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p. 33 of 68 BACK | NEXT I. Developing Asia and the World II. Economic Trends and Prospects in Developing Asia East Asia Southeast Asia South Asia Afghanistan Bangladesh Bhutan India Maldives Nepal Pakistan Sri Lanka Central Asia The Pacific III. Competitiveness in Developing Asia Statistical Appendix

Asian Development Outlook 2003 : II. Economic Trends and Prospects in Developing Asia : South Asia

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Pakistan

The medium-term prospects for the economy greatly improved in FY2002 as macroeconomic indicators remained stable, the external account improved, and the Government's ambitious reform program remained on track. Economic growth is thus expected to pick up significantly in the medium term, provided that the internal and external security situations do not deteriorate.

Macroeconomic Assessment

The economy experienced several external shocks in FY2002 (year ended 30 June 2002), generated by the post-September 11, 2001 conflict in the subregion, tension on the border with India, continuing drought, and slow growth in the global economy. However, due to improvement in macroeconomic fundamentals achieved through stabilization policies pursued in the preceding 2 years, closer relations with the Group of Seven leading industrial countries after the September 11 events, and some fortuitous developments such as increased remittances and larger foreign grants, the economy was in a better position to absorb the external shocks. The signing of the Poverty Reduction and Growth Facility with IMF and the rescheduling of the country's bilateral debt by the Paris Club in December 2001 further reduced the economy's vulnerability.

Overall performance improved in FY2002: the GDP growth rate is estimated at 3.6% compared with 2.5% in FY2001. With the population rising by 2.2% a year, per capita income increased by 1.4% after negligible growth in the previous year. The revival of the economy started in the second half of the fiscal year, as a number of developments boosted demand in the period. Total consumption expenditures rose by 5.0% in FY2002, compared with 1.2% in FY2001. Public expenditures increased sharply, mainly because of large salary hikes for civil servants that came into effect on 1 January 2002. They also increased because of tension on the border with India. While general government consumption registered a substantial increase of 18.2%, private consumption expenditures rose by 3.3%, partially due to aggressive marketing of consumer credit by financial institutions and to sharp increases in private inflows of funds from abroad.

The net contribution of the external sector also rose by over 30%, as exports picked up sharply in the second half of FY2002. However, investor sentiment remained weak throughout the fiscal year because of the uncertainty generated by the post-September 11 events and tensions with India.

Expenditures on domestic fixed capital formation declined by 3.1% in FY2002, compared with a 0.9% increase a year earlier. According to provisional estimates, total investment declined to 13.9% of GDP in FY2002 from 15.9% in the previous year (though these figures may not reflect additional investment in the textile sector, and may be revised by the end of FY2003.) National savings rose to 15.4% of GDP in FY2002 from 13.9% in FY2001, largely due to a significant increase in net factor incomes from abroad.

In terms of supply-side sectors, the improvement in GDP growth performance was driven mainly by agriculture, which expanded by 1.4%, despite the continuing effects of drought, after a contraction of 2.6% in FY2001. There was a marginal decline of 0.5% in the value added of major crops, but the robust growth of 3.4% in the livestock subsector served to buoy agricultural expansion (these subsectors contribute 40% and 38%, respectively, of value added in agriculture). The relatively small reduction in crop production, in spite of the increasing water shortage faced by farmers (a 60% shortfall compared with 40% in the previous year), shows that they are beginning to adapt to the effects of the drought by adopting water-saving techniques and adjusting cropping patterns. For example, during FY2002 farmers shifted area from rice, a highly water-intensive crop, to cotton, output of which increased by 1.9%, despite a decline in its yield. The sector's performance is expected to strengthen further in FY2003 because of some improvement in water availability.

Large-scale manufacturing was the subsector most affected by the aftermath of September 11, and growth declined from 8.6% in FY2001 to 4.0% in FY2002. The slowdown was fairly broad based, except for textiles and petroleum products where capacity increases boosted growth. The ongoing modernization of the textile industry, in anticipation of the elimination of the textile quota regime in 2005 under the WTO accord, enabled the industry to better face the global recession. Improved access to EU markets also provided a boost.

