Pakistan and the IMF

News Brief: IMF Completes Second Review Under Pakistan's Stand-By Arrangement

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Pakistan—Letter of Intent,
Memorandum of Economic and Financial Policies,
and Technical Memorandum of Understanding

June 27, 2001

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

Mr. Horst Köhler
Managing Director
International Monetary Fund
700 19th Street, NW
Washington, D.C. 20431

Dear Mr. Köhler:

The Pakistan authorities held discussions with Fund staff during May 2001 for the second review under the Stand-By Arrangement. Based on these discussions, the attached Supplementary Memorandum on Economic and Financial Policies (MEFP) reviews economic developments and policy implementation in the first three quarters of fiscal year 2000/01 (July 2000-March 2001), updates the macroeconomic framework, and discusses the stabilization policies and structural reform program for the remainder of the calendar year.

All performance criteria for end-March 2001 were met, except for the performance criterion on Central Board of Revenue (CBR) revenue, which was missed by a small margin. We are confident that all structural and most quantitative performance criteria for end-June 2001 will also be met, although data on the quantitative targets will only become available in late July. However, in part reflecting the drought and despite a determined implementation of the short-term action plan for CBR elaborated in consultation with FAD, we expect CBR revenue through June to reach only PRs 406 billion, PRs 11 billion short of the target, but nonetheless an increase of 17 percent over last year. We are also making our best effort to meet the target for net foreign assets of the SBP, and based on most recent data we are not very far from the target. However, we will have to avoid that stepped-up purchases of foreign exchange do not destabilize a fragile foreign exchange market, and with weaker external balances (again drought related) and shortfalls in external financing, a small shortfall from the NFA-target for end-June may not be ruled out. Accordingly, we request a waiver for nonobservance of the quantitative performance criteria on revenue of the CBR and the State Bank of Pakistan's NFA at end-June 2001, and waiver of applicability for all other quantitative performance criteria at end-June 2001. These latter performance criteria would apply to the purchases after July 20, 2001. On the basis of the performance up to end-March 2001 and policies set out in the attached memorandum, the government requests the completion of the second review.

The Government of Pakistan will provide the Fund with such information as the Fund may request in connection with Pakistan's progress in implementing the economic and financial policies and achieving the objectives of the program. The government believes that the policies set out in the attached memorandum are adequate to achieve the objectives of the

program. However, it stands ready to take any additional measures appropriate for this purpose, and will consult with the Fund in accordance with the policies of the Fund on such consultations.

Sincerely yours,

Shaukat Aziz
Minister of Finance and
Economic Affairs
Ishrat Husain
State Bank of Pakistan


Supplementary Memorandum of Economic and Financial Policies (SMEFP) for the Second Review Under the Stand-By Arrangement

I.  Developments During July 2000–April 2001 and Outlook
for the Remainder of FY 2000/01

1.  Macroeconomic performance suffered from a persistent drought, one of the worst in recent decades. Rainfed agriculture is most severely affected, but with water levels in reservoirs running very low the outlook for irrigated agriculture is clouded as well. The loss of hydropower necessitated additional petroleum imports for electricity production, weakening already vulnerable external balances. At the same time, available data confirm the continued recovery in the industrial sector. In the circumstances, we now expect real GDP (at factor cost) growth at 2.6 percent in FY 2000/01, compared to a target of 3.8 percent. Inflation as measured by the CPI slowed to 4.7 percent in the year through April, reflecting prudent financial policies and low food prices resulting from last year's bumper crops. Wholesale price inflation is running somewhat higher, driven mainly by increased petroleum and raw cotton prices, and may signal greater inflationary pressures ahead. Nonetheless, we expect average inflation (CPI) for FY 2000/01 to come in at 4.7 percent, slightly lower than was earlier expected.

2.  External balances for FY 2000/01 are projected to be somewhat weaker than programmed. Trends through April point to some deterioration in the trade balance, roughly compensated by higher worker remittances (including through the kerb market). Export shortfalls were due to lower unit values reflecting a softening mostly in the US market, whereas volumes increased as programmed with strong growth in nontraditional exports, such as pharmaceuticals, chemicals, and leather goods; imports were somewhat higher mostly because of higher sugar and oil import volumes. With an expected increase in remittances, we expect the external current account deficit (excluding grants) for the year to be contained to 3.7 percent of GDP. The capital account was broadly on track through March, with shortfalls in official financing offset by higher private capital inflows, but a weakening in the last quarter seems likely as the pace of private inflows seems to have slackened.

