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p. 1 of 4 BACK | NEXT I. Current Development Trends and Issues II. Implementation of the Country Strategy and Program III. Portfolio Management Issues IV. Country Performance and Assistance Levels

Country Strategy and Program Update 2006–2008: Pakistan

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I. Current Development Trends and Issues

A. Recent Political and Social Developments

1. In October 2004, the National Assembly passed a bill allowing President Pervez Musharraf to retain the office of army chief beyond 31 December 2004. Following the completion of their term, local governments were dissolved on 1 July 2005 and local government elections are scheduled for August and September 2005. Pakistan intensified its efforts to curb militancy and extremism as part of the global response to terrorism. In foreign affairs, high-level policy dialogue with India continued and additional confidence-building measures were announced. Because of the tsunami disaster in the region, political developments in Nepal, and other related issues, the South Asian Association for Regional Cooperation (SAARC) summit planned for January 2005 in Bangladesh was postponed. The summit will now be held in November 2005. Results of the recent Pakistan Social and Living Standards Measurement Survey (PSLSM [2004-2005]) show significant improvements in social sector indicators over the past four years.

B. Economic Assessment and Outlook

2. Pakistan's economic performance continued to improve and GDP growth accelerated to 8.4% in fiscal year (FY) 2005, the highest in last two decades (Appendix 1, Table A 1.2). GDP growth was led by the manufacturing sector, which grew by 12.5%. The agriculture sector also witnessed robust growth of 7.6%, while the services sector grew by 7.9%. The economic growth of recent years has had positive impact on unemployment level, which fell from 8.3% in FY2002 to 7.7% in FY2004, with a significant drop from 16.5% to 12.8% in female unemployment. However, because of steep increases in oil prices and continued high domestic demand (fuelled by negative real interest rates and a rapid expansion of private sector credit), there was a sharp increase in inflation, which rose to 9.3% in FY2005 as against 4.2% in the previous year.

3. The fiscal deficit in FY2005 was 3.2% of GDP, up from 2.3% in the previous year. This was primarily due to a 23.7% increase in federal government current expenditure, and a fall in the collection of the petroleum development surcharge. Total development expenditure, including that by provincial governments, increased by 25.9% from the previous year. The first eleven months of FY2005 saw a large deficit of $1.8 billion in the balance of payments (BOP) current account compared with the comfortable surplus of $2.0 billion in the corresponding period of the previous year. It is estimated that the deficit in BOP current account in FY2005 will be about 1.3% of GDP, primarily because of higher imports and a sharp increase in the service accounts deficit. The State Bank of Pakistan's foreign exchange reserves on 25 June 2005 stood at $9.8 billion. The Government made substantial progress in privatizing and deregulating the financial, telecommunications, energy, and oil and gas sectors. The privatization of Pakistan Telecommunication Company Limited and National Refinery Limited, and public offerings of shares (Pakistan Petroleum Limited and Kot Addu Power Company) through the stock market proved successful. Unfortunately, the final outcome of Karachi Electric Supply Corporation (KESC) privatization is still uncertain due to nonpayment by the winning bidder.

4. The high level of inflation is a major economic challenge. Measures being taken by the Government in this regard include tightening the monetary policy and improving the supply of essential items by reducing duties and taxes on imports. Inflation notwithstanding, with continued high growth rates and overall macroeconomic stability, the medium-term prospects for the Pakistan economy continue to improve. It is estimated that GDP growth in FY2006 and FY2007 will be sustained at 7% or more, inflation will be contained at around 8.5% after the sharp increase in FY2005 provided, and the fiscal deficit will remain below 4.0% of GDP. Trade and current account deficits, while rising, should not be difficult to finance. However, sustaining the high growth rate and economic stability will require managing such risks as the possibility of a relaxation in macroeconomic management; slow progress on second generation reforms, particularly improving tax administration and promoting private sector investment; and continued weaknesses in capacity to implement policies and projects. These risks could be mitigated by continued support for the Government's efforts to implement sound economic and governance policies, promote a business-friendly environment, and improve portfolio performance.

C. Implications for Country Strategy and Program

5. The focus of the country strategy and program (CSP) that was approved in May 2002 is to support poverty reduction in Pakistan through interventions in the following three areas: supporting good governance (devolution, legal, judicial, and police reforms, as well as sector- and province-based reforms); sustainable pro-poor growth (rural development and employment generation); and inclusive social development (education, health, water supply and sanitation, and social protection). The major focus of the CSP is good governance. In addition, subregional cooperation, sustainable environmental management, and gender and development were identified as crosscutting themes in the CSP.