Overall expansion in the industry sector (including mining, manufacturing, construction, and electricity and gas distribution) declined from 3.1% in FY2001 to 2.8% in FY2002, due to deceleration of growth in manufacturing, and contraction for the second successive year in electricity and gas distribution. However, large-scale manufacturing seems to have revived somewhat in the first 6 months of FY2003. Several factors, such as higher farm incomes due to stronger prices of cotton and continued increases in remittances, are likely to boost demand further.

The services sector accelerated to 5.1% growth in FY2002 from 4.8% in FY2001. This was mainly due to a sharp increase in value added in public administration and defense services (18.2% compared with 1.2% in the previous year).

According to the most recent Labor Force Survey, the overall rate of unemployment was 7.8% in FY2000. Given past trends, and the slow growth in the last 2 years, it is estimated that unemployment is likely to have increased to about 9.0% in FY2002.

The overall fiscal deficit narrowed to 5.1% of GDP in FY2002 from 5.3% in FY2001, when one-off expenditures are excluded, but widened to 6.5% if they are counted. Such expenditures in FY2002 included Karachi Electric Supply Corporation recapitalization of PRs30 billion, and the settlement (through bond issue) of excess taxes paid by banks on unrealized profits through FY2000 of PRs22 billion. The revised target for the budget deficit for FY2002 agreed with IMF under its Poverty Reduction and Growth Facility was 5.7% of GDP, and the underlying deficit is significantly below this target. While the increase in expenditures was larger than budgeted, its composition was encouraging. For example, current expenditures rose by 6.2%, with development and poverty-related expenditures rising by 35.0% and 9.1%, respectively.

Total revenues increased by 15.0%, with most of the additional receipts coming from nontax revenues and surcharges on petroleum and gas. Tax revenue collection has picked up markedly so far in FY2003, and tax revenues are up by 15.4% in the first half of the fiscal year (July-December 2002). The overall fiscal deficit in the first quarter of FY2003 decreased to 1.0% of GDP from 1.7% in the same quarter of FY2002, and the prospects of meeting the budget target of 4.4% in FY2003 are good.

Inflation declined to 3.5% in FY2002 from 4.4% in FY2001, mainly due to a comfortable supply position of essential commodities such as wheat and sugar, lower international prices of petroleum and petroleum products in the first half of the fiscal year, lower prices of cotton, a sharp appreciation of the Pakistan rupee, and low level of economic activity in general. Given the lack of inflationary pressures in the economy, the State Bank of Pakistan (SBP) implemented an easy monetary policy to boost growth. The discount rate was lowered from 14.0% in June 2001 to 9.0% by January 2002, and further to 7.5% in November 2002. The rate of return on 6-month treasury bills also declined from 12.9% to 6.3% during the fiscal year. However, banks lowered their lending rates by a smaller amount, with the average rate declining from 14.0% in June 2001 to 12.0% in June 2002, and further to 10.6% by November 2002. Domestic banks, still struggling with low profitability and substantial NPLs, are reluctant to lower lending rates or aggressively extend new loans to businesses.

The large accumulation of foreign exchange reserves in FY2002, despite SBP's efforts at sterilization, resulted in an acceleration of broad-based money (M2) growth to 14.8% in FY2002 compared with a much smaller increase of 9.0% in FY2001. The easy monetary stance continued in the first 6 months of FY2003, with broad money supply growing by 8.7%, against the whole year target of 10.8%, although SBP continued to follow a policy of sterilization of the liquidity generated by its purchases of foreign exchange in the interbank market. Extension of credit to the private sector also increased substantially in the first half of FY2003, amounting to PRs63.0 billion by January 2003, compared with PRs32.6 billion for the corresponding period of FY2002.

