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Country Strategy and Program Update 2005-2006: Pakistan

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I. Current Development Trends and Issues

A. Recent Political Developments

1. With the passing of the 17^th Constitutional Amendment by Parliament in December 2003, the prolonged standoff on the issue of the Legal Framework Order (LFO)¹ came to an end.President Pervez Musharraf won a vote of confidence on 1 January 2004 from the electoral college (comprising members of the National Assembly, Senate, and the four provincial assemblies) which confirmed him as President for a 5-year term beginning 30 April 2002. On 26 June 2004, Zafarullah Khan Jamali resigned as prime minister and Chaudhry Shujaat Hussain, the president of the Pakistan Muslim League, became the interim prime minister on 30 June 2004. Shaukat Aziz, following his election to the National Assembly, was sworn in as the new prime minister on 28 August 2004.

2. Various confidence-building measures have been announced by Pakistan and India, including a ceasefire along the Line of Control and the restoration of road, rail, and air links from January 2004. In July 2004, the foreign ministers off the two countries met in Islamabad and discussed various issues and confidence-building measures. Since then, high-level talks have taken place on a broad range of topics, including trade. The next round of meetings of the foreign ministers is scheduled to take place in New Delhi in September 2004.

B. Economic Assessment and Outlook

3. Pakistan’s economic performance continued to improve, and the macroeconomic fundamentals are better than at any time in the past decade. In FY2004, gross domestic product (GDP) grew 6.4% compared with 5.1% in FY2003 (Appendix 1, Table A1.2). A major contributor to overall economic growth was manufacturing, which grew 13.4%. The fiscal deficit fell to 3.3% of GDP in FY2004. There was robust growth in exports (10%) as well as a high level of remittances of $3.9 billion in FY2004. Imports expanded rapidly, however, and the current account surplus fell to $1.6 billion, compared to $4.1 billion in FY2003. This was the fourth consecutive year of surplus on the balance of payments, and as a result foreign exchange reserves at the State Bank of Pakistan increased to $10.6 billion (that is, more than 8 months of imports). In June 2004, the International Monetary Fund (IMF) completed its eighth review of Pakistan’s performance under the 3-year Poverty Reduction Growth Facility (PRGF) and released $253 million.

4. The medium-term prospects for Pakistan’s economy continue to improve. The finance minister in his budget speech in June 2004 set out the government’s vision for attaining 8% economic growth in the medium term. This growth target is ambitious—but not impossible—provided that risks are appropriately managed. Risks include (i) complacency in economic management because of the relatively comfortable macroeconomic situation and the ending of the PRGF in December 2004; (ii) lack of progress on second-generation reforms, particularly to tax administration and promoting the private sector; (iii) failure to address weaknesses in implementation capacity, resulting in low utilization of the Public Sector Development Program (PSDP); (iv) inefficient delivery of basic services; and (v) internal security concerns as a fall-out of the ongoing government’s actions against terrorist groups. In its dialogue with development partners, the government has committed that macroeconomic stability, along with progress on reforms, will be maintained. The government has also committed to give priority to addressing capacity and implementation issues. Both of these commitments were reiterated in the budget speech of the finance minister.

C. Implications for Country Strategy and Program

5. The country strategy and program (CSP), approved in May 2002, aims to support poverty reduction in Pakistan through specific interventions in the following three areas: (i) supporting good governance (devolution, legal, judicial, and police reforms, as well as sector- and province-based reforms); (ii) sustainable, pro-poor growth (infrastructure, rural development, and employment generation); and (iii) inclusive social development (education, health, water supply and sanitation, and social protection).

6. The Asian Development Bank's (ADB) country strategy and program needs to effectively respond to the government's increased emphasis on higher and sustained pro-poor growth. In this context, the two important operational considerations for the CSP are (i) the priority that the government accords to developing economic infrastructure as an engine for higher growth and poverty reduction in the medium-term; and (ii) the government's decision, as part of its debt management strategy, to borrow ordinary capital resources (OCR) only for priority infrastructure projects and provincial resource management programs (RMPs).²

7. ADB will support this shift in emphasis toward higher sustained growth to ensure that the benefits of the ongoing structural reforms reach the poor. This is important not only for poverty reduction, but also to ensure continuity of reform. For this purpose, ADB will redirect its OCR lending towards infrastructure projects that would have the greatest impact on growth and poverty reduction. The priority in this regard will be on rehabilitating existing infrastructure in irrigation, roads, and urban centers, as well as addressing critical gaps in the power sector. ADB will also facilitate public-private partnerships (PPPs) for infrastructure development through a combination of Asian Development Fund (ADF)/OCR loan and risk-mitigating guarantee products. ADF assistance will also be provided for agribusiness and rural development projects to alleviate poverty, generate income, and create employment.

