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Asian Development Outlook 2002 : II. Economic Trends and Prospects in Developing Asia : South Asia

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Pakistan

Economic growth slowed in 2001. A severe drought caused the agriculture sector to contract, though the rest of the economy registered strong expansion. The outlook for the medium term is for continued low growth, because of drought-induced weak agricultural performance and because industry will remain affected by weak external demand in a context of a slow improvement in the world economy and continued economic and political uncertainty.

Macroeconomic Assessment

Economic growth in 2001 is estimated to have fallen to 2.6% from 3.9% in the previous year. This was primarily due to a drought-induced contraction in the agriculture sector, which posted a decline of 2.5% compared with growth of 6.1% in 2000. The output of major crops fell by 10.5%, the most significant drop since 1993. The drought also had adverse impacts on hydropower generation, while value added in the power and gas distribution sector declined by 3.1%. Overall, non-agriculture GDP growth improved slightly to 4.3% in 2001 from 3.1% in the previous year. The drought is estimated to have caused a loss of about 2% in national income.

The large-scale manufacturing sector grew by an impressive 7.8% in 2001, as against a 0.2% decline in 2000, because of strong external demand, in part arising from exchange rate depreciation. This was the highest rate of expansion since the 1980s, and was significantly higher than the annual sector average of 4% posted in the 1990s. The performance of all major industry groups was good in 2001, but some of the better growth rates were recorded in paper and board (24.9%), automobiles (23.3%), and petroleum (16.6%). Growth in the services sector declined marginally in 2001, to 4.4% from 4.8% in 2000. The decrease was due mainly to a slowdown in the finance and insurance subsector, as well as to a reduction in the growth rate of the public administration and defense subsector from 7% to 3% over the period.

Despite a moderate rise in public investment, total investment fell to 14.7% of GDP in 2001 from 15.6% in 2000, because of a fall in private investment. This can be attributed to a range of factors, including the short-term impact of an anticorruption campaign and changes in the foreign exchange regime that eliminated subsidies, and the persistence of excess capacity in key industries, such as cement, sugar, and power, which served to retard private investment in the industry sector.

National savings slipped from 13.5% of GDP in 2000 to 12.8% in 2001. Public savings showed exceptionally high growth, and their ratio to GDP increased to 1.2% in 2001, up from 0.3% in 2000. This improvement came about as a result of a decrease in the budget deficit and improved management of SOEs. However, private savings declined by an estimated 6.5% from the 2000 level, falling to 11.5% of GDP. The continuing low levels of private savings are the result of various factors, including a high dependency ratio, low and fluctuating growth rates of per capita income, and low investment returns. Corporate savings also moved lower in 2001, partly due to high cotton prices, which reduced profit margins in the textile sector.

The annual population growth rate in Pakistan is estimated to be 2.2%, while the labor force is estimated to be growing at 2.4% a year. The unemployment rate (among those aged 10 and above) was 7.8% in 2000—6.1% for men and 17.3% for women—but underemployment is likely to be pervasive. In general, the economy’s absorptive capacity is estimated to have declined over the last few years, given low GDP growth of an average of 3.6% during 1999–2001, and increasing capital intensity in the commodity-producing sectors. Unemployment is estimated to rise by an average of 0.5 million every year.

The fiscal deficit fell from 6.5% of GDP in 2000 to 5.3% in 2001, the lowest level in 23 years (Figure 2.19). This decrease is entirely due to the Government’s reduction in public expenditures to meet its fiscal target under an IMF standby arrangement. Public revenues edged down from 16.5% of GDP in 2000 to 15.7% in 2001 because of weak tax collections. The composition of deficit financing marked a significant shift from domestic to external sources in 2001, with the proportion of funding from external sources more than doubling to 69% of the total deficit, from 33% in 2000. This was a result of higher inflows from international financial institutions.

Despite a slight rise to 4.4% in 2001 from 3.6% in 2000, inflation remained low. Contributory factors included low growth rates of the money supply (largely due to the decline in budgetary support) and lower international commodity prices. Weighted average lending rates were 13.1% in June 2001, down from 13.5% in June 2000. Real interest rates remained high, although they declined slightly from 9.9% in 2000 to 8.7% in 2001.

At the beginning of 2001, the State Bank of Pakistan (SBP) replaced the managed float exchange rate system with a market-based, free-float system. The currency subsequently came under speculative attack on several occasions during the year, and depreciated by 18.6% against the dollar. Because of the low rate of domestic inflation, this resulted in a real depreciation of over 10% in 2001, providing a much-needed boost to exports, which were close to $9 billion for the first time. Exports expanded by 9%, with eight out of the top 10 export items recording double-digit growth rates—particularly raw cotton, leather, and synthetic textiles. The trade deficit improved, from $1.4 billion in 2000 to $1.2 billion in 2001, as did the current account deficit, from $1.1 billion to $0.5 billion over the same period. If proceeds from the Saudi Oil Facility were to be categorized as official transfers, the current account deficit would, in fact, be a surplus of $331 million.

The improvement in the current account deficit came primarily from a reduction in the trade deficit, increased workers’ remittances, and higher foreign exchange purchases by SBP on the open market, which show up in the current account under private transfers. Foreign exchange reserves rose to $3.2 billion by end-June 2001. Net public debt as a proportion of GDP increased to 95.4% in 2001. Public or publicly guaranteed external debt, valued at $32.8 billion, accounted for 58% of the total public debt and was equivalent to 55.1% of GDP. At the end of June 2001, the net present value of Pakistan’s public external debt was estimated at about 260% of the value of exports of goods and services, far in excess of the commonly accepted benchmarks for sustainability, which fall in the range of 150–200%. After the debt rescheduling granted by the Paris Club in December 2001, however, this ratio fell to below 200%.

