Pakistan and the IMF

News Brief: IMF Completes Third Review of Pakistan's PRGF-Supported Program, Approves US$114 Million Disbursement

Country's Policy Intentions Documents

Free Email Notification

Receive emails when we post new items of interest to you.

Subscribe or Modify your profile

PakistanLetter of Intent, Memorandum of Economic and Financial Policies, and Technical Memorandum of Understanding

October 16, 2002

The following item is a Letter of Intent of the government of Pakistan, which describes the policies that Pakistan intends to implement in the context of its request for financial support from the IMF. The document, which is the property of Pakistan, is being made available on the IMF website by agreement with the member as a service to users of the IMF website.

Mr. Horst Köhler
Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. Köhler:

The Pakistani authorities held discussions with Fund staff in August 2002 for the third 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 August 2002 under the arrangement, updates the macroeconomic framework, and discusses the financial policies and structural reform program for the remainder of the fiscal year 2002/03. It supplements the MEFP dated November 22, 2001 as well as the supplementary MEFPs dated March 12, 2002 and June 18, 2002.

All performance criteria for end-June 2002 and for July and August 2002 were met, except for the three performance criteria on the Central Board of Revenue (CBR) revenue for total revenue through June 2002, on bringing Karachi Electric Supply Corporation (KESC) to the point of sale by end-July 2002, and on not granting any new tax exemptions. We request waivers for the nonobservance of the performance criteria, and a modification of the December 2002 target for CBR revenue, on the following grounds:

As detailed in the MEFP, and already anticipated in the June-MEFP, the CBR revenue shortfall mostly reflects the lower-than-expected imports during January-March. Despite a strong recovery of tax receipts during April-June, this shortfall could not be made up. A range of tax policy and tax administration reforms have been implemented with the fiscal year 2002/03 budget, to strengthen tax collection. The turnaround in revenue performance that started in March 2002 has accelerated in July-September, along with a recovery of exports and imports, and preliminary data indicate that the end-September target for CBR revenue was met.

On KESC, the government has taken the critical measures under its control, as detailed in the MEFP, to bring KESC to the point of sale. However, only two investors have expressed preliminary interest, and none is prepared to enter into due diligence at this stage. We remain hopeful that once security concerns subside and international equity markets stabilize, investor interest will strengthen and allow pursuit of the privatization strategy. In the meantime, as set out in the MEFP, a number of measures are being implemented to address the financial imbalances of KESC and reduce regulatory uncertainty.

Finally, for what we think are technical as well as socio-political reasons, detailed in the attached MEFP, we have eliminated the sales tax on medicines that was introduced earlier in the year. Nonetheless, the overall quarterly tax revenue targets remain unchanged, and will be secured by end-October.

On the basis of the performance up to July 2002 and the policies set out in the attached memorandum, the government requests the completion of the third review. We expect the fourth, fifth, and sixth reviews under the arrangement to be completed as scheduled by end-December 2002, end-March 2003, and end-June 2003, 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.

Sincerely yours,


Shaukat Aziz
Minister of Finance and Economic Affairs


Ishrat Husain
State Bank of Pakistan


Memorandum of Economic and
Financial Policies for the Remainder of FY 2002/03

I. Developments During May-August 2002

1. Despite several adverse external and internal shocks, such as the continued impact of post September 11 events, drought, high oil prices, and security problems, economic adjustment and reform have maintained a strong momentum. Continued private foreign exchange inflows and steady financial support by the international community have allowed the banking system to buildup foreign exchange reserves to a level that considerably reduces the economy's vulnerability to external shocks. All performance criteria for end-June 2002 and for July and August 2002 have been met, except-for reasons detailed below-the Central Board of Revenue (CBR) revenue target; the structural performance criterion on bringing Karachi Electric Supply Corporation (KESC) to the point of sale (Tables 1(a) and 2(a)); and the continuous performance criterion on the non-introduction of new tax exemptions. However, regional tensions and isolated domestic terrorist acts remain impediments to a faster recovery of private investment and growth. Technical assistance has in some cases slowed down because of travel advisories. Recent constitutional amendments aim to ensure the continuity of core reforms of recent years, while parliamentary elections planned for October 2002 provide an opportunity to strengthen involvement of the political forces in the formulation and implementation of the reform program, and to deepen program ownership.

