Pakistan and the IMF
News Brief: IMF Completes Second Review of Pakistan's PRGF-Supported Program
Country's Policy Intentions Documents
Free Email Notification
of Intent, Memorandum of Economic and Financial Policies, and Technical
Memorandum of Understanding
Mr. Horst Köhler
Dear Mr. Köhler:
The Pakistani authorities held discussions with Fund staff in May 2002 for the second review under the PRGF Arrangement. Based on these discussions, the attached Memorandum of Economic and Financial Policies (MEFP) reviews economic developments and policy implementation through March 2002 under the arrangement, updates the macroeconomic framework, and discusses the financial policies and structural reform program for the remainder of the fiscal year 2001/02 and fiscal year 2002/03. It supplements the MEFP dated November 22, 2001 and the supplementary MEFP dated March 12, 2002.
All performance criteria for end-March 2002 were met, except for the performance criterion on the Central Board of Revenue (CBR) revenue. As detailed in the MEFP, the CBR revenue shortfall reflects mostly continued lower-than-expected imports in the aftermath of the September 2001 events, and as described below a range of tax policy and tax administration reform has been implemented since March to strengthen tax collection. There has been the beginning of a turnaround in revenue performance during March-May 2002, along with a recovery of exports and imports. We expect this recovery to continue, although we recognize that it will be difficult to achieve the June target for CBR revenue, especially in light of the current level of regional tensions. We expect all other performance criteria for June 2002 to be met, on the external side with large margins. On this basis, we request a waiver for the nonobservance of the performance criterion on revenue of the CBR at end-March 2002.
On the basis of the performance up to end-March 2002 and the policies set out in the attached memorandum, the government requests the completion of the second review. We expect the third and fourth reviews under the arrangement to be completed as scheduled by end-September and end-December 2002, respectively.
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, we stand 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.
Memorandum of Economic and Financial Policies
Technical Memorandum of Understanding
Memorandum of Economic and Financial
I. Developments during January-May 2002
1. The referendum held on April 30 confirmed strong support for a continuation of the reform program and extension of President Musharraf's tenure for the next five years. This outcome should provide medium-term institutional and political stability, and strengthen the government's capacity to proceed forcefully with the implementation of its economic reform agenda. The parliamentary elections in October 2002 will provide the opportunity to strengthen involvement of the political forces of the country in the formulation and implementation of the reform program, and to deepen public ownership. On the other hand, the hoped-for reduction of military tensions on the eastern border is not yet in sight and this, along with isolated terrorist acts, impedes a faster recovery of private investment and growth. On a brighter side, the continuation of private foreign exchange inflows and steady financial support by the international community have allowed the State Bank of Pakistan (SBP) to build an unprecedented level of foreign exchange reserves, thus reducing the economy's external vulnerability. All quantitative performance criteria for end-March 2002 have been met, except (as discussed below) for the Central Board of Revenue (CBR) revenue (Table 1(a)).
2. Macroeconomic developments have been broadly in line with the program. While there has been some pick up of inflation in recent months, the average consumer price index (CPI) over July 2001-April 2002 increased by only 2.6 percent compared to the same period last fiscal year, consistent with the target of about 3 percent for the current fiscal year. In the agricultural sector, latest available data on the cotton crop indicate that the impact of various pests was less damaging than anticipated and production better than originally forecast. Rice and sugarcane production appear broadly in line with program expectations, while the wheat crop may fall short of projections, reflecting the continued shortfall in water availability from "normal" levels. Overall, agricultural value added in FY 2001/02 is projected to grow by 2 percent, in line with program projections. Growth in manufacturing is also close to projection, with a strong performance of sugar refining and more moderate growth in other manufacturing. Looking ahead, if tentative signs of a pick up in manufacturing, particularly textile, cement, and automobile firm up with the expected deepening of the incipient recovery in external demand, real GDP growth should reach the targeted 3.3 percent for this fiscal year.
3. The balance of payments position has continued to improve. Available trade data (on a custom basis) through April 2002 confirm a strong pick up in trade since March. Exports during March-April (in U.S. dollar terms) were 2.9 percent higher year-on-year (against a decline of 2.9 percent over the period July-February); and imports rose by 6.5 percent (against a decline of 10.1 percent over the period July-February). The improved export performance reflects mainly a recovery in textile orders from abroad, while higher imports reflect both the surge in oil prices and strong volume growth in most categories of goods. Remittances and private capital inflows were strong, in line with greater efforts of banks to capture transfers from migrants, and growing confidence of the business community, particularly of the expatriate community, in Pakistan's economic outlook. Official transfers are accruing broadly as projected. Official reserves reached US$3.7 billion at end-May 2002. Since early 2002, the rupee has been virtually stable, and the spread between the kerb and interbank markets has remained at around 0.2 percent. We expect these trends to continue in the coming months, and the current account balance (including official transfers) to end up at a surplus of about 1.0 percent of GDP. With a lower-than-anticipated capital account deficit, gross official reserves should reach the unprecedented level of US$3.5 billion, equivalent to 3.4 months of next year imports, by end of June.
