## _cr06426

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### Executive summary and outlook
- Real GDP growth: 6.6 percent in 2005/06.
- Average inflation (12-month rate): declined from 9.3 percent to 7.9 percent.
- Current account deficit: increased to US$5 billion (3.9 percent of GDP), from US$1.5 billion (1.4 percent of GDP) a year earlier.
- Balance of payments: record-high FDI (including privatization) and government borrowing at favorable terms more than covered the larger deficit, resulting in a balance of payments surplus of over US$1 billion.
- Gross international reserves as of end-June 2006: US$10.8 billion (3.6 months of next year’s imports of goods and services).
- Main near-term challenge: strengthen the balance of payments, in particular the external current account.

### Policy conclusions and recommendations
- Monetary policy:
  - A further tightening of monetary policy in 2006/07 that quickly aligns domestic demand growth with output growth is necessary to place the external current account deficit relative to GDP on a declining path and to increase international reserves.
  - Monetary tightening should be supported by greater exchange rate flexibility and some fiscal restraint.
- Exchange rate and reserves:
  - To be effective, macro policy should allow greater exchange rate flexibility.
  - Given the goal of strengthening the official international reserves position, the option of resorting to the use of international reserves to cover shortfalls of external financing should be used sparingly.
- Fiscal policy:
  - Some fiscal restraint is recommended to support the required moderation of domestic demand.
  - 2006/07 budget targets a deficit of 4.2 percent of GDP (excluding grants), unchanged from the estimated outturn for 2005/06. The underlying fiscal deficit (defined as the overall deficit excluding grants and earthquake-related spending) is budgeted to increase by about 0.3 percent of GDP.
- External financing strategy:
  - Given favorable prospects for non-debt-creating capital flows, meeting the external challenge requires placing the external current account deficit relative to GDP on a declining path and increasing international reserves.
  - Continued reliance on FDI flows of uncertain size and timing to finance relatively large deficits would require high policy flexibility and improved capacity for timely responses to shortfalls of external financing.

### Risks to the outlook and policy responses
- Authorities’ view:
  - Authorities believe the external current account deficit can be stabilized without major changes in macroeconomic policies, expecting deceleration of import growth as transitory import drivers unwind.
  - Government targets: real GDP growth of at least 7 percent in 2006/07 and headline CPI inflation reduction to about 6½ percent.
- Staff view:
  - Staff emphasizes need for tighter monetary policy, greater exchange rate flexibility, and some fiscal restraint to secure declining external deficits and stronger reserves.
  - Staff recommends preserving international reserves and limiting their use to cover financing shortfalls.
- Main downside risks:
  - Dependence on timely receipt of large, lumpy FDI flows.
  - Shocks to the current account from higher oil prices or lower private transfers.
- Quantified risk sensitivity:
  - Net flows of FDI (including privatization receipts) average US$5.2 billion per annum in the baseline “policy” scenario. Delays in finalizing one large transaction representing 20–25 percent of the inflows expected for any given year would create an ex-ante shortfall of financing of over US$1 billion.
- Recommended responses to shortfalls:
  - Monetary policy should respond quickly to shortfalls of external financing.
  - In very large shocks, fiscal measures to raise fiscal savings should be part of the response.
  - Pay close attention to official reserves and signal tolerance for greater nominal exchange rate flexibility.
  - Caution: using reserves to cover shortfalls carries risks because recovery time is uncertain and overuse could undermine attractiveness to foreign investors.

### Fiscal and public debt developments
- Fiscal outturns:
  - Fiscal deficit for 2005/06 exceeded original budget target owing to earthquake-related spending; excluding earthquake spending (0.9 percent of GDP), revenues and expenditures both rose slightly compared to 2004/05.
  - Budget for 2006/07 targets a deficit of 4.2 percent of GDP (excluding grants), unchanged from estimated outturn for 2005/06.
  - Underlying fiscal deficit budgeted to increase by about 0.3 percent of GDP.
- Debt ratios:
  - Government debt-to-GDP ratio: fell to 56 percent by end-June 2006 (below the 60 percent ceiling in the 2005 Fiscal Responsibility Law).
  - Medium-term objective: fiscal consolidation to bring the overall fiscal deficit (excluding grants) to about 2½ percent of GDP.
- Reconstruction spending:
  - Reconstruction-related spending after the October 8, 2005 earthquake was financed largely by external grants and loans; reconstruction-related spending expected to decline gradually over the next four years.

### Monetary and financial sector developments
- Money and credit:
  - Domestic credit was the main source of monetary expansion for the third consecutive year.
  - Private sector credit growth: 23 percent in 2005/06 (down from an average of 31 percent in the previous two years).
  - Reserve money increased by 10.2 percent; SBP claims on the government increased by more than total government borrowing from banks.
- Interest rates and instruments:
  - Six-month treasury bill rate: stable at 8.2 percent throughout 2005/06.
  - Discount rate: kept at 9 percent until end-June 2006; monetary policy tightened in July 2006 with reserve requirements raised and, two weeks later, discount rate increased to 9.5 percent.
  - Bank lending rates became increasingly positive in real terms as inflation declined; real return on bank deposits remained negative.
- Banking system soundness (selected end-June 2006 indicators as reported):
  - Capital adequacy ratio: 11.9.
  - Gross NPLs to gross loans: 8.0.
  - Return on average assets (after tax): 2.1.
  - Return on equity (after tax): 26.5.
  - Concentration: as of March 2006, five largest banks held 53 percent of system assets and 51 percent of loans.
  - Public banks: account for about 20 percent of total banking system assets (excluding the SBP).
  - Minimum required capital increases: PRs 1.5 billion at end-2004; PRs 3 billion at end-2006; PRs 6 billion in 2009.

### Structural reforms, growth, and poverty
- Medium-term challenge:
  - Sustain high growth and poverty reduction through higher rates of saving and investment.
- Priority reform areas:
  - Improve the investment climate; financial market reform; tax reform; improvements in public service delivery; trade liberalization.
- Poverty trends (HIES-based estimates):
  - Poverty headcount ratio: declined from 34.5 (2000/01) to 23.9 (2004/05) — a decline of over 10 percentage points.
  - Poverty gap: changed from 7.0 (2000/01) to 4.8 (2004/05).
  - Severity of poverty: changed from 2.1 (2000/01) to 1.5 (2004/05).
  - Memorandum: Real GDP growth (average of previous four years) rose from 3.4 (2000/01) to 6.0 (2004/05).
- Earthquake impact:
  - October 8, 2005 earthquake increased government spending needs but had relatively minor macroeconomic effects other than government spending due to weak links between affected areas and the rest of the economy.

### Foreign investor inflows and privatization outcomes
- Major events:
  - Sale of Karachi Electric Supply Company (KESC) and partial sale and transfer of management control of Pakistan Telecommunication Company Limited (PTCL) generated large foreign exchange inflows and revitalized privatization.
  - FDI inflows excluding privatization rose by 70 percent.
  - March 2006 placement of US$800 million of 10-year and 30-year government bonds at very favorable terms indicated strong foreign demand.
  - In mid-June, the Supreme Court annulled the March 2006 sale of Pakistan Steel Mills (for US$362 million) due to procedural irregularities.

### Macroeconomic outlook and staff scenario
- Authorities’ expectations:
  - Policy stance for 2006/07 will keep external current account deficit broadly similar to last year and reduce headline CPI inflation to about 6½ percent.
  - Expected import growth to decelerate sharply as transitory import drivers unwind.
  - SBP projected bank lending to the private sector to increase by about 18 percent (year-on-year) during 2006/07 (as reported to staff at the time).
- Staff scenario assumptions and outcomes:
  - Higher real interest rates starting in 2006/07 to rein in domestic demand, significantly reduce non-oil import growth, and lower inflation to 6½ percent.
  - Medium-term: fiscal consolidation to bring overall fiscal deficit (excluding grants) below 2½ percent of GDP, stable real exchange rate, and maintenance of real interest rates at positive levels.
  - Under these assumptions:
    - Output growth: 6½–7 percent (staff) vs. 7–8 percent (government).
    - Headline and core inflation: fall to 5 percent over the medium term.
    - Reserve import coverage: rise moderately.
    - Downward trend in public debt and external debt ratios would continue.
    - By 2010/11, external current account deficit as share of GDP: 2.3 percent (close to Pakistan’s current account “norm”).
- Staff policy recommendations to contain domestic demand and stabilize external current account:
  - Further monetary tightening, including allowing higher cutoff rates at treasury bill auctions to increase commercial banks’ demand for government paper and reduce SBP’s direct lending to government.
  - Support tightening with greater exchange rate flexibility and fiscal restraint to keep the underlying budget deficit at the level of 2005/06 (some 0.3 percent of GDP lower than budget outcome envisaged).
  - Substantially increase reliance on long-term government securities (PIBs) for deficit financing during 2006/07.