2. Macroeconomic developments remain broadly in line with the program. The consumer price index (CPI) increased by 3.7 percent over the year through August 2002, consistent with program assumptions. Preliminary data indicate that real GDP growth (at factor cost) for the fiscal year that ended in June 2002 reached 3.6 percent, slightly better than expected at the time of the last review. Driven by the surge in workers' remittances, real GNP grew even faster, at an estimated 5.4 percent. Regarding poverty developments, quantitative evidence will become available only once the planned strengthening of the monitoring of social sector developments is implemented (see below). However, we believe that devolution has gotten off to a good start in strengthening the delivery of social services.

3. The balance of payments position has continued to improve. Available trade data (on a customs basis) through August 2002 confirm the strong recovery in trade since March, and the other trends described in the June 2002 MEFP also remain intact, including strong remittances and private capital inflows. Thus, official reserves reached US$5.3 billion at end-August 2002, the Pakistani rupee has remained broadly stable vis-à-vis the U.S. dollar, and the spread between the kerb and interbank markets has remained virtually nil. Since June 1, 2002, foreign exchange purchases of the State Bank of Pakistan (SBP) have been confined to the interbank market.

4. Broad money grew strongly through June 2002, despite considerable efforts at sterilization. The end-June 2002 ceiling for net domestic assets (NDA) of the central bank and the floor on net foreign assets (NFA) were respected with wide margins, and the ceiling on public enterprise borrowing was also observed. However, broad money growth accelerated to 15.9 percent in the year through June 2002 (from 13.8 percent through March), driven by large foreign exchange inflows. Given the stable exchange rate and low, albeit slightly rising, inflation, we continue to view this monetary expansion as mainly a structural shift to higher money demand reflecting increased confidence in the domestic currency. In response to a modest pickup of year-on-year inflation from 1.8 percent in December 2001 to 3.2 percent in June 2002, to counter the risk of a reemergence of inflationary pressures, we moved toward a more active absorption of liquidity in recent months, and have kept the discount rate stable at 9 percent since February 2002. This helped to slow reserve money growth to 9.7 percent in the year to June 2002, from 14.3 percent in December 2001.

5. The end-June 2002 fiscal deficit performance criterion was observed, despite a shortfall in CBR tax collection. The budget deficit (excluding grants and one-off capitalization outlays) was contained to PRs 189 billion (5.1 percent of GDP), 0.6 percent of GDP lower than programmed. Cumulative CBR revenue through June 2002 fell short of the program target by about PRs 10 billion (or 2.5 percent). Although better than anticipated during the second review, the acceleration of CBR revenue growth since March 2002 proved insufficient to make up the shortfall carried over from the preceding quarter. Nonetheless, this better-than-expected outcome confirms the basis for this fiscal year's targets, and with a strong performance in July-August (where CBR revenue rose by 14 percent over last year), these targets appear attainable. Nontax revenue for FY 2001/02, including compensation for services to the coalition in the fight against terrorism, was well above expectations, mostly on account of higher dividends from public sector enterprises (PSE), and despite lower-than-expected interest payments from the Water and Power Development Authority (WAPDA). WAPDA's financial difficulties also led to its inability to make principal repayments on outstanding government loans to the budget. All in all, budgetary support for WAPDA in FY 2001/02 reached PRs 18.5 billion (0.5 percent of GDP). Defense expenditures were contained slightly below the anticipated levels. Interim Poverty Reduction Strategy Paper (I-PRSP) expenditure accelerated strongly in the last months of the fiscal year as the newly elected local governments became fully operational, indicating that their ability to spend on social services while respecting proper accounting standards has improved sharply. According to preliminary (non-reconciled) data, Interim Poverty Reduction Strategy Paper expenditure rose by 9.1 percent above the levels of the preceding year, reaching PRs 133.5 billion for the year ending June 2002 (3.6 percent of GDP), only marginally lower than the programmed levels and compared to a shortfall of 25 percent during July-December 2001. Education spending, which accounts for nearly half of the total I-PRSP outlays, was up 17 percent over last year, health spending was up 10 percent. However, reconciliation of the district accounts will take a few months and only then will fully reliable data on the exact composition of actual cash expenditure become available.

