## PAKISTAN: ECONOMIC PERFORMANCE AND THE ROAD AHEAD

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### A. Introduction and overall diagnosis
- From 2000 to 2022, Pakistan’s GDP per capita grew at an average annual rate of 1.9 percent.
- Peer average growth rates (2000–2022): Bangladesh 4.5 percent, India 4.9 percent, Vietnam 5 percent, China about 7.5 percent.
- Export growth weak; competitiveness declined with an appreciated real exchange rate relative to productivity growth.
- Recent restoration of stability provides an opportunity to implement reforms for sustained, inclusive, per capita growth and stronger export capacity.

### B. Drivers of decline in living standards and trade structure
- Growth decomposition (2000–20):
  - Physical capital accumulation: about 1.9 percentage points per year.
  - Increase in labor hours: about 1.15 percentage points per year.
  - Total factor productivity (TFP): about 0.8 percentage points per year (very little in the most recent period).
  - Improvements in labor quality: about 0.5 percentage points per year.
- TFP and labor quality gains have shrunk further over the past four years.
- Pakistan ranks 85th in the Economic Complexity Index as of 2022—the same value as in 2000.
- Export composition biased toward agriculture and textiles (cotton yarn, rice, woven fabrics, beef, leather apparel); limited high-complexity exports (medicines, medical instruments, metal hand tools, batteries, plastics).
- Trade policy: Pakistan placed around the 90th percentile of the Measurement of Aggregate Trade Restrictions index (Estefania-Flores and others, 2022).

### C. Policy-induced resource misallocation
- Large and persistent differences in labor productivity across sectors indicate resource misallocation.
- Net tax disparities:
  - Coefficient of variation of net taxes across sectors is 1.76—the highest among peers.
- Sectoral example—agriculture:
  - One of the lowest levels of labor productivity.
  - Smallest reallocation relative to peers and smallest improvement in labor productivity.
  - Government interventions (support prices, preferential taxation) contribute to resource calcification.

### D. Constraints on investment, productivity, and public sector performance
- Key constraints:
  - Regulatory environment: cumbersome, inconsistent regime deters domestic and foreign direct investment; relatively low FDI net inflows compared to peers.
  - Public investment management weaknesses: insufficient funding for quality infrastructure; project “throw forward” of 14 years; weak budgetary processes; high reliance on supplementary grants.
  - Development budget unaffordability: total cost to complete projects stands at about ten times its budget allocation in FY25.
  - Hybrid public investment efficiency gap estimated at around 38 percent (slightly larger than the peer group mean).
  - Poor public services and loss-making SOEs: roughly 82 commercial SOEs have been, in aggregate, loss-making since 2016 and a large net recipient of government support (net of corporate taxes and dividends).
  - Crowding out: credit to the government reached 72 percent of total bank lending in FY23; private credit to GDP is significantly lower than peers and the regional average.
- Manufacturing and investment indicators:
  - Credit to government 72 percent of total bank lending in FY23.

### E. Human capital shortfalls
- Education and health gaps:
  - Pakistan’s expenditure on education as a percentage of total expenditure is lower than India, Bangladesh, and Nepal.
  - Adult literacy rate and proportion of trained teachers in primary and secondary education are among the lowest in the region.
  - Primary and secondary enrollment rates trail other lower-middle-income countries.
  - Health expenditure is a significantly lower share of GDP than Nepal and Sri Lanka.
  - Pakistan has the highest infant mortality rate and one of the highest rates of stunting among children under five in the region.
- World Bank Human Capital Review projection:
  - If Pakistan moves to human capital development at the level of its peers, GDP per capita could be around 15 ppts higher by 2047.

### F. Trade policy and anti-export bias
- Trade policy features an anti-export bias:
  - High import duties across several sectors and high duties on final goods create cascading effects favoring domestic sales over exports.
  - Weighted average tariff has declined over time but remained the second highest among peers (World Bank, 2024c).
  - Additional Custom Duties and Regulatory Duties offset formal tariff reductions; average tariffs increased from less than 15 percent in FY15 to 20 percent in FY21.
- External sector policies (import restrictions, exchange rate misalignment) reinforce the anti-export bias.

### Competitive diversification, trade integration, and policy prescriptions
- Potential proximate complex goods: glassware, paints, chemicals, fabrics for industrial use, paper, cosmetics, rubber products (The Observatory of Economic Complexity, 2024).
- Policy prescriptions:
  - Remove targeted, “picking winners” policies and create a level playing field.
  - Greater integration into global trade and easier access to imports for intermediate inputs and final goods.
  - Remove fiscal incentives that misallocate resources and impede price discovery across firms.
- Real exchange rate gap estimates preserved:
  - Pakistan’s real exchange rate gap was estimated at 10-20 percent in 2017, and 7-33 percent in 2018.