### Structural reform priorities (financial markets and revenues)
- Deepening domestic financial markets:
  - Modernize National Savings Schemes (NSS); foster microfinance; phase out broker-financing (“Badla”) in favor of regular margin financing.
  - New issues of long-term government securities (PIBs) are important for developing a local bond market; staff encouraged substantially increased reliance on PIBs during 2006/07.
  - Despite improved FSIs and SBP stress tests, vigilance is prudent given rapid credit expansion.
- Increasing government revenues:
  - Raising the tax revenue-to-GDP ratio is necessary for the fiscal strategy and space for pro-poor spending.
  - Key measures with large revenue potential (taxation of agriculture and services, eliminating nonstandard exemptions) currently lack sufficient political support.
  - Continue efforts to increase tax collection efficiency by streamlining income tax rates and rolling out large- and medium-taxpayer offices; improve audit strategies and integrate income and sales tax administration.
- Specific fiscal-market developments:
  - May 2006: authorities raised PRs 10 billion through 10-year PIBs at average yield of 9.8 percent — first placement since May 2004 and represented less than 15 percent of net domestic government borrowing in 2005/06.
  - September 30 decision: re-allowed nonbank institutional investors to access the NSS; scope for large PIB issuances in 2006/07 likely to be substantially smaller as a result.

### Improving public service delivery, trade liberalization, statistics, and AML/CFT
- Public service delivery:
  - Steps underway to improve efficiency and composition of government spending and strengthen public financial management (technical assistance from FAD).
  - Work conducive to doubling spending on education and health as share of GDP within 10 years (as mandated by 2005 Fiscal Responsibility Law), including rolling out medium-term budget frameworks in key ministries and preparing a new Poverty Reduction Strategy Paper.
  - Importance of reallocating spending from untargeted subsidies to pro-poor and pro-growth spending highlighted.
- Trade liberalization:
  - Pakistan remains committed to a liberal trade regime; progress affected by inconclusive Doha round.
  - Textile exports performed reasonably well after January 2005 MFA expiration; government adopted schemes to support exporters and pursued preferential trade agreements.
  - Staff recommendation: persevere with trade liberalization despite global difficulties.
- Statistics:
  - Data broadly adequate for surveillance, but further improvements in availability and timeliness would help policy analysis.
  - Authorities plan interim arrangements for economic classification reporting pending system upgrades; work to avoid recurrence of large above- and below-the-line fiscal discrepancies.
  - Staff encouraged expediting subscription to the Special Data Dissemination Standard, including compiling quarterly national accounts and wage data and appointing a national coordinator.
- AML/CFT:
  - Strengthening continued; July 2006 SBP prudential regulations issued per FATF recommendations.
  - A bill creating a national executive committee on AML under parliamentary consideration.

### Box — Textile and Clothing Exports after MFA expiration (selected facts)
- T&C share in total exports: around 60 percent for last 10 years (up from 50 percent in early 1990s); only Bangladesh and Cambodia have larger shares.
- Post-MFA performance:
  - T&C export growth rose in 2002, sample-peak 23 percent in mid-2003.
  - Growth fell below 10 percent in Q1 2005, ratcheted up to nearly 20 percent by end-2005.
- Structural issues:
  - T&C export base concentrated in low value-added products: yarn and bedwear/towels = 45 percent of T&C exports; ready-made garments = 15 percent.
  - Input cost increases in 2005/06 (minimum wages, interest rates, energy) may have reduced competitiveness.
- Government support:
  - R&D subsidy of 5 percent for T&C exporters; loan-refinancing schemes at below-market terms.
- Staff view:
  - Prospects favorable if productivity gains are sustained and value-added content of exports increases.
  - Policies should focus on business climate, production efficiency, and product quality.
  - Across-the-board export subsidy schemes are counterproductive.

### Staff appraisal — macro performance and policy recommendations
- Recent performance:
  - Economic performance in 2005/06 was strong despite shocks: October 2005 earthquake, large rise in international oil prices, unfavorable weather.
  - Growth remained buoyant, inflation started to decline, and debt ratios fell further.
  - Financial account surplus in 2005/06 reached a historical peak reflecting marked rise in FDI.
- Domestic pressures:
  - Domestic demand pressures persistent: trade and current account deficits increased due to rapid import growth; pace of disinflation remains slow.
  - Credit growth continued strongly in 2005/06; fiscal deficit (excluding earthquake expenditures) increased slightly.
  - Monetary conditions tightened in July 2006; authorities did not envisage further changes in remainder of 2006/07 (as of discussions).
- Policy recommendations for 2006/07:
  - Gear macroeconomic policies to slow domestic demand growth to contain external current account deficit and accelerate disinflation.
  - Further tighten monetary policy resulting in higher cutoff rates at treasury bill auctions and significantly lower central bank lending to government to reduce credit and import growth, stabilize external current account deficit, and attain 6½ percent inflation target.
  - Support monetary tightening with greater exchange rate flexibility and fiscal restraint to keep underlying budget deficit at 2005/06 level.
- Medium-term framework beyond 2006/07:
  - Fiscal consolidation toward overall fiscal deficit (excluding grants) of about 2½ percent of GDP.
  - Tight monetary stance to keep real interest rates positive and align credit growth with nominal GDP growth.
  - Greater exchange rate flexibility to avoid sustained real appreciation and gradually bring external current account deficit to 2–2½ percent of GDP.
- Structural priorities reiterated:
  - Reform power sector regulatory and tariff frameworks; broaden tax base and curtail nonstandard exemptions; improve debt management by shifting to long-term securities (PIBs); modernize NSS and broker-financing; continue investment climate reforms.
- Trade policy guidance:
  - Maintain liberal trade regime; resist reinstating ad-hoc tariff and nontariff measures and broad export subsidy schemes; evaluate costs of preferential trade agreements.
- Exchange restrictions:
  - Pakistan maintains an exchange restriction on payments for current international transactions (advance payments for certain imports limited to 50 percent) that should be lifted; staff not proposing approval given lack of timetable for lifting.

### Medium-term projections and selected quantitative indicators (selected highlights)
- Real GDP at factor cost (growth): 3.1 (2001/02); 4.7 (2002/03); 7.5 (2003/04); 8.6 (2004/05); 6.6 (2005/06); 6.5 (2006/07).
- Consumer prices (period average): 2.5; 3.1; 4.6; 9.3; 7.9; 6.5.
- Gross national saving (percent of GDP): 20.7; 21.9; 18.4; 16.7; 16.1; 16.5.
- Gross capital formation (percent of GDP): 16.8; 16.9; 16.6; 18.1; 20.0; 20.5.
- Revenue (including grants; percent of GDP): 16.1; 17.4; 14.6; 14.0; 14.5; 14.6.
- Expenditure (including statistical discrepancy; percent of GDP): 19.7; 18.7; 16.4; 17.0; 18.2; 18.1.
- Budget balance (excluding grants; percent of GDP): -5.5; -3.8; -2.3; -3.3; -4.2; -3.9.
- Total government debt (percent of GDP): 81.4; 75.3; 67.8; 61.8; 56.1; 53.0.
- Six-month treasury bill rate (period average; percent): 8.2; 4.1; 1.7; 4.7; 8.2.
- Private credit (annual change; percent): 4.8; 18.9; 29.8; 33.2; 23.2; 10.4.
- Current account including official current transfers (percent of GDP): 3.9; 4.9; 1.8; -1.4; -3.9; -4.0.
- Gross official reserves (end-period; billions of U.S. dollars): 4.33; 9.53; 10.56; 9.81; 10.76; 12.06.
- Balance of payments current account (levels, millions of U.S. dollars): 2,833; 4,061; 1,811; -1,534; -4,996; -5,617; -5,608; -5,195; -5,225; -4,602.
- Exports f.o.b. (levels, millions of U.S. dollars): 9,140; 10,974; 12,459; 14,482; 16,506; 18,648; 21,445; 24,876; 29,105; 34,344.
- Imports f.o.b. (levels, millions of U.S. dollars): -9,434; -11,333; -13,738; -18,996; -24,948; -27,467; -30,158; -33,476; -37,326; -41,805.
- Public debt projections (selected): total government debt percent of GDP projected to fall to 43.1 by 2010/11 under staff scenario.
- External debt and vulnerability indicators (selected):
  - Total gross external debt (percent of GDP): 46.5; 40.4; 34.0; 30.7; 27.7 (selected years).
  - Gross international reserves (billions of U.S. dollars): 4.39; 9.51; 10.69; 9.81; 10.8.
  - De facto exchange rate regime noted: De facto currency peg since December 2004.

### Balance of payments compilation and coverage
- Concepts broadly follow BPM5; presentation based on BPM4 and BPM5 in SBP publications.
- Scope of residency generally conforms to BPM5 with exceptions (e.g., export processing zones and offshore banks treated as nonresidents; Pakistani nationals abroad owning dwellings in Pakistan regarded as residents).
- Shortcomings identified in 2004 ROSC: treatment of oil exports under product sharing agreements; estimation of reinvested earnings; absence of revision studies.
- SBP plans: continue implementation of BPM5; continue disseminating data following template on International Reserves and Foreign Currency Liquidity.
- Trade data differences between FBS and SBP for imports have been widening; most differences can be reconciled ex-post.