3.  Reserves targets for March were met and SBP purchases of foreign exchange are being stepped up. Gross official reserves (excluding FE-25 foreign currency deposits and short-term swaps and forwards) at end-March 2001 exceeded the program target, and the performance criterion on net foreign assets of the SBP was met (Table 1). The interbank market exchange rate depreciated further by 5 percent during December 2000-March 2001, while the premium on the kerb market remained mostly in a daily range of 4-5 percent. Because of much larger than expected program financing shortfalls, lower than expected inflows of FDI and portfolio investment, and the drought-related worsening of the trade balance, the SBP has stepped up--admittedly somewhat belatedly--purchases from the interbank and kerb markets to protect its reserves and service external debt. However, care needs to be taken to avoid that excessive purchases destabilize the market and excessive depreciation not rekindle inflationary pressures. To support the reserves target, we have also tightened monetary policy further and are making best efforts to ensure timely disbursements of project financing from the World Bank, Asian Development Bank, and European Union, and are also making efforts to mobilize bilateral resources. Despite these efforts, a small shortfall from the NFA target for end-June target may not be ruled out. The government has ensured, and remains committed to ensure that all current account operations can be transacted on the interbank market free of any restrictions or undue delays in the approval of payments and transfers for such transactions, and ensure compliance with Pakistan's obligations under Article VIII of the Articles of Agreement.

4.  The consolidated government deficit (excluding grants) for the first three quarters of FY 2000/01 amounted to 4.2 percent of annual GDP, lower-than-programmed. Shortfalls in tax revenues from programmed levels were more than compensated by higher nontax revenue and expenditure restraint. The revenue shortfalls were mostly in sales tax collections while all other tax categories were close to or above target. Lower current and especially capital spending at the provincial levels result from deliberate expenditure restraint and better enforcement of accountability and governance standards. In particular, despite release at the federal level of budgeted appropriations at the beginning of the year, as envisaged in the program, social and poverty-related expenditures fell short of program objectives by PRs 5 billion (as per provisional accounts). In the circumstances, the end-March performance criteria on the fiscal deficit and net bank borrowing were met while that on the CBR revenue was breached with a small margin (0.1 percent of GDP).

5.  Similar trends are expected to continue through June, and the government is confident that the deficit target for the year will be met. The main risk is a widening shortfall in revenue. In April, CBR revenue collection fell again short of the target despite a strong improvement in the number of sales tax audits and implementation of the agreed short-term CBR action plan. Although we expect the plan to begin yielding more visible results in the weeks ahead, reflecting also lower GDP because of the drought, the end-June target for CBR revenue are unlikely to be observed. However, every effort will be made to reach a level of at least PRs 406.5 billion for the year. To achieve the deficit target, we have implemented cuts mainly affecting provincial nonwage current spending and further slowed spending on low-priority public investment projects.

6.  Monetary policy remains tight to keep inflation on target. A further tightening of monetary policy (six-month treasury bill rates were raised to 11.5 percent in March) helped slow reserve money growth to 6.6 percent in the year through end-March 2001, well below the program target. To ensure observing the performance criteria on central bank NDA at end-March, the SBP gave banks the option to convert temporarily the rupee counterpart of the frozen foreign currency deposits of nonresident institutional investors, held with the SBP, into treasury bills. In the event, the NDA target was met with a comfortable margin. Even after adjusting for this temporary operation, underlying reserve money growth was 12.7 percent through March, a sharp slowdown from the underlying rate of reserve money growth through December 2000. We expect reserve money growth to slow further through June, supported by a further tightening of interest rates to ensure observance of the NDA target for end-June, and will not resort to any exceptional operations.

7.  Broad money growth slowed to 11 percent in the year through March 2001, roughly in line with the program target, and we expect it to remain on track through June. On the liability side, the expansion continued to be driven by growth in currency holdings as well as growth in foreign currency and rupee time deposits. Continued high cash preference reflects mostly the ongoing tax survey/documentation drive and increased transaction demand for the rupee in Afghanistan as confidence in the Afghani declined further with the catastrophic drought and the tightening of UN sanctions. Private credit growth (8.7 percent over the year through March) continues at a healthy pace, reflecting largely the pick-up in industrial activity.