### Modeling framework and reform calibration (DIGNAR / DIGNAD)
- Models used:
  - DIGNAR: dynamic open economy general equilibrium model with traded, non-traded, and natural resource sectors; public capital enters production; public investment inefficiencies modeled.
  - DIGNAD: model used for climate resilience scenarios with a five-year recovery horizon after shocks.
- Four structural improvements simulated:
  (i) Improvement in public investment spending efficiency (from 0.62 to comparator EMs’ average of 0.71).
    - Mean Pakistan average efficiency gap stated as 29%.
  (ii) Improvement in tax collection efficiency (C-efficiency).
    - VAT C-efficiency in 2020: 0.23.
    - PIT C-efficiency: 16 percent.
    - Simulation assumes VAT and PIT C-efficiency endpoints doubled to comparator group average by 2028.
  (iii) Reduction in labor market distortions.
    - Share of labor in agriculture fell from 47 to 37 percent between 1990 and 2019.
  (iv) Reduction in product market distortions.
  - Trade liberalization considered: increasing exports from about 8 percent of GDP to 9 percent of GDP (by 1 percent) over five years.
- Public capital and calibration specifics:
  - Public infrastructure investment aligned with projected values for FY2023/24: about 3.1 percent of GDP.
  - Public investment efficiency set at 62 percent (FAD corruption database value, 2018 PIMA).
  - Long-run output growth rate set at 4.4 percent.

### DIGNAR simulation results — growth, debt, investment, and distribution
- Aggregate outcomes (full reform scenario over five years):
  - Real output level is 7 percent higher after five years relative to the steady state.
  - Public debt-to-GDP ratio is reduced by about 6 percent over the same time period.
  - Reforms crowd in private consumption and private investment.
- Growth impacts of structural reforms:
  - Combined effect could deliver a medium-term increase in real GDP growth of 2.13 percentage points relative to baseline.
  - Simulated annual real growth gains range from 0.8 to 2 percent each year.
- Contributions by reform type (year five):
  - Labor market reforms: 0.98 percent (46 percent of the total growth gain).
  - Product market reforms: 0.74 percent (35 percent of the total growth gain).
  - Tax reforms (dividends from tax reforms): 0.14 percent (6 percent of the total growth gain).
  - Public investment efficiency gains: 0.12 percent (7 percent of the total growth gain).
  - Trade reforms: 0.16 percent (about 8 percent of the total growth gain).
- Distributional outcome:
  - Combined reforms can generate an aggregate decline in consumption inequality by about 2 percent over the simulation’s horizon.

### Climate resilience (DIGNAD) scenarios and outcomes
- Calibration: steady state excludes FY2020 and FY2022; public infrastructure investment at 3.1 percent of GDP per year; public investment efficiency gap at 62 percent.
- Shock and recovery:
  - A climate shock of 5 percent of GDP applied in year six with a five-year recovery process modeled.
- Three scenarios and key outcomes:
  - Baseline (status quo):
    - No adaptive investments; large declines in GDP, private consumption, private investment.
    - GDP remains well below steady state 13 years after the shock.
    - Debt-to-GDP increases by about 4 percentage points to 73 percent following the shock and remains at that level long term.
  - Adaptation:
    - Additional 1 percent of GDP per year invested in adaptation infrastructure (conventional public investment at steady state).
    - About 40 percent of additional investment financed via concessional debt; most of the balance financed by domestic debt.
    - Negative deviations of GDP, private consumption, private investment are between about one third and one half of the baseline.
    - Pakistan’s GDP returns to steady state 5 years after the shock.
    - Long-term debt settles about 2 percentage points of GDP higher than under the baseline.
  - Adaptation + efficiency improvements:
    - Same adaptation investment and financing as Adaptation, plus improvement in public investment efficiency to the global average.
    - Downturn is moderately shallower; GDP returns to steady state four years after the shock (one year earlier than Adaptation).
    - Long-term debt path broadly in line with the Adaptation scenario.
- Policy implication:
  - Ex-ante adaptation investments reduce the growth impact of a natural disaster shock by about a third and speed recovery; improvements in public investment efficiency further enhance resilience. Additional adaptation investment would lead to moderately higher debt levels, underscoring the need for fiscal consolidation and fiscal structural reforms to maintain fiscal space.