### Executive Board assessment and authorities’ statement (key points)
- Board commended acceleration in output growth, decline in debt ratios, fall in poverty rates, increased attractiveness to foreign investors, and resilience to shocks in 2005/06.
- Board noted risks from strong domestic demand and recommended further tightening of monetary policy, supported by exchange rate flexibility and fiscal restraint to keep underlying budget deficit at 2005/06 level.
- Directors encouraged fiscal consolidation, positive real interest rates, close monitoring of credit growth, strengthening reserves, and limited use of reserves for financing shortfalls.
- Authorities’ key points:
  - Real domestic demand growth slowed to 8.1 percent during FY06 from 11.5 percent.
  - Total consumption increase in FY06: 7.8 percent vs. 11.9 percent previous year.
  - Monetary conditions tightened in July 2006; yearly average overnight rate in FY06 was 7.9 percent compared to 3.8 percent in FY05; authorities will tighten if inflation remains above 6½ percent target.
  - Progress on revenue mobilization and tax reform; focus on extending tax net to services and agriculture and provincial contributions to revenue.
  - Banking system strengthened; authorities will encourage higher returns on deposits to promote financial savings.
  - New PIB issues seen as essential to develop local bond market; October 13, 2006 government raised Rs. 15.03 billion through placements of 3,5,10,15 and 20 year PIBs at weighted average yields including 9.78 percent, 9.93 percent, 10.39 percent, 10.85 percent, and 11.17 percent respectively.

### Exchange rate, payments restriction, poverty reduction, and investment climate
- Exchange rate:
  - SBP committed to exchange rate flexibility; flexible regime in effect since May 19, 1999.
  - De facto classification: conventional peg to the U.S. dollar (nominal range since late December 2004: 59.0 to 60.5 rupees per U.S. dollar).
  - FIBR as of September 29, 2006: PRs 60.48 per $1.
  - Staff cautioned against allowing steady real appreciation over medium term.
- Payments restriction:
  - Regulation: a 50 percent limit on advance payments for some imports; payments over 50 percent require SBP approval but blanket approvals granted for genuine requests.
  - Staff view: restriction is largely a legal issue with no material economic effect; removal requires clarifying circular.
- Poverty reduction:
  - Poverty headcount declined by over 10 percentage points from 2000/01 to 2004/05; nearly one quarter of population remains below poverty line.
  - Authorities committed to increase spending in health and education to achieve Millennium Development Goals.
- Investment climate and AML/CFT:
  - Business climate and governance improved; authorities committed to further reforms to increase efficiency, transparency, and accountability.
  - AML/CFT framework strengthened; SBP issued FATF-recommended prudential regulations in July 2006; AML/CFT unit established in SBP.

*Source: IMF staff report excerpt (content unit _cr06426).*

### conclusion of the mission (http: //www.imf.org/external/np /sec/pr/2006 /pr06191.htm).

### Conclusion of the Mission

### Executive summary and outlook
- Real GDP growth remained buoyant at 6.6 percent in 2005/06; average inflation (12-month rate) declined from 9.3 percent to 7.9 percent.
- Domestic demand and non-oil import growth remained high; the current account deficit increased to US$5 billion (3.9 percent of GDP), from US$1.5 billion (1.4 percent of GDP) a year earlier.
- Record-high inflows of foreign direct investment (FDI), including from privatization, and government borrowing from international markets at favorable terms more than covered the larger deficit, resulting in a balance of payments surplus of over US$1 billion.
- Gross international reserves as of end-June 2006 stood at US$10.8 billion (3.6 months of next year’s imports of goods and services).
- Pakistan’s main near-term challenge is to strengthen the balance of payments, in particular the external current account.

### Policy conclusions and recommendations
- Monetary policy:
  - A further tightening of monetary policy in 2006/07 that quickly aligns domestic demand growth with output growth is necessary to place the external current account deficit relative to GDP on a declining path and to increase international reserves.
  - Monetary tightening should be supported by greater exchange rate flexibility and some fiscal restraint.
- Exchange rate and reserves:
  - To be effective, macro policy should allow greater exchange rate flexibility.
  - Given the goal of strengthening the official international reserves position, the option of resorting to the use of international reserves to cover shortfalls of external financing should be used sparingly.
- Fiscal policy:
  - Some fiscal restraint is recommended to support the required moderation of domestic demand.
  - The 2006/07 budget approved in early June targets a deficit of 4.2 percent of GDP (excluding grants), unchanged from the estimated outturn for 2005/06. The underlying fiscal deficit (defined as the overall deficit excluding grants and earthquake-related spending) is budgeted to increase by about 0.3 percent of GDP.
- External financing strategy:
  - Given favorable prospects for non-debt-creating capital flows, meeting the external challenge requires placing the external current account deficit relative to GDP on a declining path and increasing international reserves.
  - Continued reliance on FDI flows of uncertain size and timing to finance relatively large deficits in the external current account would require a high degree of flexibility in economic policymaking and an improved capacity to generate timely policy responses to shortfalls of external financing arising from negative balance of payments shocks.

### Risks to the outlook and policy responses
- Authorities’ view versus staff view:
  - The authorities believe the external current account deficit can be stabilized without major changes in the current stance of macroeconomic policies, citing unwinding of transitory, nonrecurrent import drivers (e.g., oil price spike, foodstuff shortages) as likely to decelerate import growth.
  - Staff emphasize the need for tighter monetary policy, greater exchange rate flexibility, and some fiscal restraint to secure declining external deficits and stronger reserves.
- Use of reserves:
  - The staff recommends that international reserves be preserved and that their use to cover financing shortfalls be limited.

### Fiscal and debt developments
- Fiscal and public debt outcomes:
  - The fiscal deficit for 2005/06 exceeded the original budget target owing to earthquake-related spending; excluding the latter (0.9 percent of GDP), revenues and expenditures both rose slightly compared to 2004/05.
  - The government debt-to-GDP ratio fell to 56 percent by end-June 2006, below the 60 percent ceiling stipulated in the 2005 Fiscal Responsibility Law.
  - Reconstruction-related spending after the October 8, 2005 earthquake was financed largely by external grants and loans, though higher-than-budgeted fiscal resources were also allocated.
  - Reconstruction-related spending is expected to decline gradually over the next four years.

### Monetary and financial sector developments
- Money and credit:
  - Domestic credit was the main source of monetary expansion for the third year in a row.
  - Private sector credit grew at 23 percent in 2005/06 (down from an average of 31 percent in the previous two years).
  - Reserve money increased by 10.2 percent; SBP claims on the government increased by more than total government borrowing from banks.
- Interest rates and monetary instruments:
  - Interest rates on 6-month treasury bills remained stable at 8.2 percent throughout 2005/06.
  - The discount rate was kept at 9 percent until end-June 2006; monetary policy was tightened in July 2006 with reserve requirements raised and, two weeks later, the discount rate was increased to 9.5 percent.
  - Bank lending rates became increasingly positive in real terms as inflation declined, but the real return on bank deposits remained negative.
- Banking system soundness:
  - From December 2004 to June 2006 most financial soundness indicators (FSI) improved.
  - Capital adequacy ratio rose to 11.9; gross NPLs to gross loans fell to 8.0; after tax return on average assets rose to 2.1; after tax return on equity rose to 26.5 (end-June 2006 indicators as reported).
  - Concentration remains high: as of March 2006, Pakistan’s five largest banks held 53 percent of the system’s assets and 51 percent of its loans.
  - Public banks account for about 20 percent of total assets of the banking system (excluding the SBP).
  - Minimum required capital increases: from PRs 1.5 billion at end-2004, to PRs 3 billion at end-2006, and further to PRs 6 billion in 2009.

### Structural reforms, growth and poverty
- Medium-term challenge:
  - Sustaining high growth and poverty reduction through higher rates of saving and investment remains Pakistan’s main medium-term challenge.
- Priority reform areas:
  - Structural reforms to be prioritized include: improving the investment climate, financial market reform, tax reform, improvements in public service delivery, and trade liberalization.
- Poverty trends:
  - Estimates based on the Household Integrated Economic Survey (HIES) show the poverty headcount ratio declined from 34.5 (2000/01) to 23.9 (2004/05), a decline of over 10 percentage points from 2000/01 to 2004/05.
  - Poverty gap changed from 7.0 (2000/01) to 4.8 (2004/05).
  - Severity of poverty changed from 2.1 (2000/01) to 1.5 (2004/05).
  - Memorandum item: Real GDP growth (average of previous four years) rose from 3.4 (2000/01) to 6.0 (2004/05).
- Earthquake impact:
  - The October 8, 2005 earthquake imposed additional demands for government spending and had relatively minor effects on macroeconomic indicators other than government spending, owing to weak links between affected areas and the rest of the economy.

*Source: Conclusion of the mission (Article IV consultation), IMF staff report.*

### 8.      Foreign investors’ interest in Pakistan increased significantly in 2005/06. The

### _cr06426 - 8.      Foreign investors’ interest in Pakistan increased significantly in 2005/06. The

### Foreign investor inflows and privatization outcomes
- Sale of the Karachi Electric Supply Company (KESC) and the partial sale and transfer of management control of Pakistan Telecommunication Company Limited (PTCL) generated large foreign exchange inflows and revitalized the privatization process.
- Foreign direct investment inflows, excluding privatization, rose by 70 percent.
- Successful March 2006 placement of US$800 million of 10-year and 30-year government bonds at very favorable terms indicated strong foreign demand for Pakistani paper.
- In mid-June, the Supreme Court annulled the March 2006 sale of Pakistan Steel Mills (for US$362 million) to a group of foreign investors due to procedural irregularities.