8.  Structural reforms are on track. All structural performance criteria and most benchmarks for end-March 2001 were observed, including the extension of the sales tax to urea fertilizer and pesticides despite the difficult circumstances arising from the drought (Table 2). The report on the long-term tax administration reform strategy was released in April, and is now being reviewed by the government. As part of the drive to enhance fiscal transparency, the publishing of reconciled fiscal data continues; public expenditure during the first 3 quarters equivalent to some 0.9 percent of GDP is in the process of being identified through reconciliation. The envisaged price adjustments for petroleum products, electricity, and gas prices were implemented on time. In early April, the SBP reduced subsidies under the Export Finance Scheme; and enforced licensing requirements on all moneychangers. The SBP also replaced the restriction on commercial banks' placement of new foreign currency deposits abroad (FE-25) by prudential regulations and cash reserve requirements. In addition, to discourage dollarization, remuneration of the FE-25s is capped at LIBOR, and banks may not accept FE-25s beyond 20 percent of total deposits. In March 2001, the SBP established a formal process for reconciling data reported to the IMF, as well as guidelines to prohibit operations that pledge or encumber reserves, or place restrictions on or otherwise impair the availability of foreign exchange reserves outside an authorized framework.

II.  Macroeconomic Objectives and Policies for FY 2001/02 and the Medium-term

9.  The formulation of macroeconomic targets for the coming years is complicated by uncertainty as to the impact of the drought. On the basis of latest available data, and assuming normal monsoon rains this summer, we expect real GDP growth at 4 percent for 2001/02, and a further pick-up to about 5 percent during 2002/03-2003/04 fuelled by a recovery of agriculture from the drought and continued strong growth in large-scale manufacturing and in particular the textile sector. A number of factors should support growth: the large ongoing investments especially in high-value added textile sectors; declining real interest rates as crowding out and risk premia are reduced; further market opening in industrial countries that should strengthen export prospects; and the lagged impact of the recent real depreciation of the rupee. For 2001/02 and beyond, we will target an annual average inflation rate of around 5 percent, and external current account deficits at around 2 percent of GDP. However, we expect a gradual return of foreign investors' confidence and accordingly, aim at a build-up of reserves to US$2.3 billion (equivalent to 9 weeks of imports) by end-June 2002, with the aim to reach US$3.6 billion at end-June 2004.

10.  The macroeconomic policy mix will remain broadly unchanged, with the focus on continued fiscal adjustment to reduce the debt overhang, a flexible exchange rate system, and monetary policy geared towards ensuring that inflation targets are met. The draft budget for 2001/02 aims to strike a balance between the over-arching need to reduce the public debt overhang and create long-term fiscal space through debt and debt-service reduction, and the need to finance critical structural reforms and investments in infrastructure and social sectors. The budget calls for reducing the overall fiscal deficit, excluding grants, to 4.9 percent of GDP (from 5.3 percent expected for this year). While the implied fiscal adjustment appears to be less ambitious than indicated in our November-memorandum, we believe that the need for some emergency assistance to those areas most affected by the drought, the cost of launching certain structural reforms, as well as the confirmation that the Saudi oil facility is being provided as a grant rather than a loan justifies a somewhat higher deficit. The deficit also reflects one-off operations to restructure the three nationalized banks, in preparation of their privatization within 10-15 months. Excluding the exceptional outlays related to the drought and the bank restructuring, the underlying structural fiscal adjustment would be much stronger at about 1 percent of GDP. Including grants, the fiscal deficit would decline to 3.6 percent of GDP in 2001/02, from 3.9 percent in the current year. Any privatization receipts (net of the cost of financing the privatization process itself) will be used to reduce public debt.

11.  Total tax revenue is targeted to increase to 13.7 percent of GDP in 2001/02, compared to an expected 13.3 percent of GDP in 2000/01. The increase in the tax ratio is based upon the envisaged gains from various tax policy reforms (detailed below), the full year effects of the ongoing short-term action plan and envisaged gains from the tax survey and documentation drive (0.3 percent of GDP). We do not anticipate any gain from the major restructuring of the CBR during the first year. Nontax revenue is expected to rise to 3.1 percent of GDP, mostly on account of higher SBP profits as one-time charges related to loss provisioning in the current year go out of the base and higher interest rates earned on treasury bills.

12.  Total expenditure and net lending will rise to 21.8 percent of GDP. The increase is in part explained by one-off expenditure related to the drought emergency package (0.3 percent of GDP), the cost of establishing and making local governments functional under the devolution plan (0.1 percent of GDP), and a golden handshake package for nationalized banks in preparation for their privatization (0.3 percent of GDP). A cautious beginning has been made to implementing a wide-ranging civil service reform (see below); an associated wage and pension reform package addressing the quality of the civil service and containing the fast growth of pension liabilities will become effective from January 1, 2002; as a result outlays for government wages and pensions will be kept broadly stable as a share of GDP. Development spending will increase to 3.4 percent of GDP, while defense expenditure (including military pensions) will decline to 4.3 percent of GDP, with non-wage/non-pension defense outlays kept at 2000/01 levels. The budget includes an increase in social/poverty-related spending by 0.3 percentage points of GDP, much of it related to the launching of an education reform strategy focused on basic education as detailed in the draft interim PRSP and the increased pay for health and education sector staff. Expenditure authorizations for social sectors and poverty alleviation will be released as programmed and the provincial governments have been encouraged to achieve targeted spending levels.