6. Structural reforms are broadly on track, as detailed in the attached Table 2(a). All structural performance criteria for July 1 were met. As specified in the November 2001 MEFP, the cabinet approved a privatization plan for KESC in February 2002. KESC filed a tariff petition with the National Electricity Power Regulatory Authority (NEPRA) in May 2002 for a multi-year tariff to provide long-term comfort to prospective investors. The Privatization Commission started transaction procedures in March 2002 with advertisements and direct contacts by the financial advisor and called for expressions of interest (EOI) and statements of qualifications (SOQ) from prospective investors with closing date on June 24, 2002. In May 2002, a marketing conference (road show) was held in Karachi. Despite travel advisories, global corporate uncertainties, and the post-September 11, 2001 scenario, two investors submitted their EOIs. One of them also submitted the SOQ in June 2002. None of the investors who expressed interest has yet initiated due diligence, although all data are ready from our side. While all the critical steps toward privatization that were under our control were taken, the performance criterion on bringing KESC to the point of sale by end-July, as specified in the November 2001 MEFP, was thus missed for reasons related to third parties outside our control. Nonetheless, a number of privatizations in the oil and gas sectors and of United Bank Limited (UBL) were concluded, and the process of privatizing other major enterprises is gathering momentum. With the presentation of the budget, we published a draft fiscal responsibility law, inviting comments from the general public by July 15, several of which are now being incorporated. The law prescribes the budget statements that the federal government has to provide on a regular basis, and sets a number of rules and targets for fiscal policy to ensure fiscal transparency and sound fiscal management.

7. The reorganization of WAPDA has made progress. The financial improvement plan (FIP) for WAPDA recently agreed upon with the World Bank, which covers the period July 2002 through June 2004, is broadly on track, since a structural average tariff increase was recently granted by NEPRA and became effective on August 13, 2002. The increase (9.2 percent on average) is somewhat below the Financial Improvement Plan (FIP) target (12.8 percent) in order to protect the most vulnerable consumers through low increases in the low-consumption slabs. With offsetting savings expected from greater availability of hydroelectrical power and assuming full implementation of the FIP, WAPDA should need only a small amount of budgetary support in this fiscal year (see below). National Electricity Power Regulatory Authority also issued licenses to the new distribution companies (DISCOs) and generation companies (GENCOs), and the transfer of assets and liabilities to the new companies is now largely complete. A request for a tariff increase was filed by KESC, and following approval by NEPRA, a 6.5 percent average structural increase became effective September 13, 2002.

8. The Supreme Court of Pakistan on June 24, 2002 set aside its earlier judgment of December 1999 on "riba" and remitted all the cases to the Federal Shariat Court, the court of first instance, for determination anew. In late September 2002, the cabinet adopted amendments to the SBP Act that increase the SPB's independence, in particular in the area of reserve management, and in line with Fund Safeguards Assessment recommendations.

II. Economic and Financial Policies for FY 2002/03

A. Macroeconomic Objectives and Policies

9. A new government will emerge from the parliamentary elections in October 2002. We expect that because the reform package commands broad consensus across the political spectrum, economic gains are now beginning to be visible, and recent constitutional changes emphasize the need to maintain sustainable macroeconomic policies, the momentum of reforms will continue. We are confident that the thrust of economic policies set forth below will be implemented as envisaged, and that the next government will, by early 2003, finalize a full-fledged poverty reduction strategy, providing the basis for continued support through the Poverty Reduction and Growth Facility (PRGF) arrangement.