### Macroeconomic outlook and key challenges
- The outlook for sustained growth is favorable, provided inflation falls further.
- Need to strengthen the balance of payments by:
  - containing the external current account deficit;
  - obtaining foreign financing consistent with external debt sustainability;
  - achieving a higher stock of international reserves.
- With improved supply of non-debt-creating capital flows and improved access to international capital markets, Pakistan could sustain external current account deficits in the range of US$5-6 billion (consistent with a steady decline in the current account deficit-to-GDP ratio) while gradually strengthening international reserves.
- Authorities’ views:
  - Policy stance envisaged for 2006/07 will keep the external current account deficit at levels broadly similar to last year’s outturn, and reduce headline CPI inflation to about 6½ percent.
  - Government’s target of real GDP growth of at least 7 percent in 2006/07.
  - Expected import growth to decelerate sharply as transitory, nonrecurrent factors (e.g., oil price spike, unforeseen imports of sugar) unwind.
  - July 2006 tightening of monetary conditions, supported by continued exchange rate stability, expected to accelerate disinflation.
  - Prepared to tighten monetary policy further if inflation continued above the government’s 6½ percent target.
  - At the time of discussions the SBP had not finalized revising its monetary projections for 2006/07; staff was informed that the revised projections would include an increase in bank lending to the private sector of about 18 percent (year-on-year) during 2006/07.
  - Authorities saw scope for overperforming on their budget deficit target for 2006/07, including by saving higher-than-projected revenue.

### Staff scenario, projections, and policy recommendations
- Staff macroeconomic scenario assumptions and outcomes:
  - Higher real interest rates starting in 2006/07 to rein in domestic demand growth, significantly reduce non-oil imports growth, and lower inflation to 6½ percent.
  - Over the medium term: fiscal consolidation bringing the overall fiscal deficit (excluding grants) below 2½ percent of GDP, a stable real exchange rate, and maintenance of real interest rates at positive levels.
  - Under these assumptions:
    - Output growth would remain in the 6½–7 percent range (compared to growth in the 7–8 percent range expected by the government).
    - Headline and core inflation would fall further to 5 percent.
    - Reserve import coverage would rise moderately.
    - Downward trend in public debt and external debt ratios would continue.
  - By 2010/11, the external current account deficit as a share of GDP (2.3 percent) would be close to Pakistan’s current account “norm”.
- Staff policy recommendations to contain domestic demand and stabilize the external current account:
  - Further tightening of monetary policy, including by allowing higher cutoff rates at treasury bill auctions (to increase commercial banks’ demand for government paper and reduce SBP’s direct lending to the government), to slow the growth of private sector credit and non-oil imports.
  - Support tightening with greater exchange rate flexibility and fiscal restraint to keep the underlying budget deficit (the overall deficit excluding grants and earthquake-related expenditures) at the level of 2005/06—i.e., some 0.3 percent of GDP lower than the outcome envisaged in the budget.
  - Staff encouraged substantially increasing reliance on long-term government securities (e.g., Pakistani Investment Bonds (PIBs)) as a means of deficit financing during 2006/07.

### Differences between authorities and staff
- Authorities agreed broadly with inflation and international reserves objectives in the staff scenario and with the balance of payments outlook but believed major policy changes were not required.
- Authorities expected higher growth (7–8 percent) than staff’s 6½–7 percent, citing:
  - Rapid increases in investment from large FDI inflows and privatizations.
  - Continued support from credit policy.
  - Higher capital expenditure, especially in infrastructure.
  - Anticipated growth in national savings outpacing domestic investment due to gradual rise of real interest rates (lower inflation), a decline in the fiscal deficit below 3 percent of GDP over the medium term, growth-induced increases in personal disposable income, and favorable demographic trends.
- Authorities viewed the current level of the real exchange rate as broadly appropriate, noting it was significantly more depreciated than its level during the 1990s; staff cautioned that policies should avoid a steady appreciation of the real exchange rate over the medium term.

### Risks to the outlook and policy responses
- Main downside risks:
  - Dependence on timely receipt of large flows of foreign direct investment (FDI), which are “lumpy” and subject to delays.
  - Shocks to the current account from higher oil prices or lower private transfers.
- Quantified risk sensitivity:
  - Net flows of FDI (including privatization receipts) average US$5.2 billion per annum in the baseline “policy” scenario of Tables 2–6. Delays in finalizing one large transaction representing, for example, 20–25 percent of the inflows expected for any given year would create an ex-ante shortfall of financing, relative to the baseline projections, of over US$1 billion.
- Authorities’ stated responses:
  - Temporary external financing shortfalls could be accommodated by using international reserves or increasing foreign borrowing.
  - For sizable or more permanent shortfalls, the authorities would consider the full range of policy instruments.
- Staff recommendations for handling shortfalls:
  - Monetary policy should respond quickly to shortfalls of external financing because foreign borrowing may not be readily available to cover all external financing shortfalls.
  - In very large shocks, fiscal measures conducive to higher fiscal savings should also be part of the policy response.
  - Pay close attention to the level of official reserves when formulating interest rate and exchange rate policy, and signal tolerance for greater flexibility in the nominal exchange rate.
- Cautions about using reserves:
  - Using international reserves to cover external financing shortfalls (e.g., postponement of new FDI projects or large privatizations) carries risks because the time required to recover used reserves is uncertain; continued reliance could reduce reserves to levels that undermine attractiveness to foreign investors and jeopardize external sustainability.

### Structural reform priorities
- Deepening domestic financial markets:
  - Ongoing modernization of the National Savings Schemes (NSS), initiatives to foster microfinance, and phased reform of the broker-financing system (“Badla”).
  - Need to subject the NSS to market discipline to better integrate with local financial markets.
  - Advisability of moving speedily to replace Badla with regular margin financing used in modern stock exchanges.
  - Staff emphasized the importance of new issues of long-term government securities (PIBs) for developing a local bond market and encouraged substantially increased reliance on PIBs during 2006/07.
  - Although banking system soundness indicators have improved and SBP stress tests do not reveal vulnerabilities, vigilance is prudent given rapid credit expansion over the last three years.
- Increasing government revenues:
  - Raising the tax revenue-to-GDP ratio is necessary to realize the fiscal strategy and create space for pro-poor spending.
  - Key measures with large revenue potential (expanding taxation of the agricultural and service sectors and eliminating nonstandard exemptions) lack sufficient political support at present.
  - Continued efforts to increase efficiency of tax collection by streamlining income tax rates.
  - Progress on tax administration: rolling out large- and medium-taxpayer offices; priorities include improving audit strategies and advancing functional integration of income and sales tax administration.
- Specific fiscal-market developments:
  - In May 2006, the authorities raised PRs 10 billion through the placement of 10-year PIBs that carried an average yield of 9.8 percent. This was the first placement of PIBs since May 2004 and represented less than 15 percent of net domestic government borrowing in 2005/06.
  - On September 30, the authorities re-allowed nonbank institutional investors to access the NSS. The scope for large issuances of PIBs in 2006/07 is likely to be substantially smaller as a result of this decision.

*Source: IMF staff report excerpt (content unit _cr06426).*

### 25.      Improving public service delivery. Steps are being taken to improve the efficiency

### _cr06426 - 25.      Improving public service delivery. Steps are being taken to improve the efficiency

### Improving public service delivery
- Steps are being taken to improve the efficiency and composition of government spending and strengthen public financial management, including through technical assistance from FAD.
- Work underway is conducive to the doubling of spending on education and health as a share of GDP within 10 years (as mandated by the 2005 Fiscal Responsibility Law), including:
  - rolling out of medium-term budget frameworks in several key ministries;
  - preparation of a new Poverty Reduction Strategy Paper.
- Discussions highlighted the importance of reallocating spending from untargeted subsidies to pro-poor and pro-growth spending to reduce inefficiencies and facilitate faster progress towards the attainment of the Millennium Development Goals.

### Trade liberalization
- Pakistan remains committed to a liberal trade regime, but progress in trade liberalization has been affected by the inconclusive Doha round.
- Pakistan’s textile exports performed reasonably well following the January 2005 expiration of the Multi-Fiber Agreement (MFA).
- Authorities reported adopting schemes to support Pakistani exporters to offset increased subsidies provided by other textile-exporting countries, and noted increased efforts to sign preferential trade agreements with several countries as part of a global trend.
- Staff recommendation:
  - Persevere with trade liberalization despite difficulties in the global trading environment.

### Statistics
- Pakistan’s data are broadly adequate for effective surveillance, but further improvements in the availability and timeliness of key economic statistics would help policy analysis and formulation (Appendix III).
- On fiscal data, authorities plan interim arrangements (pending full implementation of system upgrades under a World Bank-supported project) for economic classification reporting.
- Authorities will work on avoiding recurrence of the large statistical discrepancies between above- and below-the-line fiscal outturns of the last two years.
- Staff encouraged:
  - Expediting subscription to the Special Data Dissemination Standard, including by compiling quarterly national accounts and wage data and appointing a national coordinator.

### AML/CFT framework
- Pakistan continues to strengthen its anti-money laundering/combating the financing of terrorism (AML/CFT) framework.
- In July 2006, the SBP issued prudential regulations recommended by the Financial Action Task Force.
- A bill creating a national executive committee on AML is under parliamentary consideration.