13.  The containment of expenditures will importantly hinge on a package of measures to strengthen WAPDA's and KESC's finances (discussed below). For the seven large public enterprises (WAPDA, KESC, PCTL, Sui-N, Sui-S, OGDC, and the railways), we will aim to reduce the overall deficit to 1.0 percent of GDP from an estimated 1.2 percent in 2000/01; this will require continued close monitoring, rapid progress in the restructuring of these enterprises, further price adjustments, and application of commercial principles. To ensure achievement of the fiscal deficit target in the event of revenue shortfalls, the MOF will continue to monitor expenditures closely and, for spending other than for social sectors or poverty alleviation, budgetary provisions will be released only gradually keeping in view the fiscal deficit target and overall revenue performance.

14.  Monetary policy will be geared towards achievement of the inflation and reserve targets. For the year through June 2002 we will aim to reduce reserve money growth to 9 percent. Given the uncertainty surrounding the evolution of the cash-to-deposit ratio, the SBP will exercise vigilance to ensure that monetary policy is adjusted through indirect instruments (principally open market operations, repos, and discount rate) as needed. As a result, broad money growth for the year through end-June 2002 is projected at 9.3 percent, in line with expected nominal GDP growth. Given the envisaged buildup of net foreign assets and public sector borrowing, this would allow for an 10.6 percent growth in private sector credit.

15.  The government remains committed to deepen the market-based exchange rate system. The SBP will phase out any intervention other than purchases required to meet the NIR target and for smoothing the impact of bulky transactions in the thin interbank market. As the official reserves position becomes more comfortable, we will phase out purchases in the kerb market and relax nostro limits on banks' balances held abroad on account of trading activities. The government reiterates its firm commitment to not delay approval of payments and transfers or hinder the flow of funds for current account transactions. The government will also ensure that no multiple currency practice will emerge and that Pakistan will comply with its obligations under Article VIII of the Articles of Agreement.

III.  Structural Reforms

16.  The government is committed to implementing an ambitious structural reform agenda as a crucial part of its strategy to revive the economy and to address the many distortions and governance problems that have impeded higher sustainable growth and contributed to widespread poverty.

A.  Tax and Subsidy Reforms

17.  The government aims to build a much more efficient tax administration and tax system that is less vulnerable to governance problems. The tax survey continues to bring additional taxpayers into the tax net. At the same time, we continue to pursue the aforementioned short-term action plan to improve tax administration, prepared with FAD technical assistance, emphasizing the audit and arrears collection process, along with a tighter penalty regime for nonfilers and late payments. We are elaborating, in close consultation with the Fund and the World Bank, a multi-year action plan for fundamental reform of the CBR, to be ready for Cabinet approval in October 2001. Key elements of the reforms will be the introduction of self-assessment for all taxes, combined with a stronger emphasis on auditing and fundamental modernization and computerization of the CBR, to reduce direct contact between tax officials and taxpayers and thereby the scope for corruption.

18.  Tax policy reforms aim to broaden the base while reducing and rationalizing rates and increasing transparency. The GST will be extended to all traders, including at the retail level (for turnover exceeding PRs 5 million) in July 2001, and to all remaining agricultural inputs (fertilizers) in September 2001. We will also seek to eliminate some other GST exemptions by July 1, 2001, but cautiously expect for 2001/02 only gains of about 0.1 percent of GDP. The GST rate for certain industrial raw material inputs will be raised to 20 percent, as an incentive for users of these inputs to register under the GST. We believe this will have a strong positive revenue impact by bringing part of the informal sector into the tax net, and the measure is strongly supported by the formal sector as helping to establish a level playing field. However, we also recognize that this measure is a deviation from the administratively simple single-rate structure that remains our objective, and will therefore review the measure after one year; in any case this measure will automatically lapse after three years. Nine minor excises will be abolished. Agricultural income has been brought into the tax net for the first time in 2000/01. Relevant legislation is in place and provincial implementing regulations will be issued in June 2001 to allow filing of returns to commence. However, administrative problems mainly relating to the lack of documentation are daunting and the measure is expected to yield only about 0.1 percent of GDP in the first year.