### Sovereign‑bank‑central bank nexus — evolution, risks, and implications
- Overview:
  - Persistently high fiscal deficits and external shocks strengthened the sovereign‑bank nexus.
  - Banks’ holdings of domestic government debt surged to around 60 percent of their assets (more than thrice the average for EMEs).
  - Government reliance on banking sector increased due to limited external funding access.
- Evolution facts:
  - By end-2019, government debt held by the SBP reached around 20 percent of GDP, close to 40 percent of domestic debt outstanding.
  - Between 2019 and 2023:
    - Banks’ exposure to the sovereign surged from 45 percent of their assets to around 60 percent.
    - Banks’ deposits doubled while nominal volumes of bonds in their portfolios quadrupled.
  - SBP provided liquidity mainly through OMOs accepting government securities as collateral in 7- to 28-day reverse repo transactions.
- Financial stability and policy implications:
  - Large bank holdings of government debt create negative feedback loops between banks and the sovereign.
  - Repricing of government securities may reduce bank profitability and government revenues.
  - Banking crises could trigger costly government interventions, amplifying debt sustainability concerns.
  - Concentration of government borrowing in banks skews issuance toward shorter-duration instruments, increasing rollover needs and gross financing risks.
  - Crowding out: high domestic debt financed by banks crowds out private credit and weakens monetary policy transmission.
- Banking sector features and vulnerabilities (as of end-2023):
  - Banks’ exposure to the government is three times more than to the private sector.
  - Around 90 percent of banks’ bond portfolios are in Held Available for Sale (AFS) and Held for Trading (HFT) categories (marked-to-market as of December 2023).
  - Banks remain profitable, highly liquid, and comply with capital requirements, aided by zero-risk weights on government securities.
  - Deposit base has not kept pace with assets; limited incentives to compete for deposits given ample liquidity and regulatory conditions (e.g., Minimum Deposit Rate - MDR).
- Central bank considerations:
  - 2022 SBP Act amendments improved governance and autonomy, but challenges remain.
  - SBP’s balance sheet exposed through government bonds used as collateral in OMOs; SBP does not apply haircuts on bonds taken as collateral in OMOs.
  - Eligible counterparties for OMOs expanded to include development finance institutions.
  - SBP progressing to improve risk management and address 2023 Safeguards Assessment Report recommendations.

### Policy recommendations to address the nexus and structural impediments
- Fiscal and debt management:
  - Address fiscal imbalances to contain and begin to unwind interdependencies.
  - Improve government cash management and better use idle cash balances to reduce public sector borrowing needs.
  - Strengthen public debt management with a robust medium-term strategy focused on diversifying the investor base, managing the cost-risk profile, and planning for the SBP bullet repayment in 2029.
- Financial sector and market development:
  - Address structural impediments to financial sector development: level the playing field between conventional and Islamic accounts; encourage increased bank deposits; reduce the informal economy.
  - Promote capital market development and growth of domestic institutional investors to deepen risk-free asset markets and allow banks to refocus on private sector financing.
  - Successfully implement SBP’s 2023-28 Strategy prioritizing greater inclusive access to financial services, including innovative digital solutions.
- Interim regulatory measures:
  - Closely monitor banking sector health.
  - Consider prudential measures to address high concentration of certain banks’ assets in government bonds.
  - Mandate more robust levels and quality of bank capital to ensure adequacy against concentration and stress.
  - SBP should continue to enhance credit risk management in OMOs to safeguard its balance sheet.

### Conclusions and sequencing of reforms
- Consistent implementation of Pakistan’s structural reform agenda can deliver stronger and more inclusive growth by:
  - Improving public investment and tax collection efficiency.
  - Reducing incentives that support low-productivity sectors and limit reallocation.
  - Improving human capital to reduce labor market frictions and enhance mobility.
  - Reducing trade barriers.
  - Advancing SOE governance reform to improve product market performance and reduce distortions.
- Sequencing matters: product market reforms that raise incomes could precede and support more difficult labor market reforms.
- Complementing structural reforms with adaptation investments enhances resilience to climate vulnerabilities and provides a buffer against natural disaster shocks.
- Continued implementation of the authorities’ adaptation agenda, progress on the C-PIMA Action Plan, and efforts to boost climate financing are critical.

*Source: Pakistan: Economic Performance and the Road Ahead (September 11, 2024), International Monetary Fund; IMF staff estimates and projections, DIGNAR and DIGNAD model simulations as presented in the provided IMF chapter.*

### References _______________________________________________________________________________ 12

### PAKISTAN: ECONOMIC PERFORMANCE AND THE ROAD AHEAD

### A. Introduction
- From 2000 to 2022, Pakistan’s GDP per capita grew at an average annual rate of 1.9 percent.
- Peer average growth rates over the same period: Bangladesh 4.5 percent, India 4.9 percent, Vietnam 5 percent, China about 7.5 percent.
- Pakistan’s export growth has been weak and competitiveness has declined, with an appreciated real exchange rate relative to productivity growth.
- The recent restoration of stability presents an opportunity to implement reforms to achieve sustained, inclusive, per capita growth and stronger export capacity.