### Box 4 — Textile and Clothing Exports Following the Expiration of the Multi-Fiber Agreement (MFA)
- Textile and Clothing (T&C) is Pakistan’s main export industry; its share in total exports has been around 60 percent for the last 10 years, up from 50 percent in the early 1990s.
- Only Bangladesh and Cambodia have a larger share of T&C in total exports.
- Performance after MFA expiration (January 2005):
  - T&C export growth started to rise in 2002 (up to a sample-peak of 23 percent in mid-2003).
  - T&C export growth fell below 10 percent in the first quarter of 2005, but ratcheted up to nearly 20 percent by the end of the year.
- Structural and competitiveness issues:
  - Pakistan’s T&C export base is relatively concentrated in low value-added products: yarn and bedwear/towels account for 45 percent of T&C exports; exports of ready-made garments account for only 15 percent.
  - Increases in input costs (minimum wages, interest rates and energy) during 2005/06 may have reduced T&C competitiveness.
  - Pakistani exporters argue foreign competitors benefit from export subsidies and protection from similar cost increases.
- Government support measures:
  - A research and development subsidy of 5 percent for T&C exporters.
  - Loan-refinancing schemes at below market terms.
- Staff view on policy:
  - Prospects for strong growth remain favorable if productivity gains are sustained and value-added content of exports increases.
  - Policies should focus on improving overall business climate, production efficiency, and product quality.
  - Across-the-board export subsidy schemes are counterproductive as they delay resource allocation toward the most competitive sub-sectors.

### Staff appraisal — macroeconomic performance and policy recommendations
- Recent performance:
  - Economic performance during 2005/06 was strong despite large negative shocks: the October 2005 earthquake, a large rise in international oil prices, and unfavorable weather conditions.
  - Growth remained buoyant, inflation started to decline, and debt ratios fell further.
- Capital flows and external account:
  - Pakistan continued to attract large inflows of foreign investment; the surplus in the financial account of the balance of payments in 2005/06 reached a historical peak, reflecting a marked rise in FDI flows.
- Domestic pressures and policy stance:
  - Domestic demand pressures have not subsided: trade and current account deficits increased, driven by rapid import growth; the pace of disinflation remains slow.
  - Credit growth continued strongly in 2005/06; the fiscal deficit (excluding earthquake-related expenditures) increased slightly.
  - Monetary conditions were tightened somewhat in July 2006; authorities do not envisage further changes in the remainder of 2006/07.
- Policy recommendations for 2006/07:
  - Macroeconomic policies should be more effectively geared at slowing domestic demand growth to contain the external current account deficit and accelerate disinflation.
  - A further tightening of monetary policy resulting in higher cutoff rates at treasury bill auctions and significantly lower central bank lending to the government would help reduce credit and import growth, stabilize the external current account deficit, and attain the government’s 6½ percent inflation target.
  - Monetary tightening should be supported by greater exchange rate flexibility and fiscal restraint to keep the underlying budget deficit (overall deficit excluding grants and earthquake-related expenditures) at the level of 2005/06.
- Medium-term framework beyond 2006/07:
  - Fiscal consolidation to bring the overall fiscal deficit (excluding grants) to about 2½ percent of GDP over the medium term.
  - A tight monetary policy stance that keeps real interest rates at positive levels and aligns credit growth more closely with nominal GDP growth.
  - Continuation of a policy allowing for greater exchange rate flexibility.
  - These measures are necessary to keep domestic demand growth in check, avoid a sustained real appreciation, and gradually bring the external current account deficit to a more sustainable level — in the range of 2–2½ percent of GDP.
- Risks and reserve policy:
  - Continued reliance on FDI of uncertain size and timing to finance large current account deficits requires flexibility in policymaking.
  - Staff recommends priority be given to significantly strengthening the international reserves position.
  - Resorting to official international reserves to cover shortfalls carries risks and should be used sparingly.
- Structural reform priorities:
  - Complete reform of the regulatory and tariff framework for the power sector to improve productivity, increase public sector savings, and enhance prospects for privatization of power companies.
  - Create space for increased public investment and pro-poor spending, and faster fiscal consolidation by broadening the tax base and further curtailing nonstandard exemptions.
  - Improve debt management to shift financing from short-term treasury bills and NSS funds into long-term government securities (PIBs) to jump-start the local bond market.
  - Modernize the NSS and reform broker-financing of stock trading, enable integration of the NSS with local financial markets, and adopt regular margin financing used in modern stock exchanges.
  - Continue efforts to improve the investment climate to sustain rapid growth and reduce poverty.
- Trade policy guidance:
  - Staff welcomes Pakistan’s commitment to maintaining a liberal trade regime and contributing to the Doha round.
  - Authorities advised to resist pressures to reinstate ad-hoc tariff and nontariff measures and to adopt special support schemes for some exports.
  - Evaluate carefully the administrative costs and trade diversion effects of preferential trade agreements under consideration.
- Exchange restrictions:
  - Pakistan maintains an exchange restriction on payments for current international transactions that should be lifted; under this restriction, advance payments for certain imports are limited to 50 percent.
  - Staff is not proposing approval given the lack of a timetable for lifting this restriction.

*Source: IMF staff report excerpt.*

### 38.      It is proposed that the next Article IV consultation take place within the standard

### _cr06426 - 38.      It is proposed that the next Article IV consultation take place within the standard

### Overview
- It is proposed that the next Article IV consultation take place within the standard 12 month cycle.
- Sources: Pakistani authorities; and Fund staff estimates and projections.
- Staff projections assume monetary and fiscal tightening during 2006/07.

### Output and Prices (selected historical and projected indicators)
- Real GDP at factor cost: 3.1 (2001/02); 4.7 (2002/03); 7.5 (2003/04); 8.6 (2004/05); 6.6 (2005/06); 6.5 (2006/07).
- Partner country demand (WEO definition): 2.4; 3.6; 4.5; 4.6; 4.6; 4.4.
- Consumer prices (period average): 2.5; 3.1; 4.6; 9.3; 7.9; 6.5.
- Consumer prices (end of period): 3.4; 1.9; 8.5; 8.7; 7.6; 6.2.
- Pakistani rupees per U.S. dollar (period average): 5.2-4.7-1.53.1-0.8... (as reported).

### Saving and Investment (percent of GDP)
- Gross national saving: 20.7; 21.9; 18.4; 16.7; 16.1; 16.5.
  - Government: -0.8; 1.3; 1.1; 0.5; 1.1; 1.6.
  - Nongovernment (including public sector enterprises): 21.5; 20.5; 17.3; 16.3; 15.1; 14.9.
- Gross capital formation: 16.8; 16.9; 16.6; 18.1; 20.0; 20.5.
  - Government: 2.9; 2.7; 2.8; 3.5; 4.7; 5.2.
  - Nongovernment (including public sector enterprises): 13.9; 14.2; 13.7; 14.7; 15.3; 15.3.

### Public Finances (percent of GDP unless otherwise indicated)
- Revenue (including grants): 16.1; 17.4; 14.6; 14.0; 14.5; 14.6.
- Expenditure (including statistical discrepancy): 19.7; 18.7; 16.4; 17.0; 18.2; 18.1.
- Budget balance (excluding grants): -5.5; -3.8; -2.3; -3.3; -4.2; -3.9.
- Budget balance (including grants): -3.6; -1.4; -1.8; -3.0; -3.6; -3.5.
- Primary balance (including grants): 2.0; 2.9; 1.7; 0.2; -0.6; -0.4.
- Total government debt: 81.4; 75.3; 67.8; 61.8; 56.1; 53.0 (percent of GDP).
  - External government debt: 41.0; 36.0; 32.1; 29.0; 26.2; 24.9.
  - Domestic government debt: 40.4; 39.3; 35.7; 32.8; 29.9; 28.1.
- Implicit interest rate on government debt (in percent): 6.9; 5.8; 5.4; 5.5; 5.8; 6.4.

### Monetary Sector and Financial Aggregates
- Net foreign assets (banking system; in percent of broad money): 13.4; 17.5; 2.1; 2.2; 1.7; 3.9.
- Net domestic assets (banking system; in percent of broad money): 2.0; 0.5; 17.5; 17.1; 13.4; 8.6.
- Broad money (12-month changes; in percent): 15.4; 18.0; 19.6; 19.3; 15.2; 12.5.
- Private credit (annual change; in percent): 4.8; 18.9; 29.8; 33.2; 23.2; 10.4.
- Six-month treasury bill rate (period average; in percent): 8.2; 4.1; 1.7; 4.7; 8.2; ...

### External Sector and Reserves
- Current account including official current transfers (in percent of GDP): 3.9; 4.9; 1.8; -1.4; -3.9; -4.0.
- External public and publicly guaranteed debt (in percent of GDP): 282.0; 229.0; 209.5; 183.7; 168.3; 156.9 (in the table’s units as reported).
- Debt service (in percent of exports): 35.8; 26.6; 17.3; 16.1; 14.1; 12.8.
- Gross reserves (in millions of U.S. dollars): 4,337; 9,529; 10,564; 9,805; 10,760; 12,060.
- Reserves in months of next year's imports of goods and services: 3.7; 6.5; 5.0; 3.6; 3.6; 3.6.

