THE STATE OF PAKISTAN’S ECONOMY

THE STATE OF PAKISTAN’S ECONOMY
First Quarterly Report for FY09
1.1 Economic Outlook
The sense of crisis gripping Pakistan’s economy in the initial months of FY09 has
visibly eased by November 2008, as the government moved to address the most
immediate risks, and entered into a macroeconomic stabilization program to
support medium-term reforms under the aegis of the IMF. The disbursement of
the first tranche of US$ 3.0 billion by end-November 2008 under the program
meant that any immediate risk of default on external obligations receded, with a
substantial improvement in foreign exchange reserve adequacy indicators. Also,
exports growth has strengthened and imports growth moderated somewhat (see
Table 1.1). This lent strength to the rupee, reducing the impact of an important
generator of inflationary pressures.
The gain on the external account was helped by a sharp decline in international
commodity prices that is expected to substantially lower the country’s import bill,
offering the possibility of a decline in the country’s very large current account
deficit, and lower inflation. This supply-side improvement has been reinforced by
the reasonably good performance of crops during kharif FY09 cropping season.
These factors appear to have already halted the persistent uptrend in inflationary
pressures in the economy. Together, they could also help support a very modest
improvement in the growth outlook for FY09.
There is also substantial progress on containing fiscal imbalances, with the
government moving bravely to reduce subsidies, contain growth in other spending
and increase revenues. The result has been an encouraging improvement in some
fiscal indicators, including a sharp fall in the fiscal deficit from 1.5 percent of
GDP during Q1-FY08 to 1 percent of GDP in Q1-FY09. This figure appears
consistent with the annual target embedded in the macroeconomic stabilization
program framework.
Notwithstanding the relative positives, there is no room for complacency. While
many of the country’s macroeconomic indicators may no longer be worsening, the
imbalances are nonetheless still quite large. Resolving them will require
disciplined efforts over an extended timeframe. This challenge is all the greater
because of the difficult international economic environment, which has restricted
the country’s ability to tap international capital markets and carries risks for other
external receipts (exports, remittances, FDI, etc.).
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2
Containing and bringing down
the persistent high inflation in
the economy will not be easy.
The November 2008 CPI
inflation of 24.7 percent YoY
is only a little lower than the
record high of 25.3 percent
seen in August 2008, and both
core inflation measures persist
at, or close to, their record
highs. This persistence, and
the evidence of excess
domestic demand, reflected in
high government borrowings
from the central bank and
widening current account
deficit, underpinned the central
bank’s decision to further
tighten monetary policy in
November 2008 by raising the
policy rate by 200 basis points.
It is also important to note that domestic commodity prices did not decline in
tandem with the sharp fall in international prices. A part of this apparent
disconnect is explained by the significant depreciation of the Pakistani rupee1
since June, which offset some gains from the large decline in international prices.
The downward stickiness of prices probably also owes to market structure and
other issues, which may be amenable to administrative and policy interventions by
the government. Transportation costs, which have substantial impacts on prices
of other products and that had been increased disproportionately more when fuel
prices rose, provide a case in point; transport fares of the railways, airlines,
commercial vehicles, most inter-city bus services, etc. were either not adjusted
downwards or saw small changes, after the decline in domestic fuel prices.
Anecdotal evidence suggests that this also holds true for trucking costs in many
regions of the country.
Government interventions however must tread a fine line, encouraging market
driven solutions while avoiding degeneration into price setting or the provision of
subsidies. In particular, broad price subsidies often prove wasteful, and in any
1 Pak rupee depreciated by 13.4 percent during Jul-Dec 22, 2008.
Table 1.1: Selected Economic Indicators
FY07 FY08 FY09
Growth rate (percent)
LSM Jul-Sep 11.3 7.3 -6.2
Exports (fob) Jul-Nov 4.5 6.5 12.7
Imports (cif) Jul-Nov 10.3 18.4 16.5
Tax revenue (FBR) Jul-Nov 19.1 14.8 24.4
CPI (12 month MA) Nov 7.9 7.6 19.1
Private sector credit Jul-Nov 7.0 5.4 5.1
Money supply (M2) Jul-Nov 3.9 4.0 -0.2
billion US dollars
Total liquid reserves1 end-Nov 12.3 15.7 9.1
Home remittances Jul-Nov 2.1 2.6 3.0
Net foreign investment Jul-Nov 2.0 1.8 1.4
percent of GDP2
Fiscal deficit Jul-Sep 1.0 1.6 1.0
Trade deficit Jul-Nov 3.1 4.6 4.9
Current a/c deficit Jul-Nov 2.8 2.8 3.9
1. With SBP & commercial banks.
2. Based on full-year GDP in the denominator. For FY09
estimated full-year GDP has been used.