10. Despite concerns about the strength of the international recovery, recent data confirm the expected upturn in domestic economic activity, and we remain confident that the original macroeconomic objectives under the program for FY 2002/03 will be achieved. Real GDP growth (at factor cost) is still projected to reach 4.5 percent in FY 2002/03. Provided security concerns subside, we expect an 8 percent increase in exports (in U.S. dollar terms) over the last fiscal year, consistent with recent trends. Export growth is expected to be underpinned by some improvement in unit prices, a shift to higher value-added products in the textile sector, and the recent improvement in access to major trading partner markets. Building on recent price developments, and assuming broad stability of the exchange rate and international oil prices, our objective to contain inflation at 4 percent remains unchanged. Rising imports related to the pickup of domestic activity as well as a return of remittances and official transfers closer to historical trends are expected to move the external current account (including official transfers) from a surplus of 2.5 percent of GDP to a balanced one in FY 2002/03. This change will be partly offset by a lower capital account deficit, largely because of lower public sector net short-term outflows (including lower repayment of trade credits and of frozen foreign currency deposits following higher-than-expected repayments in FY 2001/02). However, we expect private net inflows to ease off from the exceptionally high levels of FY 2001/02, which we view partly as a portfolio shift of Pakistani balances abroad toward the domestic financial system, partly reflecting a shift of previously unrecorded inflows toward official channels. Net exceptional financing, notably in the form of rescheduled debt service payments and program financing from the International Financial Institutions (IFIs), will be somewhat lower than in FY 2001/02, at about US$2.5 billion. While reserve accumulation is expected to be less than during 2001/02, gross official reserves are projected to rise to at least US$5.3 billion in June 2003, equivalent to almost five months of next year's imports of goods and nonfactor services.

11. As outlined in the June 2002 MEFP, we will maintain the current policy mix combining a flexible exchange rate and prudent monetary policy geared toward achieving the inflation and reserves targets, and further fiscal consolidation to extricate Pakistan from excessive levels of public debt. Given that the recent decline in the income velocity of money may be only a temporary phenomenon, we will continue to closely monitor inflation indicators as well as monetary aggregates. We have already shifted toward the pursuit of a more aggressive absorption of liquidity, and have revised downward the targets for broad money and reserve money growth, in line with projected nominal GDP growth. In view of the volatility of monetary aggregates and their unstable relation with inflation, we are pursuing preparatory work to explore the option of moving to an inflation targeting framework over the medium term.

12. Fiscal policies aim to reduce the consolidated government cash budget deficit (excluding grants and with interest on accrual basis) to 4.7 percent of GDP, from 5.1 percent in 2001/02, while substantially raising social expenditure to reduce Pakistan's "social gap." The deficit target incorporates the settlement of KESC's debt to banks and suppliers, in the context of its privatization strategy, of PRs 11 billion, for which the program provides an adjuster (to the deficit target); the target remains thus in line with the original program objective of a deficit of 4.4 percent of GDP. As detailed in the June 2002 MEFP, we expect the deficit reduction to result mostly from an increased tax effort and sharply reduced budgetary support for WAPDA and KESC. However, the projected composition of expenditure has been revised to allow additional support for public enterprise reform, with offsetting savings in the foreign interest bill (reflecting some debt data revisions and lower-than-expected interest rates on debt restructured under the Paris Club agreement), and higher federal nontax revenue on the expectation that WAPDA will pay in full its debt service to the budget. The additional subsidies/grants include additional budgetary support for KESC (PRs 11.5 billion, or 0.3 percent of GDP), due mainly to a later-than-expected electricity tariff increase and assuming a delay in KESC privatization to December 2002, including the settlement of KESC's arrears to suppliers (notably WAPDA). WAPDA will receive a subsidy to partly compensate for the delayed electricity tariff increase (PRs 0.7 billion). The fleet renewal of Pakistan International Airline (PIA) requires an additional grant (PRs 2 billion), and in the context of a major reform of rural finance institutions, PRs 6 billion have been allocated to the restructuring of the Agricultural Development Bank of Pakistan (ADBP) (see below).