### Balance of Payments (2001/02–2010/11; selected lines, in millions of U.S. dollars)
- Current account (levels): 2,833; 4,061; 1,811; -1,534; -4,996; -5,617; -5,608; -5,195; -5,225; -4,602.
- Exports, f.o.b.: 9,140; 10,974; 12,459; 14,482; 16,506; 18,648; 21,445; 24,876; 29,105; 34,344.
- Imports, f.o.b.: -9,434; -11,333; -13,738; -18,996; -24,948; -27,467; -30,158; -33,476; -37,326; -41,805.
- Net capital flows (Projections): -1.0; 1.1; 6.3; 7.0; 7.7; 7.4; 7.7; 7.8 (as reported).
- Gross official reserves (end-period; in billions of U.S. dollars): 4.33; 9.53; 10.56; 9.81; 10.76; 12.06; 13.96; 15.86; 18.06; 20.96.
- Gross financing needs (in millions of U.S. dollars): -837; -1,379; 771; 3,110; 6,242; 6,825; 6,742; 6,855; 6,965; 5,717.

### Monetary Survey and State Bank Analytical Balance Sheet (selected levels; in billions of Pakistani rupees)
- Monetary survey: Net foreign assets: 230.8; 539.6; 583.2; 636.9; 688.4; 822.5.
- Broad money: 1,761.4; 2,078.7; 2,486.6; 2,966.4; 3,416.5; 3,843.6.
- Reserve money: 584.6; 669.5; 772.9; 909.0; 1,001.3; 1,101.8.
- Net claims on government (banking system): 639.4; 561.0; 619.1; 714.9; 805.6; 873.7.
- Private sector credit: 840.9; 999.9; 1,298.0; 1,728.9; 2,129.6; 2,351.5.

### Consolidated Government Budget (levels; in billions of Pakistani rupees and percent of GDP)
- Revenue and grants (billions PRs): 70 (2001/02); 78 (2002/03); 82 (2003/04); 92 (2004/05); 191 (2005/06); 1,121 (2006/07) — (table presents revenue and grants lines with these figures).
- Revenue (percent of GDP): 14.2; 14.9; 14.1; 13.7; 14.0; 14.2.
- Tax revenue (percent of GDP): 10.9; 11.5; 10.8; 10.0; 10.4; 10.7.
- Expenditure (percent of GDP): 18.8; 18.5; 16.9; 18.2; 18.4; 18.6.
- Budget balance (including grants; percent of GDP): -3.6; -1.4; -1.8; -3.0; -3.6; -3.5.
- Financing (percent of GDP): 3.6; 1.4; 1.8; 3.0; 3.6; 3.5.

### Medium-Term Macroeconomic and Fiscal Framework (2003/04–2010/11; selected projections)
- Current account balance (percent of GDP): 1.8 (2003/04); -1.4 (2004/05); -3.9 (2005/06); -4.0 (2006/07); -3.6 (2007/08); -3.1 (2008/09); -2.8 (2009/10); -2.3 (2010/11).
- Gross national saving (percent of GDP): 18.4; 16.7; 16.1; 16.5; 17.4; 18.4; 19.1; 20.2.
- Gross capital formation (percent of GDP): 16.6; 18.1; 20.0; 20.5; 22.0; 21.5; 22.0; 22.5.
- Gross official reserves (billions of U.S. dollars): 10.6; 9.8; 10.8; 12.1; 14.0; 15.9; 18.1; 21.0.
- Total government debt (percent of GDP): 67.8; 61.8; 56.1; 53.0; 50.4; 47.9; 45.4; 43.1.
- Real GDP at factor cost (percent growth): 7.5; 8.6; 6.6; 6.5; 6.5; 7.0; 7.0.

### Public Debt Sustainability (Public sector debt and risk analysis; selected metrics)
- Baseline public sector debt (percent of GDP): 81.4 (2001/02); 75.3; 67.8; 61.8; 56.1; 53.0; 50.4; 47.9; 45.4; 43.1.
- Change in public sector debt (percent of GDP): -4.4; -6.0; -7.6; -5.9; -5.7; -3.1; -2.6; -2.5; -2.5; -2.3.
- Identified debt-creating flows (percent of GDP): -3.2; -6.1; -9.0; -5.1; -5.1; -4.2; -3.3; -3.1; -3.1; -3.0.
- Debt-stabilizing primary balance: -1.9 (2001/02 baseline example and other years presented in table).
- Key macro assumptions (selected):
  - Real GDP growth at market prices: 3.2; 4.9; 7.4; 8.0; 6.2; 6.5; 6.5; 6.5; 7.0; 7.0.
  - Average nominal interest rate on public debt (in percent): 6.9; 5.8; 5.4; 5.5; 5.8; 6.4; 7.0; 6.9; 6.7; 6.6.
  - Inflation rate (GDP deflator; in percent): 2.4; 4.5; 8.9; 8.0; 10.4; 6.5; 6.0; 5.5; 5.0; 5.0.
  - Primary deficit (percent of GDP): -2.0; -2.8; -1.7; -0.2; 0.6; 0.4; -0.2; -0.4; -0.4; -0.5.

### External Debt Sustainability and Vulnerability Indicators
- Total gross external debt (percent of GDP): 46.5; 40.4; 34.0; 30.7; 27.7 (selected years).
- Gross external financing requirement (in billions of U.S. dollars): -0.8; -1.4; 0.8; 3.1; 6.2 (selected years).
- Gross external debt-to-exports (percent): 302.1; 243.9; 220.5; 191.2; 176.2.
- Gross international reserves (GIR; billions of U.S. dollars): 4.39; 9.51; 10.69; 9.81; 10.8.
- GIR in percent of short-term debt at remaining maturity (RM): 229.6; 338.0; 348.5; 492.2; 678.9.
- Exchange rate regime noted: De facto currency peg since December 2004.

### Financial Soundness Indicators (banking system; selected)
- Capital adequacy (regulatory capital to risk-weighted assets): 8.8; 8.8; 8.5; 10.5; 11.3; 11.9.
- Nonperforming loans (NPLs) to gross loans: 23.4; 21.8; 17.0; 11.6; 8.3; 8.0.
- Provisions to NPLs: 54.7; 60.6; 63.9; 70.4; 76.7; 75.3.
- Return on assets (after tax): -0.5; 0.1; 1.0; 1.2; 1.9; 2.1.
- Return on equity (after tax): -12.6; 3.2; 20.0; 20.3; 26.5; 26.5.
- FX deposits held by residents (percent of total deposits): 11.9; 8.0; 7.6; 7.8; 7.3.

### Social and Millennium Development Indicators (selected)
- Population: 108.0 million (1990); 122.4 (1995); 141.5 (2001); 152.1 (2004).
- Poverty headcount, national (percent of population): 26.1; 29.8; 34.5; 23.9.
- Prevalence of underweight in children (under five years): 40.2; 38.2; 35.0.
- GNI per capita, Atlas method (current U.S. $): 420; 490; 480; 600.
- Trade (percent of GDP): 32.6; 30.8; 31.9; 33.4.

### Scenario and Stress-Test Notes (debt and external sustainability)
- Public debt sensitivity analyses include shocks: growth shock, primary balance shock, interest rate shock, combined shock, real depreciation and contingent liabilities shocks (e.g., one-time real depreciation of 30 percent and 10 percent of GDP contingent liabilities in 2006/07 in specified scenarios).
- External debt bound tests include shocks such as a 30 percent real depreciation and a 50 percent reduction in net FDI inflows (FDI shock).

*Italic: Source — Pakistani authorities; and Fund staff estimates and projections.*

### APPENDIX I: PAKISTAN—RELATIONS WITH THE FUND

### APPENDIX I: PAKISTAN—RELATIONS WITH THE FUND

### I. Membership Status and Quota
- Joined: 07/11/1950
- Article VIII

### II. General Resources Account (SDR Million)
- Quota: 1,033.70  (100.00 percent of Quota)
- Fund Holdings of Currency: 1,074.66  (103.96 percent of Quota)
- Reserve position in Fund: 0.12  (0.01 percent of Quota)

### III. SDR Department (SDR Million)
- Net cumulative allocation: 169.99  (100.00 percent of Allocation)
- Holdings: 146.45  (86.15 percent of Allocation)

### IV. Outstanding Purchases and Loans (SDR Million; percent of Quota)
- Extended arrangements: 41.07  (3.97 percent of Quota)
- PRGF arrangements: 959.99  (92.87 percent of Quota)

### V. Latest Financial Arrangements (Approval Date / Expiration Date / Amount Approved (SDR Million) / Amount Drawn (SDR Million))
- PRGF: Approval Date 12/06/2001; Expiration Date 12/05/2004; Amount Approved 1,033.70; Amount Drawn 861.42
- Stand-By: Approval Date 11/29/2000; Expiration Date 09/30/2001; Amount Approved 465.00; Amount Drawn 465.00
- EFF: Approval Date 10/20/1997; Expiration Date 10/19/2000; Amount Approved 454.92; Amount Drawn 113.74

### VI. Projected Payments to the Fund (SDR Million; based on existing use of resources and present holdings of SDRs)
- Forthcoming scheduled payments by year (Principal / Charges/Interest / Total):
  - 2006: Principal 29.06; Charges/Interest 3.17; Total 32.24
  - 2007: Principal 97.88; Charges/Interest 6.96; Total 104.84
  - 2008: Principal 116.16; Charges/Interest 5.61; Total 121.77
  - 2009: Principal 146.36; Charges/Interest 4.50; Total 150.86
  - 2010: Principal 172.28; Charges/Interest 3.56; Total 175.84

- Note: "This schedule presents all currently scheduled payments to the IMF, including repayment expectations and repayment obligations. The IMF Executive Board can extend repayment expectations (within predetermined limits) upon request by the member if its external payment position is not strong enough to meet the expectations without undue hardship or risk."