19.  A new income tax law will be promulgated by end-July, 2001. It aims to eliminate a host of exemptions, with specific phasing to be communicated to Fund staff in July 2001, reduce the number of rates and reduce distortions between corporate and individual income taxation, and provide for the phasing out of distortive withholding practices as the CBR administrative reforms discussed above allow the introduction of self-assessment. Specifically, individual income taxation will start above a threshold of PRs 60,000 and will feature 5 brackets (7.5, 12.5, 20, 25, 35 percent), with the same treatment for salary and non-salary income, implying an increase in the top rate by 5 percentage points. Corporate tax rates will be lowered to 50 percent for banks, and will be set at 45 percent for other privately held corporations and at 35 percent for publicly traded companies. All surcharges will be abolished. The medium-term aim will be to unify corporate rates at 35 percent. The law will phase out 5 minor withholding taxes by July 1, 2001, and another 5 a year later. Withholding on imports and on domestic contracts/sales will be phased out by July 2003 as the administrative machinery for self-assessment is being put in place. It is estimated that the reform will yield a small gain in 2001/02, but losses in subsequent years.

20.  The government is pressing ahead with trade liberalization. By July 1, 2001, the maximum tariff will be reduced to 30 percent and the number of tariff slabs will be reduced to four (5, 10, 20, and 30 percent), except for a few zero-rated items including IT imports. Discrimination in excise rates between imported and domestically produced goods will be eliminated effective July 1, 2001. Remaining regulatory duties will be allowed to lapse as soon as possible but in no case the combined duty rate (including customs duty) would exceed 30 percent after July 1, 2001. The government will phase out quantitative import restrictions/temporary high duties maintained for balance of payments reasons by end-June 2002 according to the schedule agreed with the WTO, but in advance of schedule will replace licensing requirements on wheat imports with a tariff effective with the 2001/02 budget, following the liberalization of wheat exports in May 2001.

21.  Moves towards market-based pricing in Pakistan's economy will continue with the deregulation of petroleum prices by September 2001; the gradual dismantling of the residual freight pool for petroleum products, to be completed by 2003; and six-monthly adjustments in consumer gas prices in order to move towards parity with oil prices, with the next adjustment planned for October, 2001. In the agricultural sector, the government will phase out over a two-year period the wheat subsidy accruing to millers and consumers, by selling wheat purchased under the price support program at prices that fully cover holding and other costs. This should encourage private sector entry into domestic wheat marketing and allow phasing out the government's role in wheat procurement and marketing.

B.  Public Enterprise Reform and Privatization

22.  The government is implementing an ambitious program to streamline, restructure, corporatize, and in some cases privatize public enterprises. For the three large nationalized commercial banks, a restructuring plan supported by a World Bank credit is underway, while in parallel privatization is being pursued (see below). For a number of major enterprises financial advisors are in place to prepare for privatization; as the next major step, expressions of interest will be obtained by June for United Bank Limited as well as the Pakistan Telecommunications Company Ltd.; formal offers would be sought in the fall and privatization completed by December 2001. A market-friendly regulatory framework encouraging competition in the telecom and energy sector will be fully put in place over the coming months, which should facilitate privatization in these sectors.

23.  The financial difficulties of WAPDA and KESC are being addressed in close consultation with, and support from, the World Bank and AsDB. The federal government will continue to ensure that an agreed few key federal and provincial priority connections remain current on their electricity bills, including if needed through deduction at source from the provincial share in tax revenues; for all other agencies, WAPDA and KESC will apply normal commercial practice of switching off supply if bills are not settled. WAPDA will adjust electricity and water rates in the coming months, allowing, inter alia, to initiate the phasing out of the GST subsidy on electricity. Together with a streamlining of its expenditure, corporatization, and unbundling of local distribution companies, this should allow WAPDA to remain current in its debt service payments and obligations towards the independent power producers (IPPs) and other suppliers. However, the government will keep WAPDA's situation under close review, as its financial position remains vulnerable to furnace fuel price increases on international markets and shortfalls in rain that would force WAPDA to substitute expensive thermal power production for hydro-power. The financial situation of KESC remains of even greater concern. A financial and technical restructuring operation supported by the AsDB aims to turn around KESC's financial position and prepare it for privatization by mid-2002. While KESC will need substantial exceptional financing for its projected cash shortfalls, net borrowing from the banking system by the seven major public enterprises for FY 2001/02 will be limited to PRs 12 billion.

C.  Financial Sector Reforms

24.  The government remains committed to establishing a market-based financial system. Beginning July 1, 2001 interest on all NSS instruments will be linked to comparable market rates at or below par; defense certificates are already closely linked to returns to benchmark bonds of similar maturities. The tax-exempt status for new NSS instruments will be removed. All subsidies under the existing export finance scheme (EFS) will be eliminated by mid-2001, by raising the EFS interest rate to the 6-month T-bill rate + 1.5 percent. A new fully market based export finance window is being developed with support from the AsDB to enhance export credit access for small- and medium-sized enterprises. Regarding the move to Islamic Finance, a petition filed by a bank is currently before the Supreme Court. Once the issue is clarified we will prepare a clear strategy for transition to an Islamic financial system that will not endanger financial stability and efficiency, the conduct of monetary policy, and the domestic financing of the budget. Under any circumstances, all foreign and existing domestic debt and loan contracts will be honored.