### B. Drivers of Decline in Living Standards
- Growth decomposition (2000–20):
  - Physical capital accumulation contributed about 1.9 percentage points per year.
  - Increase in labor hours contributed about 1.15 percentage points per year.
  - Total factor productivity (TFP) added about 0.8 percentage points per year (and very little in the most recent period).
  - Improvements in labor quality contributed about 0.5 percentage points on average.
- Over the past four years, gains in TFP and labor quality have shrunk further.
- Pakistan ranks 85th in the Economic Complexity Index as of 2022—the same value as in 2000.
- Export composition remains biased toward agriculture and textiles (cotton yarn, rice, woven fabrics, beef, leather apparel) with limited high-complexity exports (medicines, medical instruments, metal hand tools, batteries, plastics).
- Pakistan’s trade restrictions place it around the 90th percentile of the Measurement of Aggregate Trade Restrictions index (Estefania-Flores and others, 2022).

### C. Persistent Policy-Induced Resource Misallocation
- Large and persistent differences in labor productivity across sectors indicate resource misallocation.
- Net tax disparities: the coefficient of variation of net taxes across sectors is 1.76—the highest among peers—indicating pronounced sectoral inequities in tax burdens.
- Sectoral examples:
  - Agriculture has one of the lowest levels of labor productivity, the smallest reallocation relative to peers, and the smallest improvement in labor productivity.
  - Government interventions in agriculture include support prices and significant preferential taxation treatment, contributing to resource calcification in agriculture.

### D. Constraints on Investment and Productivity
- Key constraints identified:
  - Regulatory environment: cumbersome, inconsistent regime deters domestic and foreign direct investment; Pakistan has received relatively low FDI net inflows compared to peers.
  - Public investment management: insufficient funding for quality infrastructure, project “throw forward” of 14 years, weak budgetary processes, high reliance on supplementary grants.
  - Development budget unaffordability: total cost to complete projects stands at about ten times its budget allocation in FY25.
  - Hybrid public investment efficiency gap estimated at around 38 percent (slightly larger than the peer group mean).
  - Poor public services and loss-making SOEs: roughly 82 commercial SOEs have been, in aggregate, loss-making since 2016 and a large net recipient of government support (net of corporate taxes and dividends).
  - Crowding out: credit to the government reached 72 percent of total bank lending in FY23; private credit to GDP is significantly lower than peers and the regional average.
- Manufacturing and investment indicators:
  - Credit to government 72 percent of total bank lending in FY23 (crowding out effect).
  - LTFF and EFS spreads illustrated in authorities’ data (chart references in source).

### E. Human Capital Shortfalls
- Education and health indicators lag peers:
  - Pakistan’s expenditure on education as a percentage of total expenditure is lower than India, Bangladesh, and Nepal.
  - Adult literacy rate and proportion of trained teachers in primary and secondary education are among the lowest in the region.
  - Primary and secondary enrollment rates trail other lower-middle-income countries.
  - Health expenditure is a significantly lower share of GDP than Nepal and Sri Lanka.
  - Pakistan has the highest infant mortality rate and one of the highest rates of stunting among children under five in the region.
- World Bank’s Human Capital Review projection: if Pakistan moves to human capital development at the level of its peers, GDP per capita could be around 15 ppts higher by 2047.

### F. Trade Policy and Anti-Export Bias
- Trade policy features an anti-export bias:
  - High import duties across several sectors and high duties on final goods create cascading effects that favor domestic sales over exports.
  - Weighted average tariff has declined over time but remained the second highest among peers (World Bank, 2024c).
  - The imposition of Additional Custom Duties and Regulatory Duties offset formal tariff reductions, causing average tariffs to increase from less than 15 percent in FY15 to 20 percent in FY21.
- External sector policies, including import restrictions and misalignment of the exchange rate, have reinforced the anti-export bias.