4. Following a period of accommodative monetary policy between September 2001 and early February 2002 in response to the weakening economy, we have tightened our monetary stance to ensure continued low inflation. The end-March ceiling for net domestic assets (NDA) of the central bank and the flow on the net foreign assets (NFA) were respected with wide margins. In line with the more comfortable reserve position, the SBP stopped offering forward cover on banks' incremental foreign exchange deposits (FE-31) from April 1, 2002, leaving this task to the market. The 12-month increase in reserve money, adjusted for the effects of the various exceptional operations in 2001 on the base, slowed to 5.8 percent in March 2002 (down from the December 2001 spike of 14.3 percent). However, broad money growth accelerated to 13.8 percent in the year through March (from 11.8 percent through December 2001), driven by large foreign exchange inflows. We decided not to fully sterilize these inflows as we believe that this monetary expansion may reflect a shift to higher money demand, in particular for rupee liquidity, reflecting increased confidence in the domestic currency, as for example indicated by the decline in foreign currency deposits and the stability of the exchange rate. Factors related to the use of the rupee in Afghanistan may also play a role. In light of some firmer signs of an economic upturn and a slight pick up of inflation, we have since March 2002 tightened the monetary stance through more active open market operations and increases in refinancing rates; as a result, the weighted average yield on the six-month treasury bill in March/April hovered at 6.5 percent in recent auctions, compared to 5.6 percent at the mid-February auction. We expect these trends to continue and are confident that the monetary targets for end-June will be achieved.
5. The end-March performance criteria on net bank borrowing by the government and on bank credit to public enterprises were also met. Following what appeared to be excessively high bank borrowing by smaller public enterprises in the months to December, we undertook a major exercise to update the list of public enterprises and reconcile relevant data between the Ministry of Finance, the SBP, and commercial banks. The exercise confirmed that commercial banks had reported public enterprise credit on the basis of outdated lists of public enterprises, including firms that had been privatized in recent years, as well as a few cases of liquidated or recapitalized enterprises whose liabilities had been assumed by the government. The revised set of enterprises on which the relevant credit aggregate is to be monitored is now consistent across banks and agreed between the Ministry of Finance and the SBP. On this basis, we have revised downward the data on outstanding public enterprise credit, and revised upward private sector credit as well as government credit back to June 2001. The revised data indicate that the end-December 2001 performance criterion was actually observed, while the end-March 2002 target has been met. The revisions do not alter earlier judgments regarding compliance with program limits on bank credit to the government, including under the recent stand-by arrangement.
6. By improving further the management of federal current expenditure, we met the end-March fiscal deficit performance criterion comfortably, despite shortfalls in CBR revenue. CBR revenue for July 2001-March 2002 fell about PRs 8 billion short of the modified program target. In part, this reflects lower-than-expected imports through February and the appreciation of the rupee, which led to continued shortfalls in customs duties and sales tax receipts (about 40 percent of which derive from imports) but also in income tax, as much of the latter is collected through withholding on imports and other transactions. Another factor was lower withholding on interest income from securities, due to declining interest rates. These exogenous factors were compounded by continued shortcomings in tax administration, including difficulties to prevent abuse of existing loopholes in the refund system. Nonetheless, in March and April 2002, CBR revenue exceeded revenue collected in the same months of 2001 by 6 percent and 16 percent, respectively, indicating that some turnaround in tax collection is finally occurring. Furthermore, the backlog of refunds has been reduced to levels reflecting normal procedural lags, which we view as an important governance reform in itself. Revenue from petroleum and gas surcharges has been on track through March, but will likely come in below target for the year, following a temporary lowering of petroleum taxes during April and May. The latter was motivated by the desire to soften the impact of various other concomitant tax and gas pricing measures on consumers, in the context of surging international oil prices. Petroleum taxation has been fully restored from June 1, 2002 onwards, and we do not intend to take any measures related to petroleum taxation that will adversely affect the budget in the coming fiscal year. Nontax revenue, including compensation for services to the coalition in the fight against terrorism, was well above expectations, despite lower-than-expected interest payments from the Water and Power Development Authority (WAPDA). WAPDA's financial difficulties also reduced its principal repayments to the budget, raising net lending above projections. Defense expenditure picked up about as expected starting in January 2002, while other federal current expenditure was lower than projected during the period January-March 2002. Development expenditure rose in most recent months and local governments have now become operational to a degree which has allowed for an acceleration in the execution of the Interim Poverty Reduction Strategy Paper (I-PRSP) expenditure. These expenditures reached PRs 80 billion by end-March 2002, 17 percent below the programmed outlays, compared to a shortfall by 25 percent during July-December 2001. We expect to meet the fiscal deficit target for end-June, but are aware that this will require three major elements to fall in place: First, that the recovery of imports, some pick up in domestic activity, and the impact of the recent elimination of a few exemptions, coupled with major collection efforts, will allow CBR to further improve revenue collection. Second, that military tensions in the region do not further intensify. Third, that budgetary support for WAPDA can be limited to deferral of debt service payments to the budget (PRs 23 billion).
7. Structural reforms are on track, as detailed in the attached Table 2, with important steps in the tax administration reform implemented in February and March 2002. In addition, we have stepped up the privatization program. In early March 2002, a 90 percent stake in Pak-Saudi Fertilizer for about PRs 8 billion was sold to domestic investors; in April/May, minority public interests in seven oil and gas fields were sold, mainly to foreign investors, for US$188 million. The sale of United Bank Limited (UBL) will take place in early June; in this context we have also replaced commercial banks' claims on the government due to taxes paid through 2000 on interest accrued but not collected by government paper for PRs 22 billion. In line with our commitment to bring the Karachi Electric Supply Company (KESC) to the point of sale by July 31, 2002 (see below), the privatization commission recently invited expression of interest by potential investors, so far two major international companies expressed interest. In March, we dismantled the gas price agreement with Petroleum Pakistan Limited (PPL) and as the first step in bringing the PPL wellhead price gradually closer to the market price, increased it by more than 50 percent. Concurrently, we increased consumer gas prices by an average of 8.5 percent, in line with our commitment to bring gas prices to reflect costs and gradually eliminate cross-subsidization among different categories of consumers.