25.  To strengthen the financial soundness of the banking system, the government is strengthening prudential regulations. A doubling of minimum capital requirements is being phased in; and effective July 1, 2001 all banks have to be rated by local rating agencies and the ratings published. The SBP has classified external auditors by quality and will prescribe minimum quality of external audits for banks. The SBP has also initiated the liquidation of most public development finance institutions, starting with the biggest (NDFC), and is working to rationalize the nonbank financial sector. To further strengthen the profitability of the nationalized banks, and prepare for their privatization, the closure of nonprofitable branches in the rural areas and strong efforts to recover nonperforming loans are underway, while World Bank support is being sought for financing a major staff shedding. An FSAP mission during July/August 2001 will assist us in assessing the weaknesses in the banking sector and in formulating a comprehensive strategy to develop a financial sector that is viable and contributes to higher investment and growth, as part of Pakistan's Poverty Reduction Strategy (PRS). In this context we also will seek advise on implementing best international practices to combat money laundering.

D.  Transparency, Governance, and Public Sector Financial Management and Accountability

26.  The government remains committed to a wide-ranging agenda of reforms aimed at enhancing governance and transparency with respect to economic and financial developments and policy intentions. The government has been holding in recent months broad consultations with NGOs, donors, and other elements of civil society on the report on the government's debt strategy as well as on a first blueprint of an interim poverty reduction strategy paper. The 2001/02 budget will be prepared in the context of a medium-term strategy centered on reducing public debt, and the budget document will include for the first time a report on public contingent liabilities and the schedule of tax expenditure.

27.  Other steps to improve public sector financial accountability include the recent promulgation of legislation separating the government audit and accounting functions into two separate departments. Accounting and audit functions are being strengthened under a World Bank project (PIFRA), including through computerization and better human resource management. A recently promulgated new accounting model (NAM) broadly consistent with GFS methodology will be gradually implemented over the next two years, consistent with the devolution process, in the context of a major computerization drive and with technical and financial assistance from the World Bank. Public access to the deliberations of the ad-hoc Federal Public Accounts Committee will be provided. The quarterly report of the fiscal monitoring committee and fiscal data for the first three-quarters of fiscal year 2000/01 has been published on May 31, 2001. The government will further speed up the process of reconciliation of provincial fiscal data, especially against the background of the forthcoming devolution of many fiscal tasks to the newly created district administrations. At the provincial level, quarterly detailed expenditure accounts will be prepared with a lag of at most two months starting next fiscal year. In addition, we will set up by September 2001 a system for the tracking of poverty-related expenditures at federal, provincial, and district levels.

28.  A key element of the government's strategy to strengthen the efficiency of public expenditure is the devolution of the delivery of relevant government services to local government starting in August 2001. To ensure fiscal control and accountability, the fiscal transfer systems and financial accountability mechanisms will be devolved gradually over 3 years; salaries, recruitment, and spending on certain development projects will remain largely under provincial control throughout the transition. Particular emphasis will be given to ensuring that transfers for health and education reflect needs at the district levels, are well coordinated with donor programs, and that strong incentives for good performance on agreed outcome indicators are in place from July 1, 2001. Responsibility for accounting and auditing will remain for the time being with the established structures reporting to provincial/federal rather than local government.