### VII. Exchange System (Summary of history and current classification; as of September 29, 2006)
- Prior to mid-1998: fixed exchange rate with periodic step devaluations.
- 07/21/1998: dual exchange system introduced — fixed official exchange rate at PRs 46 per $1 and a floating interbank market exchange rate (FIBR); composite rate used for authorized transactions.
- 05/19/1999: official exchange rate eliminated; unified system with all international transactions conducted at the FIBR.
- Authorities classify regime as managed floating with no predetermined path.
- Nominal exchange rate range since late December 2004: 59.0 to 60.5 rupees per U.S. dollar.
- De facto classification: conventional peg to the U.S. dollar.
- FIBR as of September 29, 2006: PRs 60.48 per $1.
- Pakistan has accepted obligations of Article VIII, but maintains an exchange restriction on payments for current international transactions subject to Fund approval under Article VIII, Section 2a, resulting from limitations on advance payments for certain imports.

### VIII. Last Article IV Consultation
- Last Article IV consultation and ex post assessment staff reports discussed by the Executive Board on November 2, 2005 (IMF Country Report No. 05/409).

### IX. Safeguards Assessments
- Full safeguards assessment of the State Bank of Pakistan (SBP) completed on February 13, 2001, under the Stand-By Arrangement that expired on September 30, 2001; findings and recommendations reported in IMF Country Report No. 01/58, Appendix IV.
- Authorities have implemented all recommended remedial measures included under SBA conditionality.
- No new critical vulnerabilities identified under Pakistan’s subsequent PRGF Arrangement.

### X. FSAP Participation and ROSCs
- Fiscal Transparency Module available at: http://www.imf.org/external/np/rosc/pak/fiscal.htm
- Fiscal Transparency Module—Update: IMF Country Report No. 04/416
- Financial System Stability Assessment / Financial Sector Assessment Program: IMF Country Report No. 04/215
- Data Module and Detailed Assessment Using the Data Quality Assessment Framework: IMF Country Report No. 04/398

### XI. Recent Technical Assistance (by IMF department)
- FAD:
  - January–February 2000: assisted with revision of fiscal data and advised on strengthening fiscal reporting and accounting systems.
  - August 2000: joint FAD-STA mission reviewed progress and assisted preparation of revised fiscal data for 1993/94–1998/99.
  - September 2000: TA on overhauling the income tax law.
  - January 2001: advice on priorities and strategies for improving tax collection operations of the CBR.
  - May 2001: follow-up mission on income tax policy.
  - August 2001: assisted in preparation of tax administration reforms.
  - January 2002: advised on fiscal data management, quality, and transparency.
  - January 2003: assisted in reviewing and preparing tax administration reforms.
  - March 2003: advised on customs administration reform.
  - April 2004: advised on improving fiscal reporting at the subnational level.
- MFD:
  - July 2000: joint MFD/MCD mission on transforming financial system to comply with Islamic finance principles.
  - September 2000: TA on enhancing market orientation of the foreign exchange market.
  - February 2001: TA on design of public finance investment compatible with Islamic finance principles.
  - November/December 2004: joint MFD/World Bank mission on public debt reform.
  - March/April 2005: TA on development of the insurance sector.
- STA:
  - May/June 2000: mission reviewed compilation of data important for program design and monitoring.
  - July 2000: follow-up mission developed time-bound measures to improve national accounts statistics.
  - January 2001: expert provided advice and training to the Federal Bureau of Statistics for producer price indices development.
  - February 2002: mission reviewed external sector statistics and advised on steps to subscribe to the SDDS.
  - April/May 2005: mission provided TA on national accounts and consumer price statistics.
- LEG:
  - May/July 2001: LEG consultant assisted in preparation of the new income tax law, promulgated in September 2001.

### XII. Resident Representative
- A resident representative has been stationed in Islamabad since August 1991.

*APPENDIX I: PAKISTAN—RELATIONS WITH THE FUND. As of September 30, 2006.*

### 7.      The balance of payments statistics are compiled broadly in accordance with the

### 7.      The balance of payments statistics are compiled broadly in accordance with the

### Balance of payments compilation and coverage
- Concepts and definitions broadly follow the Balance of Payments Manual, Fifth Edition (BPM5); presentation in SBP publications and website is based on both BPM4 and BPM5.
- Scope of residency generally conforms to BPM5 with exceptions:
  - Enterprises operating in the export processing zones and offshore banks are regarded as nonresidents.
  - Pakistani nationals residing abroad but owning a dwelling in Pakistan are considered residents.
- Classification and sectorization systems follow BPM5 to some extent; recording basis follows best international practices.
- Shortcomings identified in the 2004 ROSC:
  - Treatment of oil exports under product sharing agreements.
  - Estimation of reinvested earnings.
  - Absence of revision studies.
- International investment position data are now compiled and published on the SBP website.
- SBP plans regarding the external sector:
  - (a) continue the implementation of the BPM5; and
  - (b) continue disseminating data on the SBP website following the format of the template on International Reserves and Foreign Currency Liquidity.
- Trade data differences:
  - Differences between FBS and SBP for imports have been widening.
  - Most differences can be reconciled ex-post (see SBP’s Second Quarterly Report for FY2006); authorities are working to narrow differences before publication.

### Macro outcomes and recent developments (FY2005/06 and surrounding period)
- Output and inflation
  - Real GDP at factor cost (percentage change): 3.1; 4.7; 7.5; 8.6; 6.6 (2001/02–2005/06).
  - Consumer prices (period average; percentage change): 2.5; 3.1; 4.6; 9.3; 7.9 (2001/02–2005/06).
  - Consumer prices (end of period; percentage change): 3.4; 1.9; 8.5; 8.7; 7.6 (2001/02–2005/06).
- External current account and capital flows
  - External current account deficit increased to US$5 billion (3.9 percent of GDP) in FY2005/06, from US$1.5 billion (1.4 percent of GDP) a year earlier.
  - Record-high net capital flows (mainly FDI—including privatization) more than covered the larger deficit and allowed for a build up of nearly US$1 billion in official international reserves.
  - Gross official reserves (in millions of U.S. dollars): 4,337; 9,529; 10,564; 9,805; 10,760 (2001/02–2005/06).
  - In months of next year’s imports of goods and services: 3.7; 6.5; 5.0; 3.6; 3.6 (2001/02–2005/06).
- Public finances and debt
  - Fiscal deficit exceeded original budget target for 2005/06 owing to earthquake-related spending.
  - Budget for 2006/07 targets a deficit of 4.2 percent of GDP (excluding grants), unchanged from estimated outturn for 2005/06.
  - Government debt-to-GDP ratio fell to 56 percent by end-June 2006 (below the 60 percent ceiling in the 2005 Fiscal Responsibility Law).
  - Selected public finance indicators (percent of GDP): Revenue (including grants): 16.1; 17.4; 14.6; 14.0; 14.5. Expenditure (including statistical discrepancy): 19.7; 18.7; 16.4; 17.0; 18.2. Budget balance (excluding grants): -5.5; -3.8; -2.3; -3.3; -4.2.
  - Primary balance (including grants): 2.0; 2.9; 1.7; 0.2; -0.6.
  - Total government debt: 81.4; 75.3; 67.8; 61.8; 56.1 (2001/02–2005/06).
- Monetary and financial indicators
  - Broad money (annual change; in percent): 15.4; 18.0; 19.6; 19.3; 15.2 (2001/02–2005/06).
  - Private credit (annual change; in percent): 4.8; 18.9; 29.8; 33.2; 23.2 (2001/02–2005/06).
  - Six-month treasury bill rate (period average; in percent): 8.2; 4.1; 1.7; 4.7; 8.2 (2001/02–2005/06).
  - Net foreign assets (change in percent of broad money): 13.4; 17.5; 2.1; 2.2; 1.7 (2001/02–2005/06).
  - Net domestic assets (change in percent of broad money): 2.0; 0.5; 17.5; 17.1; 13.4 (2001/02–2005/06).
- Trade growth rates (U.S. dollars)
  - Merchandise exports growth rate (percent): 2.3; 20.1; 13.5; 16.2; 14.0 (2001/02–2005/06).
  - Merchandise imports growth rate (percent): -7.5; 20.1; 21.2; 38.3; 31.3 (2001/02–2005/06).
- Exchange rate and competitiveness
  - Pakistani rupees per U.S. dollar (period average): 61.3; 58.4; 57.5; 59.3; 59.8 (2001/02–2005/06).
  - Real effective exchange rate (annual average; percentage change): -2.6; -0.1; -1.8; 0.3; 5.3 (2001/02–2005/06). (An increase is a real appreciation.)