8. The financial restructuring of KESC is on track and the reorganization of WAPDA has recently made progress. In April, the government repaid the bulk of KESC's debt to banks for PRs 22 billion and debt to suppliers for PRs 8 billion, increasing its equity correspondingly. While the operation had been programmed to take place through the exchange of bonds, because of favorable treasury bill rates we preferred a cash operation, financed by a special issue of treasury bills. The cabinet approved continued army support for collection enforcement to any new owner of KESC. The National Electric Power Regulatory Authority (NEPRA) is expected to formulate a set of multi-year tariff rules to provide regulatory certainty. The cabinet also approved in April 2002 the transfer of WAPDA's assets and liabilities to the new distribution (DISCOs), generation (GENCOs), and the transmission company, and by end-April all the DISCOs licenses had been issued. In mid-May, the government agreed with the World Bank on a Financial Improvement Plan (FIP) for WAPDA and its successor companies in agreement with WAPDA and NEPRA, as explained below. A first tariff increase by an average of 4 percent took place in mid-May combining the implementation of the increase under the fuel adjustment clause, that had been delayed in April due to the difficult socio-political context referred to above, with a partial implementation of the structural increase needed to absorb fuel cost increases up to the year 2000. We are confident that implementation of the agreed package will bring WAPDA to financial viability and higher efficiency, thus reducing its drain on the budget.
II. Economic and Financial Policies for FY 2002/03
A. Macroeconomic Objectives and Policies
9. Developments so far and the strengthening of the international recovery bode well for a significant pick up in domestic economic activity, and the ambitious macroeconomic objectives under the program for FY 2002/03 appear achievable. Assuming water availability at the level of recent years and a recovery of export orders as security concerns subside and international demand accelerates, real GDP growth (at factor cost) is projected to reach 4.5 percent in FY 2002/03. Building on recent price developments, assuming continued broad stability of the exchange rate, and barring persistent increases in international oil prices, we have lowered the inflation target from 5 percent to 4 percent. Higher imports related to the pick up of domestic activity as well as a return of remittances closer to historical levels are expected to cause the current account deficit--excluding official transfers--to slightly widen to 2.3 percent of GDP (from 1.3 percent of GDP projected for FY 2001/02), despite a strong recovery of exports. The latter is expected to be driven by an improvement in unit prices, a shift to higher value-added products in the textile sector, and the recent increase in market access to major trading partner markets. Including official transfers, which are expected to decrease from exceptionally high levels in FY 2001/02, the current account is projected to move from a 1.0 percent of GDP surplus to a 0.8 percent of GDP deficit in FY 2002/03. This deterioration will be offset by a lower capital account deficit, largely on account of lower public sector net short-term outflows (including lower repayment of trade credits and of foreign currency deposits). Private net inflows are expected to fall off from the exceptionally high levels of FY 2001/02 that reflected a portfolio shift of Pakistani balances abroad toward the domestic financial system. We expect that net exceptional financing, notably in the form of rescheduled debt payments and program financing from the International Financial Institutions (IFIs), will be somewhat lower than in FY 2001/02, at about US$2.6 billion. Gross official reserves would reach US$4.2 billion in June 2003, equivalent to four months of imports of goods and nonfactor services.
10. In line with our strategy of fiscal consolidation to extricate Pakistan from unsustainable debt levels, we formulated the FY 2002/03 budget with the aim to reduce the consolidated government budget deficit (excluding grants) to 4.4 percent of GDP, while substantially raising social expenditure. We expect this reduction to result from an increased tax effort and reduced low-priority expenditure, so as to ensure the implementation of the planned shift in public expenditure toward human development. This shift will also be reflected in considerable additional transfers to the provinces, in part related to World Bank loans to support provincial programs centered on improvements in governance and the provision of social services. In addition, should external budgetary cash grants plus capital grants reflecting debt cancellation exceed the programmed levels, such excess may be used for additional expenditure on I-PRSP categories for up to 0.5 percent of GDP, as specified in the Technical Memorandum of Understanding (TMU). As in the past, should unforeseen developments threaten the fiscal deficit target, we would reduce nonpriority expenditure and enact contingent tax measures as specified below.