Policy Developments

The Government’s attempts to rectify macroeconomic imbalances and stabilize the economy in 2001 were fairly successful, and the country’s macroeconomic indicators showed significant improvement. Prudent fiscal and monetary policies succeeded in reducing the budget deficit significantly and in containing inflation. However, the reduction in the deficit was achieved at the expense of development spending, which in 2001 was at its lowest level ever recorded. Given the country’s high and rising levels of poverty and its low level of human development, the Government should significantly increase development spending and focus on revenue enhancement, including reforms to improve revenue collection by broadening the tax base and strengthening tax administration. In addition, the authorities need to urgently improve the management of public sector financial resources and to stop the considerable drain of public resources to loss-incurring SOEs.

The structural changes in the exchange rate regime at the start of the year had implications for monetary policy, as SBP was forced to restrict the money supply and raise interest rates to defend the rupee against speculative attacks. SBP concentrated on reducing liquidity from the market in 2001, and replaced the system of predetermined open market operations with discretionary open market operations, depending on the prevailing conditions in the money market.

The Government continued with its structural reform agenda in 2001, including trade and tariff reforms (further reduction of the maximum tariff from 35% to 30% and of the number of tariff categories), finance sector reform (strengthening SBP and the Securities and Exchange Commission as well as deregulation of the insurance sector), and reform of public resources management (separation of government audit and accounts functions).

The response of the donor community to the country’s increased economic vulnerability since September 11th has been positive. Pakistan’s case for increased assistance was strengthened by its successful completion of a standby arrangement with IMF in September 2001. In addition, on 6 December the same year, IMF approved a

3-year arrangement for Pakistan under the Poverty Reduction and Growth Facility (PRGF), totaling about $1.32 billion.

The PRGF commits the Government to a number of performance criteria and indicative targets, including a reduction in the budget deficit to 3.2% of GDP by 2004, in addition to implementation of key sector- and governance-related reforms. The successful negotiation of the PRGF set the stage for negotiations with bilateral creditors for the long-term rescheduling of external public debt, and on 13 December, the Paris Club comprehensively restructured Pakistan’s debt. The Government estimates that the Paris Club agreement will lead to cash-flow savings of $2.7 billion during the 3-year PRGF, with further significant savings in the following decade. International sanctions against Pakistan have been largely removed or suspended, and the country has received bilateral grant pledges of $1.16 billion. In addition, the EU has pledged to ensure increased market access to Pakistan’s exporters through a combination of lower tariffs and higher quotas with a view to mitigating the fall in exports.

Outlook for 2002-2003

Large-scale manufacturing grew at a rate of 2.9% in the first 6 months of 2002, compared with growth of 2% recorded in the corresponding period of the previous year. However, it is too early to comment on how manufacturing growth in 2002 will compare with 2001 given the high variability in production of agro-based industries due to seasonal fluctuations. When the sugar industry is excluded from the analysis, for example, growth in the first 6 months of 2002 was 3.8% compared with 6.7% in the first 6 months of 2001.

In the first half of 2002, exports registered a decline of 0.5% compared with the same period in the preceding year. Imports contracted by 9.6% over the period, with the major falls seen in food items (down by 36%) and petroleum and petroleum products (down by 26.7%). The trade deficit fell by more than half to $425.4 million during July–December 2001, from $921.7 million in the corresponding period of the previous year.

The value of the rupee appreciated by about 10% in October–December 2001 as a result of the US Government’s announcement of its intention to monitor monetary transfers through informal channels, prompting a greater inflow of transfers through the banking system. This was reflected in the large increase in remittances through banks, to $982.3 million in the first half of 2001 from $609.2 million in the first half of the previous year. Foreign exchange reserves rose to $4.8 billion by end-January 2002—the highest level ever—as a consequence of the increase in remittances, higher inflows of foreign assistance, and purchases of hard currency by SBP in the interbank market to prevent the rupee from appreciating further. Revenue collections were adversely affected in the first half of 2002, mainly because of the decline in imports and slow growth in industrial production. Inflation registered 2.6% during this period compared with 4.9% in the corresponding period in 2001. This was primarily due to low food inflation and the decline in petroleum prices in the international market.

This review of the data from the first 6 months of 2002 suggests that GDP growth is likely to be only slightly higher for the whole year than it was in 2001. The short-term effects of the military action in Afghanistan on the balance of payments have been particularly adverse, as export orders were rescinded and shipping and insurance costs increased. Manufacturing has also been hit by the fall in export demand. The prevailing uncertainty led to a further deterioration in the investment climate, and effectively forestalled the proposed privatization of Pakistan Telecommunications Corporation. Growth in the agriculture sector is likely to remain slow as cotton and rice production is expected to be lower than last year due to pest attacks and an expected 51% shortfall in irrigation water. (The effects of the last 2 years’ drought are persisting in that water flows from snowmelt remained low in the winter of 2001/02, and winter rainfall was lower than expected.) The GDP growth rate in 2002 is projected to be in the range of 2.5–3%. Also, in light of the adverse expenditure and revenue impacts of the post-September 11th events, the fiscal deficit in 2002 is expected to be at least 5.3% of GDP, if not higher.

The Government has had to face a number of policy challenges in the wake of the September 11th events. At the same time, Pakistan’s support to the international community in the fight against terrorism has provided it with an immense opportunity. If the Government continues to follow sound macroeconomic policies and to implement the planned economic and governance reforms, it could fairly quickly achieve rapid and sustainable economic growth and poverty reduction. However, if increased aid flows are used to postpone the necessary reforms and macroeconomic developments, as happened in the 1980s, Pakistan will be unable to break out of the existing vicious circle of low growth and rising poverty.

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