8. The increased lending for infrastructure will not in any way dilute ADB’s strategic focus on social sectors. However, the approach will be to achieve increased allocations for social sectors as a result of policy dialogue and enhanced fiscal space through the provincial RMPs and Devolved Social Services Programs (DSSPs)³. Since the increased allocations will be part of the Government budget, this will result in sustainable increased spending in the social sectors. In Punjab, expenditure on education and health increased by about 40% and 28% respectively in the first three quarters of FY2004 compared to the same period in FY2003⁴. For Pakistan as a whole, education expenditure increased by about 30% and health expenditure by 27% during this period. Besides support for increased allocations for social sector development, ADB will continue to provide assistance for capacity building and institutional strengthening of local governments for efficient and effective delivery of social services.

9. ADB’s strategic focus on governance will continue. Under this focus—in addition to the ongoing governance reform programs including the Access to Justice Program (AJP), the Decentralization Support Program (DSP), and the Punjab Resource Management Program (PRMP)––further support would be provided on a sustained basis for second-generation reforms at the province and sector levels. Given the government’s decision to restrict OCR borrowing for policy-based operations, smaller ADF loans and technical assistance (TA) loans will be used to support policy and institutional reforms. ADB will mainstream governance as acrosscutting theme in all project interventions at the sector level. While this is already happening—most prominently in the social sectors through the provincial DSSPs—the specific governance focus on other sectors will be strengthened. At the same time, capacity enhancement and increased access to resources for local governments would be continually supported. There will be continued strong focus on gender with a focus on effective implementation of the gender reform action plans (GRAPs) prepared by the federal and provincial governments with ADB assistance.

10. To achieve greater development effectiveness and results, there will be an enhanced focus on capacity building. It will also be important to develop or update sector strategies, establish sector priorities, and prepare a prioritized pipeline of economically viable projects. To address these issues, a programmatic approach is proposed for capacity building, sector analysis, and project preparation. A TA loan has been included in the assistance pipeline to operationalize this approach in the infrastructure sector. It will have three components: water, energy, and transport and communication. Similar TA loans have been included for urban renewal and rural modernization; these areas were identified as priorities in the finance, minister’s budget speech in June 2004. The focus of the TA loan for urban renewal is on developing a strategic vision and action plans for development of megacities, and capacity building of city governments. The TA loan on rural modernization will develop a holistic and integrated vision and strategies for rural modernization and frameworks for improving rural livelihoods.

11. Given the constraints on public sector resources and capacity, the private sector needs to play an important and growing role in infrastructure development to realize Pakistan’s vision for higher growth. To support private sector development strategy in infrastructure development, ADB will provide assistance for (i) the development of a strategy to determine the role of the private sector in the financing, construction, operating and maintaining of infrastructure through the formation of PPPs; (ii) the creation of policy, regulatory and institutional frameworks to support such PPPs; and (iii) the development of pilot partnership models for specific projects. In addition, ADB would explore the use of OCR lending against GOP guarantees, risk mitigation guarantees, swaps, and other products that support availability of long-term private sector financing for infrastructure projects. Finally, under its private sector development strategy, ADB will continue to provide direct assistance to private sector entities through investments, lending, and guarantees, principally for projects in power, water, transport, and oil and gas sectors.

12. If India-Pakistan relations continue to improve, it will present a major opportunity to enhance subregional cooperation in trade, commerce, and other areas, which would contribute to higher growth rates and reduction in poverty among all member countries of the South Asian Association for Regional Cooperation (SAARC). In addition to exploring possibilities of supporting subregional cooperation in SAARC countries, ADB will continue to support several ongoing and proposed regional initiatives to strengthen Pakistan’s cooperation prospects with Afghanistan and Central Asia.

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