29.  An important element of the drive towards better governance is a comprehensive civil service reform. We strongly believe that insufficient training, wages far below market especially for the most qualified civil servants, and non-transparent recruitment and promotion practices go a long way to explain persistent governance problems and administrative lethargy. These issues need to be addressed as implementing the reform agenda will require a highly motivated and efficient civil service. Accordingly, competitive and transparent recruitment procedures have been introduced at both the federal and provincial level and the federal public service commission has been made more independent; no federal recruitment can take place without its approval, except for well-specified exemptions for temporary appointments. Teachers are now recruited only on two-year contracts with renewal dependent on performance as assessed by the local authorities to which teachers are assigned; similar rules apply for certain other categories of employees. The forthcoming budget will include a sizable increase in resources for the training of civil servants. The Cabinet has recently approved a right-and downsizing plan for federal ministries, which will reduce the number of federal civil positions by about 40,000 (11 percent of the total). Redundant staff will be placed in surplus pools (but remain on payroll) and may apply to relevant vacancies as they come up; the government will also seek donor support for financing separation packages for the surplus staff. Similar plans are being prepared at the provincial levels. These federal and provincial plans are expected to lead to an annual reduction of about 2 percent in the number of paid civil servants over the next three years. Finally, the pay and pension commission has prepared a report documenting the erosion of real wages and the growing divergence of public service salaries and private sector pay. As a first step, the 2001/02 budget includes an average wage increase of about 15 percent, to be implemented in mid-fiscal year, with some differentiation between grades to address wage compression. The increase will only be granted to workers accepting concomitantly a revision in their pension rights, notably a reduced commutation option and pensions based on 60 percent of the last wage (rather than 70 percent under the current system). This will also apply to the military. In collaboration with the World Bank we will over the coming months undertake a further in-depth evaluation of the pay and pension system, including additional actuarial analysis and on this basis as needed amend the package and, in any case formulate a strategy for long-term pension reform.

30.  The government will complete implementation of the recommendations arising out of the Fund's recent assessment of the SBP's financial safeguards in the coming months. By mid-2001 the SBP will prepare an IAS-compliant reporting format and comparable IAS financial statements for the previous years ended June 30, 2000, and will complete an independent review of SBP's internal audit function. By mid-September 2001, the SBP will publish audited IAS financial statements for the year ended June 30, 2001 and the external auditors will, as part of the annual audit, prepare a separate report on net foreign assets reported to the IMF. To strengthen the safeguarding of reserves, the SBP will reduce its term deposits with Pakistani banks abroad to a maximum of US$200 million by end-June 2001, to US$100 million by end-September and eliminate such deposits by end-2001. Current account deposits will be capped at US$120 million throughout the period. Finally, before end-August 2001 the government will prepare draft revisions to the SBP Act and issue resolutions to the Monetary and Fiscal Policy Coordination Board to: (a) ensure that the Governor and other SBP board members can be removed only by legal cause; and (b) guarantee autonomy of the SBP in respect of reserves management.

IV.  External Financing Issues

31.  External financing needs for 2001/02 and onwards remain large. Continuing support from multilateral and bilateral creditors and private sector will be essential, preferably on concessional terms. For 2001/02, the financing gap is projected at about US$ 3.4 billion. On the basis of the current IFI pipeline and debt relief agreed so far, the gap would be fully covered until end-September. For the balance of the fiscal year, part of the gap could be covered by US$1.2 billion from prospective World Bank and AsDB program loans (World Bank: US$100 million for drought-related emergency assistance, US$200 million for the Banking Sector Reform project, and US$350 million for the SAC II or a PRSC; AsDB: US$175 million for the Agricultural Program, US$50 million for TEPI, US$75 million for the Energy Sector Restructuring Program, US$80 million for the Legal Reform Program, US$20 million for Microfinance Credit Program, US$60 million for the SMETEF, and US$100 million for drought-related emergency assistance). To cover the remaining gap, we will seek further rescheduling from Paris Club and other bilateral creditors, and will also seek strong private sector involvement, mostly through the refinancing of the outstanding special bonds denominated in U.S. dollar issued in the past against frozen currency deposits.

V.  Program Monitoring

32.  The government is aware that purchases under the Stand-By Arrangement remain contingent on the observance of quantitative and structural performance criteria and the completion of reviews. The last review under the SBA will focus on financial sector reform.

33.  For purposes of monitoring the remainder of the program, performance criteria, indicative targets and structural benchmarks remain as agreed during the first review (Tables 1 and 2). The government has implemented or will implement a number of measures as prior actions for the Board completion of the second review under the arrangement (Table 3). Definitions of each of the monitoring variables and, where necessary, of the structural performance criteria and benchmarks, together with reporting requirements and monitoring mechanisms remain as detailed in the Technical Memorandum of Understanding attached to the February 2001 MEFP. The last purchase under the Stand-By Arrangement shall be subject to a review to be completed by September 2001. Indicative quantitative targets agreed for the second half of calendar year 2001 and relevant definitions and reporting requirements are outlined in the attached supplementary Technical Memorandum of Understanding.

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Supplementary Technical Memorandum of Understanding on the Program Supported by the Stand-By Arrangement

(June 2001)

1.  This memorandum supplements the Technical Memorandum of Understandings (TMU) between the Pakistan authorities and the Fund staff relating to the monitoring of the program for 2000/01 supported by the Stand-By Arrangement, dated March 2001. It specifies indicative quantitative and structural reform targets for end-September 2001 and end-December 2001 that will be reviewed and firmed up in the context of a successor arrangement expected to become operative in late 2001, as indicated in the Supplement to the MEFP (SMEFP), dated June __ 2001. The content and frequency of the data to be provided for monitoring these indicative targets remain the same as in the above-mentioned TMU; the relevant financial variables are defined in the Annex to the TMU, except for revisions in definitions described in section V.