*Source: Pakistan: Economic Performance and the Road Ahead (September 11, 2024), International Monetary Fund.*

### 10.      By removing policy-induced distortions and fostering a more competitively neutral

### 10. By removing policy-induced distortions and fostering a more competitively neutral business environment, Pakistan could develop a stronger, more competitive and technologically advanced economy

### Competitive diversification and trade integration
- Complex goods within likely technological proximity to Pakistan’s current export basket include: glassware, paints, chemicals, fabrics for industrial use, paper, cosmetics, and rubber products (The Observatory of Economic Complexity, 2024).
- Policy prescriptions:
  - Remove targeted, “picking winners” policies and create a level playing field for business.
  - Greater integration to global trade and easier access to imports for intermediate inputs and final goods to promote domestic competition.
  - Remove fiscal incentives that misallocate resources and impede price discovery across firms.
- Preservation of existing quantitative estimates:
  - Pakistan’s real exchange rate gap was estimated at 10-20 percent in 2017, and 7-33 percent in 2018 (IMF, 2017; IMF, 2019).

### Concluding remarks — supporting private sector development
- Key diagnosis:
  - The remnants of an old growth strategy based on protection, preferences, and concessions have limited competition, innovation, and investment.
  - Resources remain locked into low-productivity activities, including through Special Economic Zones, which survive because profitability is state-supported.
- Recommended reforms and fiscal adjustments:
  - Remove protections and concessions to spur competition, entry (including foreign entrants), and productivity-enhancing reallocation of resources, including labor.
  - Reduce government crowding out of private investment.
  - Raise additional revenue from undertaxed sectors by removing exemptions and other tax concessions.
- Modeling evidence:
  - The Selected Issues Paper (Sultanov and Weiss, 2024) indicates significant macroeconomic gains from implementing a distortion-reducing reforms agenda.

### Measuring the gains from structural reforms and climate-adaptive investment (overview)
- High-level finding:
  - Combined, consistent implementation of fiscal-structural, labor market, trade, and SOE reforms can increase growth by about 2 percent over a five year period while meaningfully reducing inequality.
  - Ex-ante investment in climate-adaptive infrastructure can reduce the negative growth impact of a natural disaster shock by one-third and ensure a quicker and more complete recovery.
- Contextual background and climate vulnerability:
  - Pakistan’s living standards have been declining for decades; weak productivity, declining growth, falling capital investment, and misallocation between agricultural and non-agricultural sectors are key factors.
  - SOEs have absorbed almost 9 percent of GDP in direct budget support cumulatively since 2016.
  - Climate- and weather-related disasters caused $29.3 billion in economic losses over 1992-2021, equivalent to 11.1 percent of 2020 GDP (World Bank 2022).
  - The floods of 2022: 1,700 people killed; 8 million displaced; poverty rate increased by up to 4 percentage points; economic losses equivalent to 4.8 percent of FY22 GDP; reconstruction needs estimated at 1.6 times the budgeted national development expenditure of FY23.

### Quantitative illustration: reform package and calibration
- Modeling framework:
  - Uses the IMF’s DIGNAR and DIGNAD models; DIGNAR is a dynamic open economy general equilibrium model with traded, non-traded, and natural resource sectors.
- Four key structural improvements simulated:
  (i) Improvement in public investment spending efficiency.
  (ii) Improvement in tax collection efficiency (C-efficiency).
  (iii) Reduction in labor market distortions.
  (iv) Reduction in product market distortions.
- Reform calibration details and starting points:
  - Public investment efficiency: from 0.62 (hybrid indicator) to comparator EMs’ average of 0.71.
    - Mean Pakistan average efficiency gap stated as 29%.
  - Tax collection efficiency:
    - VAT C-efficiency in 2020 was 0.23 (VAT captures less than a quarter of potential tax base).
    - PIT C-efficiency is 16 percent.
    - Simulation assumes endpoints for both VAT and PIT C-efficiency are doubled to the comparator group average by 2028.
  - Labor market distortions:
    - Share of labor in agriculture fell from 47 to 37 percent between 1990 and 2019.
    - Initial wage-markup-based distortion calibrated using a value obtained from IMF (2023b) via a DSGE estimation on Brazil’s data; simulation assumes reforms fully eliminate this markup.
  - Product market distortions:
    - Reform impact depends on net direct revenue to government and on the balance between licensing/fees and SOE losses; in Pakistan SOE support far outweighs tax and dividend inflows.
  - Trade liberalization:
    - Simulation considers increasing exports from about 8 percent of GDP to 9 percent of GDP (by 1 percent) over five years.

### DIGNAR simulation results: growth, investment, debt, and distribution
- Aggregate macro outcomes (full reform scenario over five years):
  - Real output level is 7 percent higher after five years relative to the steady state.
  - Public debt-to-GDP ratio is reduced by about 6 percent over the same time period.
  - Reforms crowd in private consumption and private investment, with positive spillovers from labor and product market improvements, public investment efficiency gains, and tax reforms.
- Distributional outcomes:
  - DIGNAR distinguishes intertemporal optimizing households and rule-of-thumb (poorer) households.
  - Combined reforms can generate an aggregate decline in consumption inequality by about 2 percent over the simulation’s horizon.