### Executive Board assessment and policy recommendations
- Commendations and risks
  - Directors commended acceleration in output growth, steady decline in debt ratios, fall in poverty rates, and increased attractiveness to foreign investors (record-high FDI and favorable sovereign bond placements).
  - Noted resilience to shocks in 2005/06: October 2005 earthquake, sharp rise in international oil prices, and unfavorable weather.
  - Noted risks: continued strength of domestic demand, adverse effects on trade and current account deficits, and on pace of disinflation.
- Monetary, fiscal, and exchange rate policy guidance
  - Many Directors considered that further tightening of monetary policy (including by allowing higher cutoff rates at treasury bill auctions) should not be delayed to strengthen the external position and help meet the inflation target.
  - Monetary policy should be supported by exchange rate flexibility and a fiscal policy that keeps this year’s budget deficit (excluding grants and earthquake-related expenditures) at least at the level of 2005/06.
  - Beyond 2006/07, macroeconomic policies should ensure the external current account deficit-to-GDP ratio remains on a declining path with a steady build up of reserves.
  - Encouraged policy stance that maintains real interest rates at positive levels, close monitoring of credit growth, and fiscal consolidation to lower overall fiscal deficit to sustainable level over the medium term.
  - Cautioned that reliance on FDI inflows of uncertain size and timing requires flexibility in policymaking; recommended limited use of international reserves to cover shortfalls of external financing.
- Structural reform priorities
  - Reforms to broaden tax base and streamline rates; step up efforts to curtail tax exemptions.
  - Complete reform of regulatory and tariff framework for the power sector.
  - Improve government debt management strategy by increasing issuance of long-term marketable securities and reducing reliance on treasury bills and National Savings Schemes (NSS).
  - Modernize NSS and integrate NSS with local financial markets.
  - Maintain a liberal trade regime; resist pressures to reinstate ad-hoc tariff and nontariff measures and broaden export subsidy schemes.
- Data and transparency
  - Encouraged authorities to improve quality and timeliness of data, including reporting fiscal data on an economic classification.
  - Urged authorities to expedite process of subscribing to the Special Data Dissemination Standard.

### Authorities’ statement (key points)
- Fiscal and monetary stance
  - Real domestic demand growth slowed to 8.1 percent during FY06 from 11.5 percent.
  - Total consumption increase in FY06 was 7.8 percent compared to 11.9 percent in previous year.
  - Authorities expect import growth to decelerate sharply as transitory factors unwind.
  - Monetary conditions tightened in July 2006; yearly average overnight rate in FY06 was 7.9 percent compared to 3.8 percent in FY05.
  - Authorities will tighten monetary policy if inflation remains above the government’s 6½ percent target.
  - Underlying budget deficit (overall deficit excluding grants and earthquake-related expenditures) kept at level of 2005/06.
- Revenue mobilization and tax reform
  - Progress made in raising tax revenue-to-GDP ratio and groundwork laid to broaden tax base.
  - Reforms to improve documentation of the economy, greater reliance on self-assessment and risk-based auditing.
  - Focus on extending tax net into service and agriculture sectors; increasing provinces’ contribution to revenue remains an area of attention.
- Financial sector and long-term securities
  - Banking system strengthened; banks improved rankings in capital adequacy, asset quality, and profitability since 2001.
  - Authorities will encourage higher returns on deposits to promote financial savings.
  - New issues of long-term government securities (e.g., Pakistani Investment Bonds, PIBs) viewed as essential to develop local bond market.
  - On October 13, 2006, government raised Rs. 15.03 billion through placement of 3,5,10,15 and 20 year PIBs at weighted average yields of 9.78 percent, 9.93 percent, 10.39 percent, 10.85 percent and (text continues).

*Public Information Notice No. 06/139 — IMF Executive Board Concludes 2006 Article IV Consultation with Pakistan (December 7, 2006).*

### 11.17 percent, respectively. The sale of the Karachi Electric Supply Company and the partial

### Pakistan: Exchange rate, Payments restriction, Poverty reduction, Investment climate, and Medium-term outlook

### Exchange rate
- The SBP is committed to exchange rate flexibility; a flexible exchange rate regime has been in effect since May 19, 1999.
- Intervention in the foreign exchange market is limited to preventing excess volatility.
- The current level of the real exchange rate is broadly appropriate: the real exchange rate was significantly more depreciated than its level during the 1990s.
- The staff’s classification of Pakistan’s exchange rate regime as a conventional peg is based on a methodology essentially centered on the variability of the nominal exchange rate and gives very little weight to other considerations such as foreign exchange intervention and judgmental elements.
- Authorities’ view:
  - Movement of the exchange rate within a narrow band, particularly when due to effective policy measures, should not be treated as equivalent to the de jure (announced) peg.
  - Greater exchange rate stability per se is not sufficient evidence of less flexibility in the exchange rate regime, since it may reflect a different pattern of shocks to the foreign exchange market.
  - A country experiencing a decrease in the intensity and number of shocks (e.g., terms of trade, cost of borrowing, policy induced) could see a stable exchange rate over a 12-month period.
  - A country should not be encouraged to have greater fluctuation in the exchange rate so that it may be categorized as following a de facto floating exchange rate regime.
- On intervention in the interbank foreign exchange market, especially to provide support for lumpy payments for petroleum imports, a recent SBP study showed that the effects of intervention on dampening volatility of the exchange rate are more pronounced compared to the effects on the level of the exchange rate.

### Payments restriction
- Regulation: a 50 percent limit on advance payments for some imports.
- Authorities’ clarifications:
  - Payments of over 50 percent are not prohibited but require SBP’s approval; genuine requests receive blanket approval to effect 100 percent advance payment.
  - The 50 percent advance payment limit is an adjustment in the mode of payment aimed at curbing speculative activity in the market and has no effect on meeting genuine business needs.
  - Importers have been given blanket approvals to effect 100 percent advance payment where it was either a supplier’s requirement or global corporate policies.
- Staff view:
  - The regulation states that requests shall be considered for approval by the SBP on the basis of evidence of the bona fide nature of the underlying transaction and a bank guarantee, and all bona fide transactions have been allowed.
  - There is an exchange restriction that could be removed by clarifying the regulations: authorities have not yet issued the circular clarifying that despite the various limits on advance import payments, foreign exchange will be provided without limitations for advance import payments upon verification of the bona fide nature of the underlying transactions.
  - In short, there is no payment restriction in the sense of having any real world effects, that is, affecting current account transactions in a material way that would classify as a payment restriction.
  - This is entirely a legal issue, with no economic effects, and the authorities are looking into the exact wording of the regulation that would lead to the removal of this restriction.

### Poverty reduction
- Estimates based on the recent Household Integrated Economic Survey (HIES):
  - The share of Pakistan’s population living below the poverty line (poverty headcount ratio) declined by over 10 percentage points from 2000/01 to 2004/05.
  - Two other key measures of poverty incidence (the poverty gap and severity of poverty) also showed improvement during the last four years.
- Authorities’ concerns and commitments:
  - Nearly one quarter of Pakistan’s population lives below the poverty line.
  - Authorities are committed to making further inroads on poverty and are determined to increase spending in health and education because that is a sine qua non for achieving the Millennium Development Goals.

### Investment climate, anti-money laundering, and trade policy
- Business climate and governance:
  - Overall business climate and governance in key macroeconomic institutions have clearly improved, as attested by the data on fiscal transparency and Doing Business survey of the World Bank.
  - Authorities remain determined to create an environment conducive to investment and to improve governance in all public institutions.
  - Priorities include bolstering reforms to increase efficiency, transparency, and accountability in the use of public resources.
- AML/CFT:
  - The anti-money laundering/combating the financing of terrorism (AML/CFT) framework has been strengthened.
  - In July 2006, the SBP issued prudential regulations recommended by the Financial Action Task Force.
  - An AML/CFT unit has been established in the SBP under the direct supervision of the Governor.
- Trade policy:
  - Authorities assure that progress in bilateral and regional trade agreements has not compromised Pakistan’s commitment to maintaining a liberal trade regime.
  - Authorities support contributing to multilateral trade negotiations, including a successful Doha round of trade talks.

### Medium-term outlook
- Agreement between authorities and staff:
  - Broad agreement on the medium-term path for the external current account deficit, the prospects for external financing, and the targets for international reserves.
- Risks and external financing:
  - Staff noted that the external current account deficit has reached relatively high levels and a further widening could compromise external sustainability.
  - Authorities recognize medium-term outlook is subject to various risks.
  - Authorities note increased attractiveness to foreign investors has led to a notable rise in the supply of non-debt-creating capital flows, as well as relatively low spreads and long maturities in recent borrowings from international and regional capital markets.
- Growth and savings outlook:
  - Authorities anticipate growth would be somewhat higher than assumed by staff, mainly due to rapid increases in foreign direct investment and domestic private investment.
  - Growth in national savings would outpace the increase in domestic investment, driven by a gradual rise of real return to financial savings (as a result of the lower inflation), as well as a decline in the fiscal deficit below 3 percent of GDP over the medium term.
- Policy anchors and commitments:
  - The Fiscal Responsibility Law will serve as a key anchor for sound macroeconomic policies.
  - Authorities are resolute in their focus on fiscal and external sustainability, including an ambitious program to increase domestic revenue.
- Authorities’ stance toward the Fund:
  - Authorities value their close relationship with the Fund, gratefully acknowledge the support received over the years from the Board, management, and staff, and look forward to the Board discussion.

*Source: IMF staff report excerpt.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06426.pdf_