6. Under the country strategy and program update, CSPU (2005-2006), endorsed by the Board in September 2004, ADB supported the Government's shift in emphasis towards higher sustained growth. Given the favorable economic and political situation, the strategy updated in CSPU (2005-2006) continues to be relevant. The emphasis on lending for economic infrastructure will be continued, which is consistent with the high priority attached to it in the Government's medium-term development framework (MTDF). ADB's support for economic infrastructure development will be mainly, but not exclusively, in the areas of water resources, power, transport and communications, and urban renewal and development. ADB views itself as one of Pakistan's strategic development partners for infrastructure development. The capacity building and strategic planning technical assistance (TA) loans for infrastructure (power, water resources, and energy), rural modernization and mega city renewal included in the 2005 assistance program will provide an overall strategic framework to further strengthen and promote long-term partnership in these sectors. The TA loans will, among other things, support sector assessments, preparation of projects, and capacity building in these sectors.

7. ADB's strategic focus on social sectors will continue to support progress towards attainment of the Millennium Development Goals (MDGs) and improvements in social development outcomes. Following stagnation and weak performance in the social sectors in the 1990s, the PSLSM (2004-2005) indicates that there have been substantive improvements in social sector indicators over the past four years (para. 1). Assistance will be provided to consolidate this improved performance through province-based support for social sectors and provincial resource management programs that permit more spending on social sectors. This approach of financing social sectors through the budget will help to ensure increased expenditures are sustained. By making sure funds for social sectors flow through provincial finance commissions to local governments, this approach is also in line with devolution. For direct support for the social sectors, new and flexible social sector lending products-Social Sector Development Projects (SSDP)-are proposed. The mode of assistance will be defined at the project preparatory technical assistance (PPTA) stage and may include a sector development program, sector, program, or other suitable instrument, based on an assessment of the ongoing Devolved Social Services Programs (DSSP), and the specific needs identified at the design stage in the individual provinces. This generation of lending products will strengthen the capacity and functioning of local governments in delivery of social services as mandated under the devolution framework.

8. However, the recent Sector Assistance Program Evaluation (SAPE) carried out by the Operations Evaluation Department (OED) for the social sectors in Pakistan has raised a number of important issues. Consequently, several recommendations are already being considered for implementation. For instance, a dedicated unit will be established to strengthen the implementation capacity of Pakistan Resident Mission (PRM) for DSSP activities. Also such recommendations in the SAPE "as the need to promote public private partnerships in delivery of basic services" are being incorporated in designing the new DSSP for Balochistan. Finally, a review of ADB strategy for social sector operations in Pakistan will be an integral part of the new CSP, work on which shall be starting soon.

9. Governance continues to be mainstreamed in all ADB operations. The focus will be on ensuring effective implementation of the Access to Justice Program (AJP) and the Decentralization Support Program (DSP), as well as on provincial resource management programs (RMPs). ADB's support for improvements in governance also covers second-generation reforms concerned with access to justice, province-level governance reforms, ensuring all ADB operations are aligned with the devolution process, mainstreaming gender and civil society participation in the development process, and capacity development at all levels.

10. Against the backdrop of continuing improvements in economic fundamentals and progress in domestic capital markets, ADB is promoting the role of the private sector as a driver of investment, growth, and employment generation. It supports expanding the outreach of small and medium-sized enterprises and microfinance services and strengthening institutions with private sector participation. ADB currently has a portfolio of equity investments, loans, and complementary cofinancing loans in power generation, cement production, export finance, and venture capital, among others. Consideration is being given to supporting private sector investment projects in water, power, and energy infrastructure, mining, and local currency financing. In addition, ADB is currently processing a Private Partnership in Infrastructure Development (PPID) Project.

11. In view of the continuing positive political developments in the subregion, with relative stability in Afghanistan and an improving Pakistan-India relationship, there appears to be increasing recognition among political leaders of the need to enhance collaboration in trade, commerce, and other areas. ADB can play a catalytic role in promoting and strengthening regional cooperation in South and Central Asia. In addition to support for the feasibilities studies of the Turkmenistan-Afghanistan-Pakistan Gas Pipeline Project (TAP) and projects to improve regional connectivity among Pakistan, Afghanistan and the Central Asian Republics, new road projects are proposed for 2005 and 2007 that will further strengthen regional connectivity and facilitate trade. Pakistan is also part of a continuing high-level policy dialogue facilitated by ADB among the South and Central Asian countries on the need to improve infrastructure and remove any non-infrastructure barriers to better trade cooperation.

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