*International Monetary Fund.*

### 13.      We find that structural reforms can substantially raise Pakistan’s growth. The combined

### We find that structural reforms can substantially raise Pakistan’s growth.

### Growth impacts of structural reforms
- The combined effect of the reforms could deliver a medium-term increase in real GDP growth of 2.13 percentage points relative to baseline.
- The combined effects of the comprehensive reform package are somewhat greater than the sum of individual effects obtained in isolation due to general equilibrium and nonlinear features of the model.
- Simulations show that the real growth gain ranges from 0.8 to 2 percent each year, contributing to a reduction of Pakistan’s debt and external vulnerabilities.
- These are static gains; potential gains could be more substantial and permanent if reforms open up new sectors and drivers of growth.

### Contributions by reform type (year five)
- Labor market reforms: 0.98 percent (46 percent of the total growth gain).
- Product market reforms: 0.74 percent (35 percent of the total growth gain).
- Tax reforms (dividends from tax reforms): 0.14 percent (6 percent of the total growth gain).
- Public investment efficiency gains: 0.12 percent (7 percent of the total growth gain).
- Trade reforms: 0.16 percent (about 8 percent of the total growth gain).
- Labour and product market reforms account for most of the output gain in the simulation horizon.

### Public debt, tax collection efficiency, and private sector reaction
- At a first approximation, reforms produce growth dividends that benefit the country’s debt-to-GDP ratio; the size of gains depends on:
  - Soundness of the tax administration system and tax collection efficiency.
  - Public spending efficiency.
  - Impact of labor, financial, and product market distortions.
- By reducing market distortions and facilitating competition, reforms widen the potential tax base available to pay off debt.
- The extent to which the potential tax base becomes actual higher tax receipts depends on the quality of the domestic revenue mobilization system.
- Higher tax collection efficiency implies fewer leakages and greater reduction in the debt-to-GDP ratio following reforms.
- Combined reforms (gradually adding one reform on top of another) boost GDP and widen the tax base, accounting for most of the reduction in the government debt-to-GDP ratio.
- Improving revenue mobilization has a limited impact on both growth and debt given the conservative assumption applied, but is important to ensure activity shows up in revenue and that public investment is effective in supporting growth, development, and climate resilience.

### Model used and calibration (Box 1: Pakistan DIGNAR Model Specifications)
- Model: Debt, Investment, Growth and Natural Resources (DIGNAR), a real, dynamic, open economy general equilibrium model with traded, non-traded, and natural resource sectors; public capital enters production technologies; public investment is subject to inefficiencies and absorptive capacity constraints.
- The general equilibrium nature permits simultaneous analysis of output, private investment, consumption, and fiscal outcomes.
- Calibration to Pakistan:
  - Public capital infrastructure investment aligned with projected values for FY2023/24, amounting to about 3.1 percent of GDP.
  - Public investment efficiency set at 62 percent based on the FAD corruption database value (2018 PIMA).
  - Long-run output growth rate set at 4.4 percent.
  - Initial level of financial labor distortion set to match the average wage markup.
  - Tax collection efficiencies (C-efficiency) based on recent values from the FAD corruption database.
- Simulations assume gradual improvement in the four dimensions of governance over 5 years, tracing implications for reforming single aspects and then a comprehensive package.

### Climate resilience scenarios (DIGNAD model)
- Model calibrated to Pakistan with steady state excluding FY2020 and FY2022; public infrastructure investment set at 3.1 percent of GDP per year and public investment efficiency gap set at 62 percent.
- A climate shock of 5 percent of GDP is applied in year six, with a five-year recovery process modeled.
- Three illustrative scenarios and key outcomes:
  - Baseline (status quo):
    - No adaptive infrastructure investments; following the shock, large declines in GDP, private consumption, and private investment.
    - Large reconstruction spending needs lead to a sustained increase in public investment.
    - GDP remains well below its steady state 13 years after the shock.
    - Debt-to-GDP increases by about 4 percentage points of GDP to 73 percent following the shock and remains at that level in the long term.
  - Adaptation:
    - Additional 1 percent of GDP per year invested in adaptation infrastructure (conventional public investment remains at steady state).
    - About 40 percent of this additional investment is financed via concessional debt, with most of the balance financed by domestic debt.
    - Negative deviations of GDP, private consumption, and private investment from the steady state following the shock are between about one third and one half of that in the baseline.
    - Pakistan’s GDP returns to its steady state 5 years after the shock.
    - Debt-to-GDP steadily rises before the shock and then increases to a greater degree following the shock, settling about 2 percentage points of GDP higher in the long term than under the baseline scenario.
  - Adaptation + efficiency improvements:
    - Same adaptation investment and debt financing as the adaptation scenario, plus improvement in public investment efficiency score to the global average (IMF 2021).
    - Downturn is moderately shallower; GDP returns to its steady state four years after the shock (one year earlier than the previous scenario).
    - Long-term debt path broadly in line with the adaptation scenario.