11. Achieving our fiscal deficit target while protecting human development expenditure will require a significant improvement in tax revenue performance. The target for FY 2002/03 on total tax revenue of 13.6 percent of GDP implies an increase of around 0.9 percentage points of GDP over the expected outcome for FY 2001/02. Part of this increase reflects a base effect due to the one-off impact of the regional conflict (on imports and exports) and change in sales and customs refund procedures, cautiously estimated at 0.5 percent of GDP. Therefore our target implies a structural increase in tax revenue of about 0.4 percent of GDP. While the impact of improvements in tax administration have been disappointing so far, we believe that an increasing impact of the reform of CBR together with a few important tax policy measures will make this objective achievable. The full-year impact of the recent elimination of GST exemptions on nonlife-saving pharmaceuticals and fertilizers and of the January increase in diesel taxation should yield 0.15 percent of GDP, while the elimination of the exemption on domestic edible oil/vegetable ghee would add 0.1 percent of GDP on an annual basis. In order to limit the negative impact on the poor of the elimination of GST exemption on edible oil/vegetable ghee and on medicines, we have strengthened the budgetary allocation to food and food-for-work programs targeted toward the most vulnerable. We also envisage establishing a few special programs in the poorest areas of the country, such as distribution of food at schools to girls regularly attending classes. In order to protect low-income earners, we increased the personal income tax threshold from PRs 60,000 to PRs 80,000. To further remove distortions in income taxation that impede the efficient allocation of resources and provide privileged treatment to certain kind of incomes or specific entities or sectors, the budget for FY 2002/03 includes an income tax reform package that should be broadly revenue-neutral in the short term. It includes the elimination of two minor withholding taxes, the elimination of 55 income tax rebates, concessions, and nonstandard exemptions from the CRITO-list, the lowering of the interest income withholding threshold on National Saving Schemes (NSS), and a further step in unifying corporate income taxes. In the context of the planned World Bank-support operation to Sindh and North West Frontier Province (NWFP) and in view of the poor collection from the agricultural income tax, we will work with provincial governments to strengthen their tax policy and administration and implement base-broadening and revenue-enhancing measures, including stronger enforcement efforts on the agricultural income tax. We have also further streamlined the system of excises with the 2002/03 budget, and eliminated six minor excise taxes, while adjusting the rates of others to maintain revenue neutrality. Finally, we will pursue our strategy to harmonize petroleum taxation among the different products. Should revenue fall short of the target by end-2002, we will implement appropriate revenue measures.
12. Unfortunately, the continued tension on the eastern border constrains our ability to create space for the much needed increase in human development expenditure. Nonetheless, we intend to reduce the share of defense expenditure in GDP to about 3.6 percent, thus reverting to our trend aimed at maintaining defense expenditure constant in real terms over the medium term. To ensure that human development expenditures are as effective as possible we have been holding discussions with the World Bank staff to assess the quality of the proposed Public Sector Development Program (PSDP) and the I-PRSP programs. With the FY 2002/03 budget, the elected district governments will be responsible for preparing their investment budgets in line with the needs and priorities of the community they administer. We expect that the devolution of investment expenditure to elected local administrations will increase the effectiveness of such expenditure (see below). We also expect that various reforms in government procurement policies, the restructuring of WAPDA and KESC, and better monitoring and greater accountability of public enterprises (as detailed below) will achieve the programmed reduction of quasi-fiscal activities and of explicit and hidden subsidies to public enterprises.
13. We remain committed to a policy mix combining a flexible exchange rate and prudent monetary policies, geared toward achieving the inflation and reserves targets. The targets for broad money and reserve money growth are broadly in line with the projected nominal GDP growth. We will ensure that our interest rate policy as well as the pace of SBP purchases of foreign exchange is consistent with the inflation objective and the monetary/reserves targets, within the framework of a fully flexible exchange rate. In light of the continued volatility in money demand, and notably the uncertainty as to whether the recent decline in velocity is a structural shift or only a temporary phenomenon, we will continue to closely monitor inflation developments and prospects as well as monetary aggregates, and stand ready to respond to any reemergence of inflationary pressures with a more aggressive absorption of liquidity. Given the limited stability of monetary aggregates, we are accelerating preparatory work toward moving to an inflation targeting framework; an important step will be legal reforms, to become effective before end-2002, enshrining greater independence of the SBP in the law (see below).
14. As described above, an important income tax reform package will become effective with the FY2002/03 budget, and income earned from July 1, 2002 will be covered by the new income tax law promulgated in September 2001, notably including nonmonetary benefits in taxable income. On the sales tax side, beyond the elimination of the GST exemption for nonlife-saving pharmaceuticals last April, we will eliminate the exemption for edible oil/ghee with the FY 2002/03 budget. We will also maintain, for FY 2002/03, the special GST rate of 20 percent on certain inputs as it helps to put pressures on traders to register under the GST to be able to get credit for sales tax payments. We estimate the measure is yielding PRs 2 billion per annum. Reform of the CBR will be pursued forcefully. We are on track to make a large taxpayer unit (LTU) in Karachi operational by July 1, 2002, as a pilot to provide valuable lessons for the planned functional integration of the administration of all taxes on a national basis. Ahead of schedule, we will establish a model income tax office for small and medium taxpayers in Lahore. Business procedures within CBR are being reformed, with the help of World Bank-financed consultants. Human resources management will be revamped over the next 12-15 months, including by late 2002, recruitment procedures that will emphasize CBR relevant special skills, a move to more merit-based promotion and remuneration rules, and developing a system of performance-related bonuses. Modern information technology will be introduced at all levels, with focus in the short term on providing the LTU with a database integrated across taxes, and PC-based information systems.