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3
case, entail fiscal costs which the budget can ill afford. A key test could come
with the wheat harvest. The generous support price offered earlier may not be
sustainable as international prices have collapsed. Extensive government
purchases to support prices at this level would entail fiscal costs, lead to wastage
(as millers would prefer lower, market-driven, prices) and potentially, raise
imports.
The data available so far shows that the government has made a fine start to
containing the fiscal deficit. However, the fiscal improvement in Q1-FY09
appears largely based on reduction of oil subsidies and a cut in development
spending. This is understandable since (1) any meaningful effort to expand
revenues (particularly by broadening the tax base) will only work in an extended
time frame, and (2) given fiscal rigidities in current expenditures (especially
interest payments) the gains will not be available in the short term. In the medium
term, such measures must be supplemented by policies to discipline growth in
non-development expenditures and broaden the revenue base. This will provide
the necessary fiscal space to ensure appropriate levels of public spending on social
and infrastructure projects in the future.
A change in mind-set is also required in fiscal planning. Expenditure growth must
be kept consistent with a realistic assessment of revenues, and appropriate
adjustments made as the year progresses. This will ensure that the government will
not crowd-out private sector investment, as the domestic banking sector would
then have the space to meet the requirements of the private sector.
Simultaneously, it is also imperative that the temptation for government to seek
unlimited financing from the central bank be strictly restricted by law. Empirical
international studies, and evidences from recent history in Pakistan, clearly
demonstrate the dangers to macroeconomic stability resulting from heavy recourse
to inflationary borrowings by governments from the central bank.
Acknowledging this, the government had already committed to zero additional
budgetary borrowings from the central bank, and this has now been incorporated
into the IMF supported macroeconomic stabilization program. The resulting
elimination of the fiscal demand stimulus, a contractionary monetary policy, and
declining international commodity prices will hopefully also shrink the large
current account deficit.
Provisional data indicates that the growth of the current account deficit may have
halted in November 2008. If as expected, a declining trend takes hold in
succeeding months, this will significantly boost prospects for regaining
macroeconomic stability. It must be kept in mind that the slide of the rupee value
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4
during Jul-Nov FY09 was mainly a function of continued deterioration in external
balances, which resulted in depletion of forex reserves and also generated liquidity
problems for the domestic financial markets.
This weakness of the rupee also contributed to the decline in investment inflows,
and capital flight by investors. However, a crackdown on illegal forex transfers,
and the near simultaneous entry into a stabilization program with the IMF, has
helped the rupee recoup some of its earlier losses. A further boost to confidence in
the local currency came from signs of slowing import growth.
The weakening in import growth is attributed to both, the substantial downtrend in
international commodity prices as well as a relative ease in domestic demand.2
However, lower commodity prices could also hit export prospects. The sharp fall
in international rice prices means that in H2-FY09 it is likely that export quantum
will grow but values may decline, relative to H2-FY08. The improvements in
external sector are expected to be more visible during H2-FY09 and coupled with
fiscal prudence could potentially have impacts on monetary policy.
First, an improvement in external accounts would enhance credibility and
minimize the speculation of crisis, which would help SBP to manage liquidity in
the banking system. Second, government’s commitment not to resort to
borrowings from the central bank would make it easier for the SBP to focus on
eliminating earlier overhang created by monetization of the fiscal deficit. Third,
absence of government borrowings from the central bank would help improve
monetary policy transmission mechanism through reflecting true cost of funds in
the money market. Finally, a relative contraction in fiscal deficit would help
contain aggregate demand pressures, which would supplement monetary policy.
The stabilization efforts were underway even before the initiation of IMF program
as government passed through the impact of higher international oil prices to
domestic prices of key fuels Q4-FY08 onwards; fiscal consolidation during the
first quarter of FY09 and monetary tightening by the central bank in May and July
2008 are examples of these efforts. In particular, the fiscal consolidation program
of the government for FY09 consists of (1) substantial reduction in overall budget
deficit, as a percent of GDP, through a mix of cut in expenditures (as a share of
GDP) and a rise in tax revenues (as a share of GDP), and (2) a gradual elimination
of government budgetary borrowings from SBP.
2 For example, import quantum of crude oil, palm oil, soybean oil, fertilizers, iron & steel, rubber
tyres and tubes declined during Jul-Nov FY09.
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Despite these efforts, temporary liquidity shortages with the commercial banks
were viewed as signs of financial crisis in the country. This led to a fresh round of
speculative attack on domestic currency. Unfortunately, these developments
coincided with the global financial and liquidity crises, thus it was perceived that
the domestic crisis was also triggered due to the same reasons as faced by western
financial institutions. The central bank assessed the situation and took important
measures to ease liquidity in the financial system and stabilize the domestic
currency.