- Policy implication: Ex-ante adaptation investments would reduce the growth impact of a natural disaster shock by about a third and speed post-shock recovery; enhancements in public investment efficiency further improve immediate resilience. Additional investment needed to bolster resilience would lead to moderately higher debt levels. Fiscal consolidation and fiscal structural reforms are critical to maintain fiscal space to weather such shocks.

### Conclusions and policy directions
- The DIGNAR model demonstrates stronger and more inclusive growth is available via consistent implementation of Pakistan’s structural reform agenda, including:
  - Improving public investment and tax collection efficiency.
  - Reducing incentives that underpin activity in low-productivity sectors and limit reallocation.
  - Improving human capital to reduce labor market frictions and improve labor market mobility.
  - Reducing trade barriers.
  - Following through on SOE governance reform to improve product market performance and reduce distortions.
- Sequencing matters: product market reforms that raise incomes could precede and support more difficult labor market reforms.
- Complementing structural reforms with adaptation investments enhances resilience to climate vulnerabilities, providing a large buffer against natural disaster shocks and faster post-shock recovery.
- Continued implementation of the authorities’ adaptation agenda, progress on the C-PIMA Action Plan, and efforts to boost climate financing are critical to success in building resilience.

*Source: IMF staff estimates and projections, DIGNAR and DIGNAD model simulations as presented in the provided IMF chapter.*

### 1.      Persistently high fiscal deficits, coupled with the impact of recent external shocks, has

### 1.      Persistently high fiscal deficits, coupled with the impact of recent external shocks, has

### Overview
- Persistently high fiscal deficits and recent external shocks have significantly strengthened the sovereign‑bank nexus in Pakistan.
- Government reliance on the banking sector increased because of limited access to external funding; banks’ holdings of domestic government debt surged to around 60 percent of their assets (more than thrice the average for Emerging Market Economies, EMEs).
- With limited growth in their depositor base, banks mainly financed the government’s additional demand for funds through liquidity provided by the State Bank of Pakistan (SBP) via Open Market Operations (OMOs).
- The balance sheets of the sovereign (government), commercial banks, and the central bank have become increasingly interconnected.

### Evolution of the Nexus
- Until 2019, direct financing by the SBP sustained the fiscal deficit; monetary financing accelerated between 2017 and 2019.
  - By end-2019, government debt held by the SBP reached around 20 percent of GDP, constituting close to 40 percent of domestic debt outstanding.
- Mid-2019: authorities committed to refrain from new direct SBP financing of the budget and to reduce SBP holdings of government debt.
- 2022: policy institutionalized and made legally binding through amendments to the SBP Act prohibiting direct lending to the government and purchases of government issued securities in the primary market.
- Despite commitments, external shocks and policy slippages led fiscal deficits to a new plateau of over 7 percent of GDP after 2019.
- Between 2019 and 2023:
  - Banks’ exposure to the sovereign surged from 45 percent of their assets to around 60 percent.
  - Deposits in the banking sector doubled while the nominal volumes of bonds in their portfolios quadrupled.
- SBP provided liquidity mainly through OMOs accepting government securities as collateral in 7- to 28-day reverse repo transactions.
- A time-bound relaxation of the Leverage Ratio requirement below 3 percent for some financial institutions likely facilitated additional purchases of government bonds.
- SBP’s total share in outstanding government debt has been stable since 2019 when securities received as collateral from banks are considered.

### Implications of the Nexus and Potential Risks
- Financial stability and debt sustainability:
  - Large bank holdings of government debt create negative feedback loops between banks and the sovereign.
  - Repricing of government securities may reduce government revenues because bank profitability would decline.
  - Banking crises may activate costly government interventions, amplifying debt sustainability concerns.
- Fiscal policy constraints:
  - Concentration of government borrowing in banks can limit fiscal policy effectiveness and encourage short-maturity issuance preferred by banks.
- Distortions in financial intermediation:
  - Banks focused on funding the government hamper supply of funds to the real economy, potentially raising borrowing costs and reducing private lending.
- Monetary policy challenges:
  - High domestic debt financed by banks crowds out private credit and weakens policy transmission.
  - Central bank may face pressure to keep interest rates low to limit government interest costs, compromising price stability objectives.
- Long-term economic drag:
  - The sovereign‑bank nexus can reduce economic potential, a concern amplified in Pakistan by the degree of the nexus and how securities are funded.