15. I-PRSP implementation and reforms on improving fiscal transparency and data quality are proceeding as envisaged under the program. Implementation of the anti-poverty measures under the I-PRSP continue. Specific actions in recent months include electricity subsidies for use of tubewells by farmers in drought-stricken areas, and the launching of a program to reschedule debt of small farmers in such areas. The recently established I-PRSP secretariat has intensified the monitoring of pro-poor expenditures, which are now regularly reported to the public on a quarterly basis, and with the Department for International Development (DFID) and World Bank support we are in the process of identifying suitable intermediate poverty indicators that could be monitored by early 2003. We will improve our I-PRSP quarterly monitoring as specified in Table 2. Three such indicators have been incorporated into the regular reporting under the program (see TMU), while recognizing that the outcome data reported by the existing systems suffer from various shortcomings that will be addressed over the coming months and year. On fiscal transparency and data quality, we will continue to implement measures in line with the Accountable Fiscal Management Framework (AFMF), and as agreed with the World Bank in the context of the Pakistan Improvement of Financial Reporting and Accounting (PIFRA) project. We will issue the FY 2003/04 budget call on the basis of the New Accounting Model (NAM), in parallel with the old one, for the federal government and NWFP, to push ahead with the eventual implementation of this model at all levels of government. At the provincial level, fiscal transparency and data work is being supported through the IFIs-financed provincial structural adjustment loans. As part of these reforms, Sindh Province will begin to publish quarterly fiscal data on its website, starting with the first quarter of FY 2002/03.
Other governance reforms
16. Ongoing reforms in the areas of devolution, civil service, tax policy and administration, and public financial management, as well as our ambitious privatization program all derive from the core of our reform program, that is to improve governance. Specific additional steps involve the reform of police and the judiciary under an Asian Development Bank (AsDB)-supported program, and public procurement reforms under the SAC II including the passage of a law establishing the Public Procurement Regulatory Authority. We recently invited Transparency International (TI) to assess the status of our anti-corruption activities and to make suggestions how to make them more effective. TI has clearly recognized our efforts and confirmed its view that corruption at the top levels of government has very significantly decreased. TI also made recommendations aimed at further reducing corruption, in particular through a proactive information and transparency policy, continued civil service reform, and reform of the procurement system, which we will carefully review and as appropriate incorporate in our reform agenda. A first step will be to increase accountability of public enterprise managers by publishing quarterly performance reports for key public enterprises, as detailed below.
17. The privatization program suffered a serious setback due to the events of September 11, but is now broadly on track, except that the privatization of Pakistan Telecommunications Company Limited (PTCL) has been delayed by a few months due to limited investor interest in the context of the weak financial position of the international telecommunication sector. We are also in the process to work out quarterly performance targets for Pakistan International Airlines (PIA), Pakistan Railways, Pakistan Steel Mills, and WAPDA/successor companies, to be ready in August 2002, with quarterly public reporting on such targets to start in November and covering the first quarter of FY 2002/03. In particular for designing a monitoring and reporting framework for WAPDA, which is complicated by the ongoing unbundling of WAPDA into various corporate entities, in line with the strategy supported by the World Bank, we have requested urgent assistance from the World Bank. The quarterly performance targets for WAPDA/successor entities will be derived from the financial improvement plan (FIP) recently agreed with the World Bank, covering the period through June 2004. The key elements of the FIP include a request to NEPRA for a structural average tariff increase of 16 percent in July 2002; enhanced efforts on billing including prompt disconnection of consumers whose current bills are not paid in a timely manner; limits on the growth in administrative expenses; strict application of the automatic fuel adjustment clause; and realistic targets for reduction of technical and distribution losses. On this basis, WAPDA should not require any further budgetary support (deferral of debt service or cash support) from FY 2003 onwards.
18. Our strategy in agriculture centers on better water management, providing better extension service to improve yields and reduce vulnerability to drought and pests, and to gradually reduce government involvement in the marketing of agricultural commodities, as specified in a reform program supported by an AsDB loan. A policy statement setting out the government's policies in this regard will be issued shortly. However, during FY 2001/02 the private sector has been quite slow in assuming a greater role, especially in investing into wheat storage facilities. In part this reflects uncertainty as to whether the recent wheat surpluses will be sustained (and with it the possibility to export freely), or whether a return to deficits would imply a return to the rationing and control mechanisms of the past. In part, it also reflects a continued policy of supporting the wheat price through public procurement at a fixed price. However, private traders and mills seem now ready to embark on a significant storage building program, owing to an incentive package including (a) interest rate subsidies to allow private traders to borrow at the same rate as public procurement agencies for procurement and storage building; (b) guarantee of occupancy of new storage facilities by the Pakistan Agricultural Storage and Services Corporation (PASSCO, the public procurement agency managing the national security stock) for the first five years; (c) support for private exporters toward the cost of upgrading domestically procured wheat to export quality; (d) setting up of export silo facilities at Port Qasim; (e) the ongoing rapid development of laboratories certifying for international, and perhaps soon to be developed national, standards; and (f) a policy of gradually rising issue prices starting in September 2002, to reflect the physical and financial cost of storage. The incentive package will be reviewed at the latest by June 2004.
