeding 1.5 percentage points, thus fully eliminating any subsidy as defined in the TMU. The structural performance criteria for the period July-September 2001 have also been met, with the exception of the passage of a new income tax law (see below). Most structural benchmarks for the period April-August 2001 have also been met, with a few qualifications as indicated in Table 2.
7. The new income tax law will be promulgated in early September 2001, somewhat later than programmed, to allow more time for public scrutiny and comment (the draft was posted on the web in early July and triggered a lively debate and a host of suggestions from the public and especially various professional associations). The new law, elaborated with Fund technical assistance, will considerably streamline and clarify income tax rules, generalize self-assessment with clearly specified record-keeping rules, remove the ambiguities of current regulations, include the taxation of nonmonetary benefits as a principle, and incorporate all the substantive reform elements that were already made effective July 1, 2001 under the current budget law as described in our June letter. The law will apply to income earned from July 1, 2002. At that time a further reduction in exemptions will be phased in.
8. Moves towards market liberalization have continued with the liberalization of petroleum imports in June 2001. Registered oil marketing companies (OMCs) are free to import any petroleum product. The OMC since June 2001 jointly determine every fortnight, subject to monitoring by the Ministry of Petroleum, the prices charged at the 29 central depots to reflect import prices (calculated as weighted average of the prices paid by the various OMCs), exchange rates, primary freight up to the depots, and other domestic costs as well as taxes and duties. Retail prices are free up to a fixed margin over ex-depot prices to allow for differences in transport costs between retail outlets and the depots.
9. The government has continued its program to streamline, restructure and corporatize public enterprises, and prepare several important enterprises for privatization. Market-friendly regulatory frameworks encouraging competition in the telecom and energy sector are being put in place. Progress has been made in reforming WAPDA through creation of autonomous distribution and generation entities (which would eventually be privatized) and the new corporate entities are fully functional. KESC has been put on a fast track towards privatization by end-June 2002, but continues to face very large collection shortfalls, theft and leakage of electricity, and financial distress; privatization will eventually require a major recapitalization operation by the government. The federal government will continue to ensure that a few key federal and provincial priority connections (such as hospitals and schools) remain current on their electricity bills. For all other agencies, WAPDA and KESC will apply normal commercial practice of switching off supply if bills are not settled.
10. To strengthen the financial sector's soundness, restructuring of the three nationalized banks has continued with the closure of 450 branches by end-July; and two of the three banks have completed major voluntary early retirement programs, although the staff reductions achieved cover only 60.8 percent of UBL and 31.3 percent of Habib Bank's respective initial targets. Both banks are being prepared for privatization, with UBL expected to be brought to the point of sale before year-end; recently cabinet also authorized the sale of a 5-10 percent share of the National Bank of Pakistan (NBP). The insolvent National Development Finance Corporation has been put in liquidation and assets will be transferred to the NBP. Finally, in close consultation with the World Bank, the SBP has approved a liberal policy regarding branch openings or closures for scheduled banks. The SBP has also stepped up its efforts to combat money laundering. Prudential regulations have been put in place, in line with the recommendations of FATF, to prevent criminal use of banking channels for the purpose of money laundering and other unlawful trade. An additional regulation directs the banks to make all reasonable efforts to determine the identity of the account holders. Regarding the issue of Islamic Finance, the Supreme Court has extended the deadline for the transition to July 1, 2002. Under any circumstances, all foreign and existing domestic debt and loan contracts will be honored.
11. In the context of preparing for the launching of our poverty reduction strategy, we have made progress in developing a system of improved monitoring of pro-poor and social spending, specifying coverage, frequency of reports, along with monitoring of intermediate outputs. We expect the system to start reporting quarterly data with a four-month lag for a first set of key expenditure categories by end-October 2001; other categories as well as more disaggregated data below the sector head level will become available only later. We have also made progress in building a debt database and management system, and we expect to sign before end-November the contract with UNCTAD for full implementation of the upgraded DMFAS system.
12. Devolution of the delivery of relevant government services to local government has started in earnest. Elections to the various local government councils were completed in July/August, and local government laws have been promulgated by all provinces. The elected Nazims are now in place. The primary objective of the process is to politically and economically empower the people at the grassroot level. The process has been carefully designed to avoid fiscal irresponsibility and to ensure accountability. The laws explicitly do not allow local governments to incur any debt.
13. The Cabinet approved in March, 2001 a right-and downsizing plan for federal ministries, which will reduce the number of federal civil positions by about 40,000 (11 percent of the total) over the next four years. Redundant staff are being placed in surplus pools (but remain on payroll) and may apply to relevant vacancies as they come up; the government will also seek donor support for financing separation packages for some surplus staff. Similar plans are being prepared at the provincial levels. In collaboration with the World Bank, we have started to undertake a further in-depth evaluation of the pay and pension system, including additional actuarial analysis and on this basis will design a strategy for long-term pension reform.
II. Adjustment and reform program 2001-2004
14. We have initiated discussions with Fund staff on a three-year program to be supported under the PRGF, and expect shortly to finalize the discussions with a view to bring a request to the Fund's Executive Board. In this context we will report in detail about financial and economic policies for the coming years. A new draft I-PRSP has been prepared in August, based on broad consultation within Pakistan, donors, and discussions with the staff of the Fund, the World Bank, and the Asian Development Bank (AsDB). It will be posted on the web in September to invite broader public debate. We have also organized consultations with each province on both the content and their role in implementing the strategy and in tracking results.
15. For the remaining period under the Stand-By Arrangement, we will pursue efforts on deepening the interbank foreign exchange market to facilitate the phasing out of the SBP's kerb market purchases; and have implemented additional revenue and expenditure measures to offset recent revenue slippages in order to ensure that the 2001/02 fiscal deficit target is met without compromising social sector or essential development expenditure; and further improve expenditure data reconciliation. The measures included an increase in diesel taxation by PRs 0.50 per litre effective September 1, 2001; cuts in nonpriority federal development expenditure to be managed by the federal government and the provinces. We expect the indicative financial program targets for end-September to be achieved, except for CBR revenue (as discussed) and possibly the NFA target, and intend to complete the actions listed in Table 3 prior to the Board meeting on the third review under the Stand-By Arrangement. To address continued large financial imbalances, WAPDA and KESC will continue to implement restructuring programs with support from the World Bank and the AsDB. In addition, we expect WAPDA and KESC to move the regulatory authority in the electricity sector (NEPRA) to authorize further adjustment of electricity tariffs. In September 2001, gas consumer prices will be adjusted as envisaged under the six-monthly adjustment mechanism. We will also review the experience with the 20 percent GST rate on selected inputs in March 2002. Finally, we plan to lift the commercial backing constraint for foreign exchange interbank transactions, while strengthening our supervision over money changers to better monitor transactions in the kerb market.
III. External Financing Issues
16. External financing needs for 2001/02 and onwards remain large. Continuing support from multilateral and bilateral creditors and private sector will be essential. At the same time, preliminary indications from ongoing work on a debt sustainability analysis indicate that financing at largely non-concessional terms, while addressing immediate liquidity needs, keeps Pakistan's long-term external outlook unsustainable, with most debt indicators worse than for many countries supported under the HIPC initiative. Given the need to reduce a debt overhang that deters domestic and foreign investment and implies a burden on public finance that depresses much-needed spending on development and poverty reduction, we are therefore seeking to shift financing for the coming years towards more concessional terms. In particular, in the context of the discussions on a PRGF-supported program, we will seek a multiyear rescheduling from Paris Club creditors at terms more concessional than traditional Houston terms, and will limit as far as possible any non-concessional borrowing.