PAKISTAN Economic Update 2

BACKGROUND

1. In November 2008, to avoid a default on foreign debt payments, the authorities developed a homegrown

stabilization program, which was supported by the IMF through a Stand-By Arrangement (SBA).

In 2007/08, the sharp rise in international oil and food (specifically wheat) prices, in combination with

policy inaction and internal political turmoil, had led to rapidly expanding macroeconomic imbalances in

Pakistan. In the absence of adequate remedial policy measures to address the imbalances—in particular

not passing on the international price increases to domestic consumers, but covering prices increases

through rising subsidies—the economy slid to a balance of payments crisis. By mid-October 2008 the

foreign exchange reserves of the State Bank of Pakistan (SBP) had dropped to about three weeks of

imports (US$3.3 billion), nominal exchange rate had significantly depreciated, monetization of

government debt was in full swing and led to a rapid rise in inflation, and the EMBI Global Bond spread

of Pakistani sovereign bonds had climbed to above 2,000 bp. In response, the stabilization program

envisaged fiscal and monetary tightening to bring down inflation and reduce the external current account

deficit to sustainable levels.

2. The volatile political and security environment has complicated policy-making and made the

implementation of the stabilization program challenging since its launch. Political tensions between the

two leading parties PPP and PML-N intensified in the second half of 2008/09 and culminated in the “long

march of lawyers” in March 2009. Since then political volatility has somewhat subsided. Terrorist

attacks have, however, continued. The attack on the Sri Lankan cricket team and bombing of a five star

hotel in Peshawar were among them. Furthermore, Pakistan engaged in a full-fledged war with militants

in the Federally Administered Tribal Areas (FATA) and portions of the Northwest Frontier Province

(NWFP) in May 2009, as an agreement to allow Sharia law (Nizam-e-Adal regulation) in Swat in April

2009 quickly fell apart. Full scale military operations have led to about 2.7 million internally displaced

persons (IDPs). Taking care of IDPs as well as reconstructing the conflict-damaged areas will be a

challenge moving forward, and adding to the fiscal burden.

3. Frequent changes in the country’s economic management have also continued, adding instability to

policy-making. While the Finance Minister has remained unchanged since November 2008, a new

Governor took over SBP in early 2009, the Finance Secretary was replaced in March 2009, and the

Chairman of the Bureau of Revenue of Revenue (FBR) in May 2009.