Financial sector and exchange system reforms
19. Banking sector reform is proceeding as planned, centered on the privatization of the nationalized banks (UBL in June, Habib in the fall of 2002, and further floating of the National Bank of Pakistan (NBP) shares in 2002/03) following extensive restructuring of the branch networks, staffing, and balance sheets in the context of a World Bank project. We are also modernizing the prudential framework, particularly for SME and consumer financing. We plan to pursue an evolutionary approach to Islamic finance, encouraging the development of Islamic banking alongside traditional financial institutions, while adapting regulations for the supervision of chartered Islamic banks. We look forward to discussing our strategy in detail with the planned IMF/World Bank Financial Sector Assessment Program (FSAP) mission, and finalize specific actions in particular (a) to protect the financial system against illicit use, by bringing anti-money laundering rules up to best practices; (b) further modernize the prudential framework; and (c) phasing out the remnants of administered credit allocation (such as prescribed lending to agriculture). In the context of a capital market reform program supported by an AsDB loan, we will aim to further strengthen stock market supervision, develop secondary markets for government paper, and streamline the instruments of the national saving scheme. With the FY 2002/03 budget, we will take further steps toward harmonizing withholding rates across all financial instruments (including NSS) and rationalizing interest rates for NSS instruments. A new central bank law will be adopted by end-October 2002, strengthening SBP independence in particular in the area of reserve management, in line with Fund safeguard assessment recommendations. To further deepen the foreign exchange market, and strengthen monitoring of inward transfers, we will enact a legal and regulatory framework for the transformation of moneychangers into foreign exchange companies (which will be allowed inward transfers) by August 2002, and subsequently allow banks to purchase foreign exchange from moneychangers at freely negotiated rates, thus moving further toward unification of the interbank and the kerb market.
20. We are confident that the program is fully financed for FY 2002/03. We are working to conclude the bilateral agreements implementing the recent Paris Club Agreed Minute as scheduled on favorable terms, and have initiated discussions with all creditors. In line with the Paris Club Agreement, we will seek to ensure treatment of our debt due to all bilateral creditors on terms comparable to those agreed with the Paris Club creditors. During meetings with our official development partners, notably during the recent Pakistan Development Forum in Paris, partner countries and multilateral institutions indicated strong support for our reform strategy, as laid out in the I-PRSP, and we expect to obtain financial support at least at the levels assumed in the program, including possibly sizable debt swaps (for social expenditure) in the context of the aforementioned bilateral debt restructuring agreements, as well as in some cases outright debt cancellation. We are also firmly determined to meet the conditionality attached to program loan disbursements with the AsDB and World Bank to ensure the projected disbursements on time.
21. In the context of the project to revise and change the base year of national accounts, five additional studies, including on agriculture, construction, and large scale manufacturing, have been completed and will be sent to IMF staff for comments shortly. Three other studies, including on saving and investment, that had to be outsourced should be ready by June 2002. Our plan to publish producer price indices has been somewhat delayed, and is now scheduled for late 2002. Due to administrative capacity constraints, the planned steps toward improvement in statistical data dissemination outlined in the March 2002 MEFP could not be taken. These steps will however be implemented by June 30, 2002. Work on institutional reform plans for the statistical system has been carried on. With the help of a foreign technical advisor, we expect to finalize a restructuring plan by mid-2002.
IV. Program Monitoring
22. The proposed quantitative performance criteria and indicative targets for end-September and end-December 2002 are set out in Table 1. Table 2 reports on the status of the structural performance criteria and benchmarks; it also includes the new measures we intend to take in FY 2002/03 and the actions we intend to take prior to the Board discussion of the second review. To clarify the definition of program targets and to extend the reporting requirements under the program to additional variables considered essential for appropriate monitoring, the existing TMU has been amended. Starting July 1, 2002, the attached TMU will replace the existing one for the definition of performance criteria and for program monitoring purposes; it now specifically includes a few monitorable social sector targets. We expect the third review to take place as scheduled by end-September 2002. The review will focus on public enterprise finances and the monitoring of I-PRSP expenditures and intermediate outcome indicators.
Technical Memorandum of Understanding on the Program
(June 18, 2002)
1. With effect from July 1, 2002, this memorandum replaces the Technical Memorandum of Understanding (TMU) relating to the monitoring year under the PRGF-supported program, dated March 2002. The main qualitative changes from the March 2002 TMU involve specification of extended reporting requirements on Water and Power Development Authority's (WAPDA) financial performance, while removing the monitoring of arrears on account of priority connections (along with the corresponding performance criterion). Throughout, "government" is meant to comprise the federal and provincial governments, except in relation to the external debt ceiling performance criteria, where it also comprises local governments, as well as public sector enterprises and government-owned banks. The latter refers to enterprises or banks in which the government holds a direct majority ownership interest (i.e. equity participation of above 50 percent).
I. Definitions of Monitoring Variables
Valuation of foreign exchange denominated assets and liabilities
2. For the purposes of monitoring under the program, all assets and liabilities as well as debt contracted, denominated in SDRs or in currencies other than the U.S. dollar, will be converted into U.S. dollars at their rates prevailing as of March 29, 2002, as published in the International Financial Statistics (IFS). The U.S. dollar value of all foreign assets and liabilities, as well as external proper financing and cash grants, will be converted into Pakistan rupees at the end-March 2002 exchange rate of PRs 60.07 per US$1.
3. Reserve money (RM) is defined as the sum of: currency outside scheduled banks (deposit money banks); scheduled banks' domestic cash in vaults; scheduled banks' required and excess rupee, as well as foreign exchange deposits with the State Bank of Pakistan (SBP); and deposits of the rest of the economy with the SBP excluding those held by the federal and the provincial governments.