### The Banking Sector: Features and Risks
- Banks remained profitable by focusing on financing the government’s fiscal deficit; treasury operations became profit centers.
- Holding sovereign bonds provides regulatory, collateral, secondary-market trading, and operational advantages relative to private lending.
- As of end-2023:
  - Banks’ exposure to the government is three times more than to the private sector.
- Banks comply with capital requirements and remain very profitable and highly liquid partly due to zero-risk weights on government securities.
- Risks under stress:
  - Valuation and liquidity of government securities may rapidly deteriorate under stress.
  - Around 90 percent of banks’ bond portfolios are in Held Available for Sale (AFS) and Held for Trading (HFT) categories, which are marked-to-market as of December 2023.
- Deposit dynamics:
  - Banks’ deposit base has not kept pace with assets; limited incentives to compete for deposits given ample liquidity and regulatory conditions (e.g., Minimum Deposit Rate - MDR).
  - Shifts toward current accounts or Islamic banking accounts (not bound by MDR) and low banking penetration discourage small savers.
  - High demand for physical currency, extent of the informal economy, low savings rates, and instability contribute to funds remaining outside the banking system.

### The Sovereign: Debt Management Implications
- Heavy bank subscription to domestic debt exposes public debt management to banks’ investment preferences, skewing issuance toward shorter-duration instruments (Treasury bills, floating-rate notes).
- Short-tenor and floating-rate issuance reduces locking in long-term costs but increases frequency of rollovers, raising gross financing needs and associated risks.
- Under stress, diminished bank capacity to carry government securities could initiate a cycle of shortening maturities, rising interest rates, and turmoil in domestic debt and financial markets.

### The Central Bank: Roles, Trade-offs, and Vulnerabilities
- SBP responsibilities:
  - Manage liquidity for monetary policy and serve as banking sector regulator/supervisor.
  - 2022 SBP Act amendments improved governance and autonomy, but challenges remain.
- Trade-offs:
  - SBP provided liquidity to the banking system, increasing net domestic assets; it reduced quasi-fiscal activities and its own bond holdings to contain growth.
  - A systematic shortage of liquidity exists in the banking system which SBP must carefully manage.
- Regulatory and balance-sheet risks:
  - High banks’ holdings of government bonds alter monetary policy transmission; banks may prioritize government bonds even if policy rates decline.
  - Treatment of sovereign investments may make financial soundness indicators misleading under stress.
  - Banks’ reliance on short-term funding creates vulnerability to interest rate risk and duration mismatch.
  - Under sovereign stress, SBP’s balance sheet is exposed through government bonds used as collateral in OMOs.
  - SBP does not apply haircuts on bonds taken as collateral in OMOs, nor does it have sound counterparty eligibility conditions; eligible counterparties have been expanded to include development finance institutions.
  - SBP is progressing to improve risk management and address recommendations of the 2023 Safeguards Assessment Report.

### Conclusions and Policy Recommendations
- Priority actions to address the sovereign‑bank‑central bank nexus:
  - Address fiscal imbalances to contain and begin to unwind interdependencies.
  - Improve government cash management and better use idle cash balances to reduce public sector borrowing needs.
  - Strengthen public debt management with a robust medium-term strategy focused on:
    - Diversifying the investor base.
    - Carefully managing the cost-risk profile of public debt.
    - Prudent advance planning for the SBP bullet repayment in 2029.
  - Address structural impediments to financial sector development:
    - Level the playing field between conventional and Islamic accounts.
    - Encourage increased bank deposits.
    - Reduce the extent of the informal economy.
  - Promote capital market development and growth of domestic institutional investors to deepen the market for risk-free assets and allow banks to refocus on private sector financing.
  - Successfully implement the SBP’s 2023-28 Strategy prioritizing greater inclusive access to financial services, including innovative digital solutions.
- Interim and regulatory measures:
  - Closely monitor banking sector health.
  - Consider prudential measures to address high concentration of certain banks’ assets in government bonds.
  - Mandate more robust levels and quality of bank capital to ensure adequacy against concentration levels and potential stress events.
  - SBP should continue to enhance credit risk management in OMOs to safeguard its balance sheet.

*Prepared by Emre Balibek (MCM), International Monetary Fund.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2024/english/1pakea2024004-print-pdf.pdf_