IMF Executive Board Concludes 2007 Article IV Consultation with PakistanPublic Information Notice (PIN) No. 07/143
December 20, 2007
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.
On December 17, 2007, the Executive Board of the International Monetary Fund (IMF) concluded the 2007 Article IV consultation with Pakistan.1
Pakistan has experienced a remarkable turnaround in its economic performance since 2001/02. Sound macroeconomic management and wide-ranging structural reforms have contributed to high real GDP growth, a reduction in the debt burden, and an improved business climate. Adherence to pro-poor policies has helped lower poverty rates. Increasingly, Foreign Direct Investment (FDI) and portfolio flows have become an important source of external financing.
Economic developments during the fiscal year ending in June 2007 remained favorable. Real GDP growth increased to 7 percent, with a recovery in agriculture and a strong performance of large-scale manufacturing and services; the debt ratio continued to decline; and the international reserves position strengthened further. The disinflation process, however, slowed somewhat, with average inflation persisting near 8 percent.
Strong capital inflows boosted the overall balance of payments, but the current account deficit widened for the third consecutive year. The growth of exports and private transfers slowed, offsetting a significant decline in import growth. As a result, the current account deficit reached 4.9 percent of GDP (US$7 billion) in 2006/07. A surge in FDI flows and portfolio inflows resulted in a record-high surplus in the financial account. Overall, gross official reserves increased by US$3.5 billion, to US$14.3 billion by end-June 2007. The rupee continued to fluctuate within a narrow band against the U.S. dollar, and the real effective exchange rate remained broadly stable.
Although lending to the government by the State Bank of Pakistan (SBP) ceased in 2006/07, reserve money and broad money grew by about 20 percent, driven by the accumulation of international reserves and lending to commercial banks for subsidized credit to the textile industry. The SBP was able to offload some of its holdings of treasury bills to the commercial banks for the first time in four years. The corresponding pickup in commercial banks' credit to government offset a deceleration in credit to the private sector to 17 percent, from 23 percent a year earlier.
The fiscal stance was kept broadly unchanged in 2006/07, with the fiscal deficit (excluding grants) estimated at 4.3 percent of GDP, the same as in 2005/06. Current expenditure overruns were fully offset by a strong performance of revenues (especially nontax) and underspending on investment projects. The deficit was financed in roughly equal shares from external and domestic sources. The public debt ratio declined by an additional 3 percentage points to about 55 percent of GDP.
Progress on privatization and other structural reforms was mixed. Privatization stalled after the Supreme Court annulled the sale of Pakistan Steel Mills in June 2006, but placements of Global Depository Receipts went ahead as planned. Electricity tariffs were adjusted by 10 percent in February 2007, unlocking World Bank loans and preparing the ground for greater private participation in electricity generation. In the financial sector, the regulations regarding broker financing of share trades were strengthened. The authorities have also been working on their second Poverty Reduction Strategy Paper, which is expected to be completed by the spring of 2008.
The authorities' economic program for 2007/08 envisages real GDP growth of 7.2 percent. The budget deficit target has been set at 4 percent of GDP, below last year's outcome, and in its July Monetary Policy Statement the SBP announced tighter monetary conditions to slow broad money growth to 13.7 percent by the end of 2007/08.
The economy has shown considerable resilience to recent domestic political uncertainties and the turbulence in international capital markets, with provisional data for activity in large-scale manufacturing showing continued strong growth in the first quarter of 2007/08. Owing mainly to the increase in food prices, the 12-month rate of inflation was 8.7 percent in November. The stock market has recovered from losses suffered in early November. However, the spread for Pakistani international bonds over 10-year U.S. Treasuries as measured by the J.P. Morgan Emerging Markets Bonds Index Global was 400 basis points as of December 14, compared with 214 basis points at end-June.
Preliminary balance of payments information provided by the SBP for July-October 2007 suggests that the current account deficit narrowed relative to the same period of last year, with export growth recovering and remittances showing a strong increase. Net international reserves fell by US$1 billion since end-June 2007, to US$13.3 billion as of December 14, with the decline concentrated in November owing to large oil and debt payments and some portfolio outflows. The fiscal position deteriorated in the first quarter of 2007/08 relative to the same period of 2006/07, due mainly to strong growth of development spending and higher than envisaged interest payments and energy subsidies. During July-September 2007, domestic financing of the government was provided mainly by commercial banks, but starting in October SBP's financing of the government increased markedly as commercial banks reduced their demand for treasury bills.
Executive Board Assessment
Executive Directors welcomed that Pakistan's economy continued to perform strongly in 2006/07. Real GDP growth increased, the international reserve position strengthened, and debt ratios declined. The favorable economic performance and structural reforms to improve the business climate have spurred capital inflows in recent years. At the same time, Directors noted that inflation remains relatively high, the external current account deficit has widened, and Pakistan's external financing needs remain large. Continued vigilance is required to reduce vulnerabilities and maintain investor confidence in light of recent political uncertainties and developments in the global credit markets.
Looking ahead, Directors considered Pakistan's main challenge to be the maintenance of high growth while lowering inflation and reducing the external current account deficit to a more sustainable level. This will require continued tight fiscal and monetary policies. In this regard, Directors encouraged the authorities to strengthen the fiscal program for 2007/08 to complement monetary tightening, particularly by reducing energy subsidies and capital spending.
Directors welcomed the tightening of the monetary stance since mid-2007. They regretted the re-emergence of central bank financing of the budget, and stressed the need to adjust the interest rates in treasury bill auctions as needed in order to ensure that the government's 2007/08 domestic borrowing requirement is fully met through the commercial banks or nonbank institutions. Many Directors called for greater exchange rate flexibility, to enhance the effectiveness of monetary policy and better absorb external shocks, while some Directors felt that exchange rate stability is important at this juncture to maintain investor confidence.
Looking beyond 2007/08, Directors stressed that further fiscal consolidation will be required to reduce inflation and the external current account deficit while lessening pressures on real interest rates. In this regard, they noted the low ratio of tax revenue to GDP, and recommended to press ahead with reforms to increase revenue so that it can reduce the fiscal deficit while boosting spending on infrastructure and poverty alleviation. Directors called for a broadening of the tax base, including through expanding taxation of the agricultural and services sectors and reducing tax exemptions. They also supported the use of public-private partnerships in infrastructure development, but cautioned that any contingent liabilities should be fully identified and incorporated in the budget.
Directors agreed that the real effective exchange rate is broadly in line with Pakistan's economic fundamentals. They underscored that fiscal adjustment accompanied by higher levels of investment and vigorous implementation of structural reforms constitute the main avenues to improve external competitiveness. Directors welcomed the central bank's intention to gradually shift direct provision of foreign exchange to oil importers to the inter-bank foreign exchange market, with a view to fostering a market-determined exchange rate.
Directors encouraged the authorities to vigorously implement structural reforms in order to sustain growth and poverty reduction. They underscored the need to modernize the energy sector's regulatory and tariff framework and revive the privatization process. It will also be important to reduce subsidized central bank credit to certain sectors and disengage the central bank from development financing, to further deepen domestic financial markets and enhance the efficiency of financial intermediation, and to move forward with plans to shift from the use of short-term government financing instruments to long-term securities. Directors urged action to strengthen public financial management. They also encouraged the authorities to resist pressures to reinstate ad hoc tariff and nontariff barriers, and to press ahead with their plans for further trade liberalization.
Directors welcomed the recent enactment of regulations governing legislation to combat money laundering and terrorism financing. They underscored the need to obtain parliamentary approval of such legislation, make the Financial Monitoring Unit fully operational, and clarify related reporting and accountability issues.