4. Net foreign assets (NFA) of the SBP are defined as the difference between its foreign assets and foreign liabilities. Foreign assets of the SBP consist of gold, foreign exchange, balances held outside Pakistan, foreign securities, foreign bills purchased and discounted, net IMF position and SDR holdings. The definition of foreign assets of the SBP will be consistent with the Data Template on International Reserves and Foreign Currency Liquidity. Gold will be valued at SDRs 35 per fine troy ounce. Foreign liabilities of the SBP include deposits with the SBP of foreign governments, foreign central banks, foreign deposit money banks, international organizations, and deposits of foreign nonbank financial institutions (NBFI).1
5. Net domestic assets (NDA) of the SBP are defined as the difference between RM and the NFA of the SBP.
6. Net borrowing from the banking system by the government is defined as the difference between the banking system's claims on the central and provincial governments and the deposits of the central and provincial governments with the banking system. For purposes of this memorandum, claims on government exclude credit for commodity operations; government deposits exclude outstanding balances in the Zakat Fund. The stock of bonds which were issued to banks in substitution of outstanding nonperforming loans to certain public entities, and which are being fully serviced by the government, are included in banking system claims on government (e.g. bonds issued in 1995, 1996, and 1998 by GCP, RECP, CEC, TCP to UBL, Habib Bank, and NBP).
7. The definition of the overall budget deficit (excluding grants) under the program will be the consolidated budget deficit excluding grants, excluding the operations of local governments financed from local funds. It will be measured by the sum of (a) the total net financing to the federal and provincial governments; and (b) the total external grants to the federal and provincial governments. The former is defined as the sum of net external budget financing (defined below), net borrowing from the banking system (as defined above), and net domestic nonbank financing (defined below). The latter is defined as the sum of project grants, the rupee counterpart of the Saudi Oil Facility, cash external grants for budgetary support, and capital grants reflecting the principal amounts of external debt cancellation or swaps.
8. Net external budget financing is defined as net external program financing plus all other external loans for the financing of public projects or other federal or provincial budget expenditures. Net external program financing is defined to include external privatization receipts; budget support loans from multilateral (other than the Fund, but including the World Bank's BSAC and any World Bank and Asian Development Bank (AsDB) provincial structural adjustment loans), official bilateral, and private sector sources; rescheduled government debt service and change in stock of external debt service arrears net of government debt amortization due on foreign loans, the latter including any implicit accelerated amortization related to debt swaps or debt cancellation recorded as capital grants. It includes foreign loans onlent to financial institutions and companies (public or private) and emergency relief lending. Program financing excludes all external financing counted as reserve liabilities of the SBP (defined above). Amounts assumed for net external program financing and external grants are provided in Tables 1(a) and 1(b).
9. Net domestic nonbank financing of the budget is defined as: domestic privatization receipts plus the change, during each fiscal year, in the stock of (a) permanent debt, which consists of nonbank holdings of prize bonds, all federal bonds and securities; plus (b) floating debt held by nonbanks; plus (c) unfunded debt, which consists of National Savings Scheme (NSS) debt, Postal Life Insurance, and the General Provident Fund; plus (d) stock of deposits and reserves received by the government (public accounts deposits); plus (e) suspense account; plus (f) any other government borrowing from domestic nonbank sources net of repayments; minus (g) government deposits with NBFIs. Nonbank holdings of permanent and floating debt is defined as total debt outstanding, as reported by the SBP, minus holdings of banks as per the monetary survey. Total treasury bill and other relevant government debt is valued at discount value.
10. Net claims of the banking system on public sector enterprises comprise the banking system's claims on all public sector enterprises, excluding credit for commodity operations. Net claims include both credit and holding of corporate paper, netted against outstanding deposits on the special account with the SBP for payments on public enterprises' rescheduled debt.
11. The performance criterion on contracting or guaranteeing of medium-term and long-term nonconcessional external debt by the government or the SBP applies not only to debt as defined in point No. 9 of the Guidelines on Performance Criteria with Respect to Foreign Debt (adopted by the IMF Executive Board on August 24, 2000), but also to commitments contracted or guaranteed for which value has not been received.2 Excluded from this performance criterion are (a) foreign currency deposit liabilities of the SBP; and (b) the outstanding stock of debt of Foreign Exchange Bearer Certificates (FEBCs), Deposit Bearer Certificates (DBCs), and Foreign Currency Bearer Certificates (FCBCs). The performance criterion setting a limit on the outstanding stock of short-term external debt refers to debt (as defined in footnote 2) with original maturity of up to and including one year. Medium- and long-term external debt comprises debt with initial maturity of over one year. The external debt will be expressed in U.S. dollar terms, with debts in currencies other than the U.S. dollar converted into U.S. dollars at the market rates of the respective currencies prevailing on March 29, 2002 as published in IFS.
12. Nonconcessional borrowing is defined as borrowing with a grant element of less than 35 percent, following the methodology set out in the staff report SM/96/86 and approved by the IMF Executive Board on April 5, 1996. The discount rates used to calculate the grant element will be the six-month and ten-year Commercial Interest Reference Rates (CIRRs) averages, as computed by the Policy Development and Review Department of the Fund. Six-month CIRRs are updated mid-February and mid-August (covering the six-month period preceding the date of update) and the ten-year CIRRs averages are updated mid-December (covering a period of 10 years preceding the date of the update). Six-month CIRRs averages are to be used for loans whose maturity is less than 15 years, while ten-year CIRRs averages are to be used for loans whose maturity is equal or more than 15 years.