I.  Quantitative Indicative Targets

2.  The quarterly indicative targets will consist of ceilings or floors on the following variables:

3.  The floors and the ceilings applicable to the preceding variables will be monitored on the basis of the magnitudes specified in the attached Table.

II.  Adjustors

4.  The floors on the net foreign assets of the SBP will be adjusted upward by the excess in program financing (as defined in Section V), and downward by the cumulative shortfall in program financing, capped however at US$100 million as of end-September 2001 and US$100 million as of end-December 2001. The floors will also be adjusted upward/downward for the excess/shortfall in foreign currency deposits with the SBP (including the reserve requirements) above their projected end-June 2001 level of US$410 million.

5.  The ceilings on the net domestic assets of the SBP and on net bank borrowing by the government will be adjusted downward by the excess in program financing (as defined in Section V), and upward by the cumulative shortfall in program financing, capped however at US$100 million as of end-September 2001 and US$100 million as of end-December 2001 evaluated at the program exchange rate.

6.  The ceilings on the net domestic assets of the SBP will also be adjusted downward/upward by the amount of banks' reserves freed/seized by any reduction/increase of the daily CRR of 4 percent, and by the amount of any reduction/increase in the deposit base with respect to the programmed level of PRs 980 billion at end-September 2001 and PRs 1030 billion at end-December 2001 that is related to changes in deposits subject to CRR. Changes in required reserve regulations will modify the NDA ceiling of the SBP according to the formula: deltaNDA = deltarB0 + r0deltaB + deltardeltaB, where r0 denotes the daily reserve requirement ratio prior to any change; B0 denotes the programmed level of the reservable money supply in the period prior to any change; deltar is the change in the reserve requirement ratio; and deltaB denotes the change in the reservable deposits with respect to the programmed level as a result of changes in definition of reservable money supply (deposits).

7.  The ceilings on banking sector's credit to the seven major public enterprises for end-September 2001, and end-December 2001 will be adjusted downward (upward) by the amount by which the actual AsDB loans onlent to KESC and WAPDA from the budget exceed (fall short) of the programmed amount (PRs 3 billion for KESC in the first quarter of 2001/02 and PRs 4.5 billion for WAPDA the second quarter of 2001/02).

III.  Indicative Targets for Structural Reforms

8.  The implementation of the following measures will be used to assess progress under the structural reform program of the authorities during October-December 2001:

IV.  Revised Definitions of Monitoring Variables

9.  Starting July 1, 2001, the definitions of monitoring variables are changed as follows:

Table 1. Pakistan: Quantitative Indicative Targets, September–December 20011
(Cumulative flows from July 1, 2001 unless otherwise specified)

June 2001
  Indicative Targets

Net foreign assets of the SBP (in millions of U.S. dollars) -574.3     39.0 211.0
  (In billions of Pakistan rupees)
Net domestic assets of the SBP 581.8     -2.9 16.4
Overall budget deficit -183.2 2   -57.5 -90.9
   Of which: net bank borrowing 531.4     8.3 29.4
CBR revenue 406.5 2   91.8 207.6
Credit to the seven major public enterprises 52.0     -5.0 -10.0
Accumulation of budgetary arrears to WAPDA . . .     0.0 0.0
Social and poverty-related spending 97.5 2   21.9 49.2
  (In millions of U.S. dollars)
Contracting of short-term public and publicly
   guaranteed external debt
      900 900
Contracting of nonconcessional medium- and long-term
      public and publicly guaranteed external debt
      500 1,000
   Of which: External debt with an initial maturity
      of over one year and up to five years
      250 250
Accumulation of external payments arrears (continuous
   performance criterion during the program period)
0     0 0
SBP's forex reserves held with foreign branches
      of domestic banks
320     -100 -200
   Of which: other than current account 200     -100 -200
Contracting of foreign currency swap and forward sales 0     0 0
Memorandum items:          
Net program financing3       -228 -457
Foreign currency deposits with the SBP
   (incl. reserve requirements)
410     0 0
Daily cash reserve requirement ratio
   (in percentage points)
4.0     4.0 4.0

Sources: Quarterly macroeconomic projections agreed between the Pakistan authorities and the Fund staff.
1As defined in the Technical Memorandum of Understanding dated March 2001, unless otherwise specified.
2Projected flow for 2000/01.
3See definition in section V.