13. Should unforeseen developments threaten the fiscal deficit target, we plan to reduce nonpriority expenditures, while striving to protect the budgeted increase in I-PRSP expenditures. One main risk would be a prolongation or escalation of tension on the eastern border that could constrain our ability to achieve the fiscal targets. Barring such developments, we intend to reduce the share of defense expenditure in relation to GDP to about 3.6 percent, from 4.0 percent in 2001/02. Another risk is that for various reasons, KESC and/or WAPDA may not achieve the planned efficiency gains, such as the envisaged reduction in theft and technical losses or improvements in bill collection from FATA. For example, additional budgetary outlays of up to PRs 5 billion would be required if KESC were not privatized during this fiscal year. Furthermore, as set out in the June 2002 MEFP, an excess in external budgetary cash grants plus capital grants over programmed levels may be used for additional expenditure on I-PRSP categories, for up to 0.5 percent of GDP.

B. Structural Policies

Tax policy and tax administration

14. As described in the June 2002 MEFP, a substantive tax reform package has become effective with the FY 2002/03 budget, and is being complemented by revamping business procedures within the CBR. As a first step, the large taxpayer unit (LTU) in Karachi has become operational and is now treating the files of major taxpayers on the basis of greater functional integration of the administration of all taxes. Specific recommendations on how to revamp CBR's human resource management (recruitment procedures, a move to more merit-based promotion and remuneration rules) and how to make better use of modern information technology will be prepared with the help of World Bank-financed consultants by November 2002. Effective August 23, 2002, we eliminated the GST on medicines introduced in March 2002 for two reasons: First, it became evident that the tax did not command sufficient social or political consensus and contributed to a weakening of public support for the entire adjustment program. Second, following the exemption of a large number of "life saving" drugs, the administration of the tax became extremely complex. To offset the revenue losses from the elimination of the GST on medicines (about PRs 2.5 billion on an annual basis), we will adjust taxation of various petroleum products, to yield about PRs 2.5 billion additional revenue on an annual basis. We look forward to review shortly with planned Fiscal Affairs Department (FAD) technical assistance missions progress to date on the various tax reforms, and formulate specific actions for the second half of the fiscal year, with focus on customs reform (where a draft reform plan has been prepared), refund procedures, and other administrative reform.

I-PRSP implementation, public expenditure management, and fiscal transparency

15. I-PRSP implementation and reforms on improving fiscal transparency and data quality are proceeding as detailed in the June 2002 MEFP. The recently established I-PRSP secretariat has intensified the monitoring of pro-poor (that is, I-PRSP) expenditures, which are now reported to the public on a quarterly basis. The secretariat will work with the provincial governments to improve their capacity to conduct qualitative analysis of expenditure patterns and take remedial policy action as needed. Specific proposals for setting up mechanisms to monitor intermediate poverty indicators have been worked out with the World Bank and the U.K. Department for International Development (DFID), and will become operational by end-2002. We will continue to implement fiscal transparency and data quality measures in line with establishing an Accountable Fiscal Management Framework (AFMF) and in the context of the Pakistan Improvement of Financial Reporting and Accounting (PIFRA) project. At the provincial level, fiscal transparency and data work are being supported through World Bank provincial structural adjustment loans. The main challenge will be to ensure timely and reliable reporting and reconciliation of expenditure data at the district level, through capacity building at the local government level (supported by the AsDB (Asia Development Bank)) and other international organizations; and strengthening the comptroller general of accounts (CGA) as planned under Pakistan Improvement of Financial Reporting and Accounting (PIFRA).

Other governance reforms

16. Improving governance remains at the center of our economic strategy and informs the ongoing reforms in the areas of devolution, civil service, tax policy and administration, and public financial management, as well as our ambitious privatization program. An international workshop in August discussed a National Anti-Corruption Strategy, prepared by the National Accountability Bureau, which will be taken to the cabinet for further consideration, with specific actions to be planned on this basis. The reform of police and the judiciary under an AsDB-supported program is off to a good start with improved allocations for police and judicial reform in this year's provincial budgets; preparation of a draft "Freedom of Information" Act; and passage of a police ordinance clarifying the role and powers of the police consistent with devolution, including the constitution of local citizen boards to enhance oversight over the local police. Another AsDB-supported program, currently under negotiation, aims to strengthen corporate governance in the nonbank financial sector (notably insurance and pension funds). Public procurement reform got under way in May 2002 with the passage of a law establishing the Public Procurement Regulatory Authority, which will have the task to ensure enforcement of clear and transparent procurement rules.