Share prices maintained a rising trend through most of 2002, with the Karachi Stock Exchange (KSE)-100 index increasing to over 2,500 in December 2002 from less than 1,400 in January that year. A continued increase in remittances, appreciation of the Pakistan rupee, low deposit rates, and absence of investment opportunities in real sectors raised the demand for equities. The corporate debt market also expanded in FY2002, and over PRs10 billion of term finance certificates were issued, compared with PRs6.5 billion in FY2001. The trend was sustained to FY2003, with over PRs4.5 billion of such certificates being issued in the first quarter.

Pakistan's balance of payments improved significantly during FY2002 due to a sharp increase in remittances from workers abroad, larger inflows of foreign loans and grants, and receipts for the use of civil aviation facilities by the international coalition forces. The balance-of-payments data showed a large surplus of $2.7 billion on the current account compared with a marginal surplus of $0.3 billion recorded in the previous year. The trade deficit narrowed to $360 million from $1.3 billion in FY2001, due to a decline in imports. Net current transfers increased to $5.7 billion (from $4.7 billion in FY2001) mainly due to the steep rise in worker remittances and official transfers in the post-September 11 period. The capital account balance, however, worsened in FY2002, primarily because of SBP's deliberate policy to pay off expensive debt and short-term liabilities.

The sharp improvement in the balance of payments observed in the last three quarters of FY2002 also continued in the first quarter of FY2003, with the current account remaining in surplus by $1.2 billion, in contrast to a deficit recorded in the corresponding quarter of FY2002. Pakistan's external debt stock and liabilities also declined in FY2002 as SBP retired its expensive, short-term liabilities, from $37.1 billion at the end of FY2001 to $36.5 billion at the end of FY2002. Foreign exchange reserves held by SBP closed at $4.3 billion at the end of the fiscal year, and subsequently rose to $7.6 billion by December 2002.

Policy Developments

The Government's fiscal policy agenda for the medium term has been effectively articulated in the federal budget for FY2003. The vision of the tax policy is based on four principles: (i) simplification of the tax regime by gradually eliminating withholding taxes, withdrawing exemptions, and reducing the number of statutory regulatory orders; (ii) reform of income tax; (iii) expansion of the general sales tax base; and (iv) continuation of trade reform through tariff reduction. Some of the key reforms announced in the budget included the initiation of a universal self-assessment scheme for income tax, the progressive reduction of the tax rate for banks and private companies over the next 5 years to 35% (the existing rate for public companies other than banks), and the continued progressive elimination of withholding taxes. In general, the taxation structure has changed significantly over the last 5 years, with a clear shift from trade taxes to taxes on domestic production and income. Among domestic taxes, a VAT-type sales tax has emerged as the largest revenue generator (Figure 2.17).

Since the announcement of the budget, the process of Central Board of Revenue (CBR) reforms has gathered momentum and various initiatives for structural reform in tax administration have been undertaken. These include setting up a Large Taxpayers Unit and a Model Income Tax Unit in Karachi and Lahore, respectively, where tax administration is organized along functional lines, thereby breaking with traditional practice. In addition, the CBR has initiated a Sales Tax Automated Refund Repository facility both to expedite the process of verification of invoices submitted with sales tax refund claims and to reduce the chances of spurious refunds. Other reforms include the Customs Administration Reform Plan, which envisages computerization of all customs refund applications, and a new recruitment and promotion policy. These measures aim at improving services for taxpayers through reorganization of the CBR along functional lines and automation of processing of tax returns and applications for tax refunds, as well as improving the skills-mix incentives of CBR staff through merit-based recruitment and training, and market-based salaries.

The Government has drafted a Fiscal Responsibility and Debt Limitation Ordinance. This requires it to eliminate the revenue deficit by 30 June 2007; reduce the outstanding public debt to 60% of GDP by 30 June 2012; reduce the outstanding public debt by 2.5% of GDP in every year, while ensuring that social- and poverty-related expenditures do not fall below 4% of GDP; and not to issue guarantees for any amount exceeding 2% of GDP. The bill is to be presented in Parliament for debate later in the year.