13. Poverty-related and social public spending ("I-PRSP expenditure") consists of central provincial and district government spending under the current budget and the Public Sector Development Program (PSDP), as defined in Table 2. The indicative Interim Poverty Reduction Strategy Paper (I-PRSP) expenditure targets will be adjusted upward by any nondebt creating relief on external interest payment as a result of bilateral debt restructuring and debt swaps.
14. The floors on the NFA of the SBP and ceilings on the NDA of the SBP will be adjusted (a) upward/downward (respectively downward/upward) by the cumulative excess/shortfall in net external program financing (as defined below; Table 1(a)); and (b) upward/downward (respectively downward/upward) by the cumulative excess/shortfall in external cash budget and capital grants resulting from debt cancellation and debt swaps (as defined below; Table 1(b)). Downward adjustments of NFA and upward adjustments of NDA will be capped at US$400 million.
15. The ceiling on net bank borrowing by the government will be adjusted downward/upward by the cumulative excess/shortfall in net external program financing plus external cash budget and capital grants resulting from debt cancellation and debt swaps; and upward by any downward adjustment in the budget balance in conjunction with higher I-PRSP expenditure as set out below. Total upward adjustments will be capped at US$400 million. The ceiling will also be adjusted upward by the increase in net claims of the banking system on the government resulting from (a) the takeover of NBFI by a scheduled bank; and (b) the government's paying-off residual debt of Karachi Electric Supply Corporation (KESC) toward banks or suppliers in the context of privatization, up to PRs 11 billion.
16. The ceilings on the NDA of the SBP will also be adjusted downward/upward by the amount of (a) banks' rupee reserves freed/seized by any reduction/increase of the daily CRR of 4 percent; (b) banks' reserves freed/seized by any reduction/increase in the total reserve requirements on foreign currency deposits of 25 percent; and (c) any reduction/increase in the reservable deposit base that is related to definitional changes, as per the following formula: ∆NDA = ∆rB0 + r0∆B + ∆r∆B, where r0 denotes the reserve requirement ratio prior to any change; B0 denotes the level of the reservable deposits in the initial definition; ∆r is the change in the reserve requirement ratio; and ∆B denotes the change in the reservable deposits as a result of definitional changes.
17. The floor on the consolidated overall budget balance (excluding grants) will be adjusted downward for the cumulative excess in external cash budget grants and capital grants resulting from debt cancellation or debt swaps for up to PRs 5 billion at end-September 2002, PRs 10 billion at end-December 2002, PRs 15 billion at end-March 2003, and PRs 20 billion at end-June 2003. Downward adjustments in the floor will have to be matched by identical increases in actual budgetary I-PRSP expenditures above the program levels (Table 2). The floor will also be adjusted downwards by the government's outlays for paying-off residual debt of KESC toward banks or suppliers in the context of privatization, up to PRs 11 billion.
18. The ceiling on net claims of the banking system on public sector enterprises will be adjusted downward for the amount of repayment by the government of bank credit to KESC outstanding as of July 1, 2002, in the context of KESC privatization. The ceiling will also be adjusted downward by the amount of net claims reclassified as claims on the private sector as a result of the privatization of any public enterprise.
III. Program Reporting Requirements
19. The following information, including any revisions to historical data, will be provided to the Middle Eastern Department of the Fund through the office of the Senior Resident Representative of the IMF in Pakistan, within the timeframe indicated:
(i) monetary survey;
1 The definition of NFA of the SBP used here implies that, for program monitoring purposes, disbursements and/or purchases from the Fund are to be recorded in the monetary accounts as external liabilities of the SBP, rather than deposits of the government.
2 The definition of debt set forth in No. 9 of the guidelines reads as follows: "(a) For the purpose of this guideline, the term "debt" will be understood to mean a current, that is, not contingent, liability, created under a contractual arrangement through the provision of value in the form of assets (including currency) or services, and which requires the obligor to make one or more payments in the form of assets (including currency) or services, at some future point(s) in time; these payments will discharge the principal and/or interest liabilities incurred under the contract. Debts can take a number of forms, the primary ones being as follows: (i) loans, that is, advances of money to obligor by the lender made on the basis of an undertaking that the obligor will repay the funds in the future (including deposits, bonds, debentures, commercial loans, and buyers' credits) and temporary exchanges of assets that are equivalent to fully collateralized loans under which the obligor is required to repay the funds, and usually pay interest, by repurchasing the collateral from the buyer in the future (such as repurchase agreements and official swap arrangements); (ii) suppliers' credits, that is, contracts where the supplier permits the obligor to defer payments until some time after the date on which the goods are delivered or services are provided; and (iii) leases, that is, arrangements under which property is provided which the lessee has the right to use for one or more specified period(s) of time that are usually shorter than the total expected service life of the property, while the lessor retains the title to the property. For the purpose of the guideline, the debt is the present value (at the inception of the lease) of all lease payments expected to be made during the period of the agreement excluding those payments that cover the operation, repair or maintenance of the property. (b) Under the definition of debt set out in point 9(a) above, arrears, penalties, and judicially awarded damages arising from the failure to make payment under a contractual obligation that constitutes debt are debt. Failure to make payment on an obligation that is not considered debt under this definition (e.g., payment on delivery) will not give rise to debt."