Public enterprises

17. The privatization program has partly overcome the setbacks following the events of September 11. However, the privatization of Pakistan Telecommunications Company Limited (PTCL) is being delayed due to limited investor interest in the context of the weak financial position of the international telecommunication sector, since so far none of the interested investors fully complies with the required qualifications. We hope to complete the privatization of KESC before end-2002. Discussions with at least one interested investor are being pursued and various complementary reforms are being put in place to reduce regulatory uncertainty. These include the write-down of capital and clarification of the respective responsibilities of NEPRA and the monopoly commission. These steps would also constitute the basis for an alternative restructuring strategy, should privatization at this time prove impossible. Various other PSEs are being prepared for privatization in the near future. In particular, expressions of interest have been received for the Oil and Gas Development Corporation (OGDC), Habib Bank Ltd. (HBL), and Pakistan State Oil (PSO). Due diligence by qualified investors will likely proceed during September-October, with bidding expected shortly thereafter. To enhance PSE monitoring and accountability, we have worked out quarterly performance targets for PIA, Pakistan Railways, Pakistan Steel Mills, and WAPDA/successor companies. The performance of WAPDA, in particular, is being closely monitored by a ministerial committee to ensure improvements in line losses and billing/collection as planned. Given the uncertainty over the timing of its privatization, we have prepared a similar plan for KESC for this fiscal year, with quarterly public reporting to start in November and covering the first quarter of FY 2002/03. The plan provides for cash deficits consistent with the budgetary support discussed above. We are pleased that strong governance reforms in recent years have helped to turn around the financial performance of many PSEs, in particular the national airline (PIA), the railways, and Pakistan Steel. We have endorsed a business plan prepared by PIA that aims to increase efficiency further, including greater focus on its core business (by selling its real estate holdings and outsourcing) and renewal of the fleet. We are also working, in close consultation with the World Bank, on a plan to incorporate the railways (currently operated as a government department) and to involve private sector financing where possible, for a planned modernization program.

Agriculture and marketing reforms

18. As set forth in a policy statement to be issued shortly, our strategy in agriculture centers on further improving water management, providing better extension services to raise yields and reduce vulnerability to drought and pests, and gradually reducing government involvement in the marketing of agricultural commodities, as specified in a reform program supported by an AsDB loan. In order to encourage the private sector to assume a greater role, especially in investing into wheat storage facilities, we have put in place an incentive package as detailed in the June 2002 MEFP. We are quite encouraged by initial results, as the private sector has now, for the first time in recent history, become involved in wheat marketing, exporting about 0.5 million tons.

Financial sector and exchange system reforms

19. Banking sector reform is continuing in accordance with our financial sector strategy. At its core is the reform of seven public sector financial institutions (United Bank Limited, Habib Bank Ltd., National Bank of Pakistan (NBP), Allied Bank of Pakistan (ABP), National Development Finance Corporation (NDFC), Agricultural Development Bank of Pakistan, and Industrial Development Bank of Pakistan (IDBP)), which account for 80 percent of nonperforming loans of the entire banking system. The reform involves several specific action plans.

  • Following extensive restructuring of the branch networks, staffing, and balance sheets of the three nationalized banks, we are about to complete the sale of 51 percent of shares in UBL to a strategic investor. The remainder of the SBP's holdings in UBL will be floated subsequently in light of market conditions.

  • We have invited expressions of interest for the sale of Habib Bank, which will lead to its eventual sale to the private sector.

  • We plan to float another 5-10 percent of NBP shares, reducing the government's share to about 80 percent.

  • The planned disposal of the government's minority holding in Allied Bank (49 percent) has been delayed since a number of unexpected legal complications are being resolved, but we remain committed to sell it to a strategic investor.