In September 2002, the federal cabinet approved an order granting full autonomy to SBP in the formulation of monetary, credit, and exchange rate policies as well as in the management of foreign exchange reserves. This should reduce policy uncertainty and encourage private sector development. Monetary policy is constrained by the conflicting demands of containing inflation and promoting economic growth. Given the relatively benign inflationary environment in 2002, SBP gradually eased monetary policy. It also removed restrictions on nationalized commercial banks for consumer financing, to boost economic growth.

The other policy issue faced by SBP in 2002 was that the large current account inflows into Pakistan were exerting upward pressure on the local currency. Given the uncertainty associated with these flows, and to protect exporters from large changes in the exchange rate, SBP has followed a policy of allowing only a gradual appreciation of the Pakistan rupee, by reducing excess liquidity in the interbank foreign exchange market. However, to prevent the buildup of foreign exchange reserves from expanding liquidity, SBP at the same time followed a policy of sterilization through treasury-bill auctions used to retire SBP holdings of government paper. However, the policy had substantial costs, as the domestic treasury-bill rate was significantly higher than that available to SBP on its foreign currency placements.

The Government has undertaken a series of banking sector reforms over the past year, with a strong emphasis on improving corporate governance through implementation of directives to regulate appointments of board members and chief executive officers of commercial banks, as well as more stringent review of audit procedures. In addition, minimum paid-up capital requirements of banks have been raised from PRs500 million to PRs1 billion, and banks have been authorized to issue term finance certificates as subordinated debt to raise their capital. SBP is also working with the Corporate Industrial Restructuring Corporation and the Committee on the Revival of Sick Units to effect financial restructuring of banks and reduce the proportion of NPLs in bank portfolios.

The Securities and Exchange Commission of Pakistan continued with reform of the stock markets. This included reconstitution of the boards of directors to include directors nominated by the Commission (a move toward demutualization of the stock exchanges with a view to preventing conflicts of interest on the part of individual members), prescription of an adequate capital base for each brokerage house, permission for futures trading in selected shares, and the prescription of a code of corporate governance for listed companies.

The Government also continued with the process of trade and foreign exchange system reforms. The main thrust of the Government's trade policies over the past 2 years has been to reduce the anti-export bias through trade and tariff liberalization. In addition to reducing the maximum tariff rate from 30% to 25% in 2002, the number of statutory regulatory orders governing tariff exemptions was further reduced; procedural requirements for imports were simplified; and exports and imports of wheat and its milling products and petroleum products were completely liberalized, in addition to imports of textiles, mobile phones, gold, and silver. From 1 July 2002, SBP put an end to the practice of purchasing foreign exchange from the kerb market. To remove segmentation in the foreign exchange market, and to facilitate the move toward a unified exchange rate, the Government announced a plan to allow the establishment of foreign exchange companies from August 2002. Some companies have started operations.

Privatization picked up momentum in 2002, with one nationalized commercial bank, United Bank Ltd., privatized in September 2002, and 20% of the Government's stake in the National Bank of Pakistan having been divested through the stock market. A number of public sector mutual funds have also been privatized. The Government has privatized its working interests in nine petroleum concessions, and in noncore assets of the two gas transmission and distribution companies, Sui Southern Gas Company and Sui Northern Gas Pipelines Ltd. Appreciable progress has been made in the privatization of the country's largest oil company, Pakistan State Oil, and largest commercial bank, Habib Bank Ltd. The Government also set up the Oil and Gas Regulatory Authority in 2002 to encourage competition and private sector growth in the oil and gas sector.

The Government approved a new labor policy in September 2002, which is aimed at reconciling national laws governing industrial relations with international labor and trade union laws. The policy revamps and consolidates over 30 existing laws into six. Similarly, a new power generation policy was announced in October 2002, the main objective of which is to encourage the private sector to invest in hydropower and indigenous fuels-based electricity generation projects.