  • We have already liquidated the NDFC and merged its residual functions with NBP.

  • With technical and financial support from the AsDB, we have embarked on the restructuring of the ADBP which involves downsizing to half the current staff through a voluntary separation program; appointing a board drawing on professionals from the private sector; and recapitalization through conversion of outstanding government loans into equity. We are aware that maintaining ADBP as a publicly-owned corporation carries risks, notably that it will prove difficult to turn around the performance of the staff kept on payroll, or that eventually its lending and staffing will again become dominated by noncommercial considerations, which in the past has led to its current insolvency. We believe, however, that given ADBP's critical role in the rural sector, the immediate liquidation of ADBP would have had unacceptable social costs. As other rural finance institutions are being developed under the AsDB program, we will, after two years, review the possibility of privatizing ADBP or if needed consider its liquidation.

  • We are also considering restructuring and privatization of the IDBP since it holds a commercial banking license and should be attractive to private investors.

20. The aforementioned Supreme Court decision has cleared the way for pursuing an evolutionary approach to Islamic finance, through encouraging the development of Islamic banking alongside traditional financial institutions, while adapting regulations for the supervision of chartered Islamic banks. We remain disappointed that the Fund and the World Bank have again delayed the planned Financial Sector Assessment Program (FSAP) mission, but we will seek every opportunity to discuss with the Fund our strategy on (a) protecting the financial system against illicit use, by bringing anti-money laundering (AML) rules up to best practices; (b) further modernizing the prudential framework; and (c) phasing out the remnants of administered credit allocation (such as prescribed lending to agriculture). A draft AML law has been prepared and will be promulgated before October 2002. It includes provisions to criminalize money laundering, to set up a financial intelligence unit, and to allow freezing and forfeiture of assets and international cooperation. In order to further strengthen the regulatory and supervisory framework and promote consumer financing and lending to small-and medium-sized enterprises (SME), the SBP is formulating separate prudential regulations for these two types of lending. The SBP has already removed certain impediments that stood in the way of consumer financing by the nationalized commercial banks. A study on housing finance has been completed and the commercial banks are embarking on developing new mortgage products. In the context of a capital market reform program supported by another AsDB loan, we plan a number of steps to strengthen stock market supervision, develop secondary markets for government paper, strengthen corporate governance in the nonbank financial institutions, and pursue the reform of the National Saving Schemes (NSS) to reduce remaining distortion and further lower the budgetary cost of such debt.

21. The legal and regulatory framework for the transformation of moneychangers into foreign exchange companies (FECs) has been promulgated in July 2002. Existing moneychangers will have two years to register as FECs and comply with relevant prudential rules/capital requirements, but no new licenses for moneychangers will be issued. After the two-year period, no moneychanger will be allowed to operate unless registered as FECs. The FEC will be allowed to effect inward transfers. Banks have been allowed, effective February 1, 2002, to purchase foreign exchange from moneychangers at freely negotiated rates, thus moving further toward unification of the interbank and the kerb market. We expect all major moneychangers to convert within the next few months; commercial banks are also in the process of setting up FECs as subsidiaries. We expect the FECs will, over time, also absorb much of the legitimate transfer business currently going through the Hawala system.

C. Financing Issues

22. While official reserves have been rising much faster than expected at the launch of the PRGF-supported program, the further accumulation called for under the revised program is warranted in view of the many risks to our economy, most notably those related to regional tensions. We are confident that the revised program remains fully financed for FY 2002/03. Ongoing discussions with all creditors aim at concluding the bilateral agreements implementing the recent Paris Club Agreed Minute, and ensuring treatment of debt due to non-Paris club bilateral creditors on terms comparable to those agreed with the Paris Club creditors. While these discussions are well advanced, they could not yet be concluded, in part due to travel advisories, and Paris Club creditors recently agreed to extend the target date for conclusion of these agreements to December 31, 2002. Partner countries and multilateral institutions have voiced strong support for the reform strategy laid out in the I-PRSP, and we expect to obtain financial support at least at the levels assumed in the program, sizable debt swaps (for social expenditure) in the context of the aforementioned bilateral debt restructuring agreements, and 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 are on time.

III. Data Issues

23. In the context of the project to revise and change the base year of the national accounts, the last three studies, including on saving and investment, were recently completed and sent to Fund staff for comments. Publication of a producer price index (PPI) is scheduled to commence in late 2002. Recent steps toward improvement in statistical data dissemination include the publication of an advance release calendar for selected statistical data; and dissemination of quarterly balance of payments statistics (with one quarter lag) and of monthly analytical accounts of the SBP in the format called for under Special Data Dissemination Standard (with a one-month lag). We expect to finalize an institutional reform plan for the statistical system by early 2003, consolidating various existing statistical agencies into one agency with enhanced autonomy. We are working on the cleaning up and consolidation of the latest Pakistan Integrated Household Survey (PIHS) data to allow an updated analysis of social- and poverty-related developments internally, as well as by international organizations and researchers, including the delayed social impact assessment for selected reform under the I-PRSP to be conducted jointly with the World Bank and the Fund.

IV. Program Monitoring

24. The proposed performance criteria and indicative targets through end-June 2003 are set out in Tables 1(b) and 2(b). Table 2(a) reports on the status of the existing structural performance criteria and benchmarks; Table 2(b) includes the additional conditionality proposed as well as the actions we intend to take prior to the Board discussion of the third review. Further actions will be developed in the next reviews based, in particular, on input from the planned technical assistance on CBR reform; formulation of specific actions emerging from our anti-corruption strategy; and public enterprise reform once the prospects for some of the more difficult privatizations have become clearer. This will also allow the new government to take full ownership of such steps. The attached amendments to the Technical Memorandum of Understanding (TMU) of June 2002 apply effective January 1, 2003 and clarify the treatment of the privatization accounts at SBP and NBP, and update the baseline assumptions for external program financing, external grants, and deposit reserve requirements. We expect the fourth review to take place as scheduled by end-December 2002. The review will focus on public enterprise finances and public expenditure monitoring, especially I-PRSP spending.

Amendments to the Technical Memorandum of Understanding (TMU)

The TMU dated June 18, 2002 ("June-TMU") will remain valid for the remainder of FY 2002/03, with the revised baseline assumptions for net external program financing and external grants as indicated in Tables 1(a) and 1(b), and the following amendments to apply from January 1, 2003.

1. The second sentence of para. 6 of the June-TMU should be replaced by: "For the purposes of this memorandum, claims on government exclude credit for commodity operations; government deposits exclude outstanding balances in the Zakat Fund and balances in the various privatization accounts kept by the government in the banking system."

2. The first sentence in para. 8 of the June-TMU should be replaced by: "Net external budget financing is defined as net external program financing excluding privatization receipts (as recorded in the balance of payments) plus all other external loans for the financing of public projects or other federal or provincial budget expenditures, and plus external financing receipts transferred to the budget from the various privatization accounts."

3. Para. 16 of the June-TMU should be replaced by the following: "The ceilings on the NDA of the SBP will also be adjusted downward/upward by the amount of (a) banks' Pakistani rupee reserves freed/seized by any reduction/increase of the daily CRR relative to the baseline assumption; (b) banks' reserves freed/seized by any reduction/increase in the total reserve requirements on foreign currency deposits relative to the baseline assumption; 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."

4. In para. 19, the following changes should be made:

First, the second bullet should be replaced by: "Deposits into and withdrawals from the privatization accounts for each quarter, within one month. Withdrawals will be reported with the following breakdown (a) those which constitute budgetary use of privatization proceeds; (b) those which constitute costs of privatization; and (c) other (with explanation of the purpose of other withdrawals)."

Second, items (ii) and (iii) in the 23rd bullet in para. 19 should be replaced by:

    (ii) Quarterly contracting or guaranteeing of nonconcessional medium- and long-term government debt; and
    (iii) Information on any rescheduling on public- and publicly-guaranteed debt reached with creditors, within one month.