Outlook for 2003-2004

Prospects of realizing and possibly surpassing the government-projected growth rate of 4.5% in FY2003 are quite bright. This optimism is based on an improved outlook for the agriculture and industry sectors. Both supply and demand factors are expected to boost domestic economic activity. With regard to the former, increased availability of water should boost agriculture and hydropower generation. The textile industry is also better placed for increased production after heavy investment in the past 2 years. Demand factors include larger remittances (of $2.1 billion in the first half of FY2003, which are expected to increase to over $3.5 billion by the end of the fiscal year) and the associated increase in construction activity, as well as aggressive marketing of consumer credit by financial institutions. The growth rate is expected to improve further to 5.0% in FY2004 with acceleration in the agriculture sector, and more robust expansion in large-scale manufacturing led by the textile and consumer durables industries. The services sector is expected to maintain a growth rate of about 5.5%.

Economic uncertainty has been greatly reduced by Pakistan's improved macroeconomic fundamentals. Political uncertainty has been reduced by the smooth transfer of power to elected federal and provincial governments in October 2002 and the new Government's commitment to the reform program of the last 3 years. Total investment is thus expected to show marked improvement in the medium term, rising to 16.0% of GDP by FY2004.

It is anticipated that an easy monetary policy will continue through at least FY2003. The rate of inflation has shown an upturn in the first quarter of FY2003 due to an increase in prices of food items and an upward adjustment in domestic oil prices. The trend is likely to continue over the medium term, and inflation may rise to 5.0% in FY2004.

The modernization of the textile industry that has been under way for the last couple of years has started showing results in the form of a substantial increase in the industry's output and in export volumes.

Both for this reason, as well as a greater level of activity in the domestic economy and better access to EU markets, exports are likely to grow significantly in the medium term, registering increases of about 12% and 10% in FY2003 and FY2004, respectively. Exports and imports strengthened by 16.6% and 18.7%, respectively, in the first half of FY2003, compared with the corresponding period of FY2002.

Increased domestic activity, particularly higher growth in manufacturing, together with a reduction in import tariffs and a strong local currency, is likely to lead to strong growth in imports, which are likely to rise by about 14% in FY2003. The trade deficit is thus expected to almost double from FY2002 levels, to over $600 million in the medium term. The surplus on the current account, which is the result of fortuitous developments since September 11, 2001, is expected to fall to about $638 million in FY2004. Some exceptional current transfers like grants will not be available in FY2003, but remittances are likely to exceed the high level achieved in FY2002.

FDI is expected to pick up significantly in the medium term provided that the domestic political situation remains stable, and that there is no recurrence of subregional tensions. The planned major privatizations, such as that of Pakistan State Oil and Habib Bank Ltd., are likely to be major factors in increasing FDI during the next 2 years. FDI was $570 million in the first half of FY2003, and is projected to rise slightly to about $600 million by the end of the year.

The outstanding external debt stock is expected to be maintained at about $32 billion over the medium term, with further improvement in the debt profile, as expensive, short-term debt is replaced by long-term concessional borrowings. External debt servicing is therefore projected to fall to some 20% of foreign exchange earnings by FY2004.

The Government's success in maintaining macroeconomic stability over the last year—in the face of unprecedented domestic and international shocks such as the prolonged drought, internal insecurity, and tensions on both its western and eastern borders—has greatly improved the medium-term prospects for the economy. This optimism is reflected in the new Five-Year Economic Vision recently articulated by the Government, which underlines the shift in policy focus from macroeconomic stabilization to a more broad-based focus on growth and poverty reduction. If the Government continues to pursue sound macroeconomic policies and to implement the planned economic and governance reforms, it should be possible to achieve the goals in the vision statement.

Although the outlook is generally positive, the above scenario is subject to risks, such as the possibility of renewed tensions on the border with India, political uncertainties that may unfold given that coalition governments are in place in the center and two provinces, and the ambiguities surrounding the future course of the global economy. In the immediate future, Pakistan's economy faces challenges arising from the conflict in Iraq and its consequences, as well as possible social and political instability and a loss in investor confidence in the medium term.

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