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p. 42 of 77 BACK | NEXT Foreword, Acknowledgments, Acronyms and Abbreviations, Definitions 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. Promoting competition for long-term development Statistical appendix

Asian Development Outlook 2005 : II. Economic trends and prospects in developing Asia : South Asia

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Pakistan

The economy picked up further in FY2004, with GDP growth coming in at over 6% for the first time in 7 years. With sound macroeconomic fundamentals achieved and key sectors strengthened by reforms implemented in the past 4-5 years, the economy is well positioned to sustain 7% or more growth in the medium term.

Macroeconomic assessment of 2004

Economic performance improved further in FY2004 (ended 30 June 2004), and GDP growth exceeded 6% for the first time in 7 years. Investment in key sectors, such as large-scale manufacturing (LSM), oil and gas, telecommunications, and construction, picked up. The fiscal position strengthened further, the current account of the balance of payments remained in surplus for the fourth consecutive year, and foreign exchange reserves touched new highs. However, the size of the current account surplus fell sharply, and inflation started to creep up.

GDP growth accelerated to 6.4% from 5.1% in FY2003, driven by investment and private consumption expenditures. With historically low interest rates, a conducive regulatory and policy environment--particularly in the oil and gas and the telecoms sectors--and most industries having reached near full capacity utilization, fixed investment went up by 14.7%, accounting for more than one third of GDP growth. As a share of GDP, total investment, including changes in inventories, climbed to 18.1% in FY2004 from 16.7%. Private consumption expenditures picked up by 5.5%, contributing almost two thirds of the GDP growth.

On the supply side, GDP’s improvement was led by the industry sector, which put on 13.1%. The LSM subsector, which constitutes about half of industry, registered its fastest pace in two decades. Value added in LSM rose by 17.1%, as domestic demand strengthened on the back of a rapid rise in consumer credit, higher cash incomes of farmers, continuing strong levels of remittances, and an accelerating economy. LSM’s momentum was shared by all subsectors, with more pronounced rises recorded by the electronics, automobile, fertilizer, chemical, cement, cooking oil, and cotton cloth subsectors. Although the bulk of LSM’s expansion came from higher capacity utilization, capacity itself also stepped up, as indicated by a 28.4% augmentation in investment in LSM in FY2004. Electricity and gas distribution, as well as construction, also exhibited marked improvements. However, agricultural growth decelerated to 2.6% from 4.1% in FY2003, due mainly to continuing water shortages, which resulted in a slide in cotton production and slower growth among other major crops.

The services sector more or less maintained the prior year’s rate, though subsector performance showed considerable variation. Value added in wholesale and retail trade grew by 8.0%, up from 5.9% in FY2003, reflecting recovery in domestic economic activity, acceleration in imports, and continuing double-digit increases in exports. Telecoms services were also very buoyant, with the number of cellular phone subscribers doubling to 5.0 million. Growth in public administration and defense, conversely, was significantly slower than in the previous year.

The improved economic performance of the past 2 years has had a positive impact on employment in the country, with the average unemployment rate declining from 8.3% in FY2002 to 7.7% in FY2004. A particularly large fall was seen in female unemployment, which dropped from 16.5% to 12.8%, although it remains about twice as high as that for males, which receded only marginally to 6.6% in this period.

Strong growth, as well as a substantial lift to poverty-related public expenditures in the past 2 years, should also have generated a positive impact on poverty. A survey of household consumption expenditures, conducted by the Government in early 2004, showed a significant reduction in poverty since 2001. However, these numbers are only indicative of the trend, because the survey covered only about 2 weeks, and was based on one third of the sample covered in the Pakistan Integrated Household Survey 2000-01.

Inflation bottomed out in September 2003, with the annual rate, based on a 12-month moving average of the CPI, accelerating from 2.6% that month to 4.6% in June 2004. On a point-to-point basis, inflation jumped from 1.9% in June 2003 to 8.5% in June 2004. The move back up was initially triggered by supply-side factors, such as a shortage of wheat and the setback suffered by the poultry business due to avian flu. This was compounded by rises in housing rents, which reflected sharply higher real estate values. Despite the upswing, the State Bank of Pakistan (SBP) did not reverse its easy monetary stance so as not to stall the nascent economic recovery. Also, as inflation was initially confined to food prices caused by supply constraints, it did not consider appropriate a tightening of monetary policy. Money supply (M2) rose by 19.6% in FY2004 compared with 18.0% in FY2003, and the increase in credit to the private sector, at PRs325.2 billion, was almost twice as large as in FY2003.

In FY2004, the Karachi Stock Exchange’s KSE-100 index leaped by 55.2%. The stable exchange rate, low interest rates, higher economic growth, improved corporate profitability, and improvement in relations with India were key factors.

The Government maintained a tight fiscal stance in FY2004 and the overall budget deficit came down further to 3.2% of GDP from 3.8% in FY2003. The sharp improvement in the fiscal position was the result of strong economic growth and good expenditure management. Revenues strengthened by 11.4% and expenditures by a slower 7.9%, despite large rises in development and defense spending. Revenues exceeded their target, whereas expenditures came in below theirs. The debt profile of the country continued to improve, with the ratio of public debt to GDP declining to 72.3% from 79.3% in the previous year.

Despite a double-digit rise in exports, the trade deficit more than tripled to $1.3 billion in FY2004, as imports outpaced exports by a large margin. Imports powered forward by 21.2% to $13.7 billion, while exports rose by 13.5% to $12.5 billion. Besides a broad-based strengthening in domestic economic activity, various nonrecurring transactions, such as import of aircraft for the national airline, temporary import of dredgers on a reexport basis, and exceptionally high imports of raw cotton due to lower cotton production, also inflated the import bill. Export growth stemmed from price rises, which may partly be attributed to a shift from lower to higher value-added items. The deficit on the services account widened sharply (to $1.3 billion from only $2.0 million) due to reintegration of travel-related payments into formal channels and higher payments for shipments associated with stronger imports. Among current transfers, workers’ remittances weakened by 8.6% and the Saudi Oil Facility was discontinued effective January 2004. As a result, the current account surplus narrowed to $1.8 billion from $4.1 billion in FY2003.

The $0.7 billion surplus in FY2003 on the capital and financial account of the balance of payments turned into a deficit of $1.3 billion in FY2004. The deterioration in the capital account was the combined effect of a $1.0 billion debt forgiven by the US in FY2003 (which shows up in the accounts as a capital inflow) and an early repayment of $1.1 billion of debt to ADB in FY2004. A 29.6% fall in disbursement of foreign assistance in FY2004 also contributed to the wider deficit. These were partly offset by a bond issue of $500 million and larger FDI in FY2004.

Reserves held by SBP moved $1.0 billion higher to $10.6 billion in FY2004. Total external debt and liabilities further declined by $216 million to $35.3 billion, and as a share of total foreign exchange earnings, external debt and liabilities fell to 164.1% from 180.5% in the preceding year.

Macroeconomic policy developments

The FY2005 budget marked a break with the previous 4 years with a change in focus from fiscal stabilization to growth. The Government also continued the process of reform started in FY2002, including tax reforms, liberalization of the external trade regime, deregulation of the telecoms sector, and privatization of public sector enterprises.

The FY2005 budget took full advantage of the fiscal space created by improved revenue generation and reduced interest payments to expand development expenditures and lower business costs for the private sector. The allocation for development expenditures was increased by 25.9%, and import duties and sales tax on many raw materials and capital goods were reduced. As a result of reductions in import tariffs over the past several years, the average tariff rate has been cut to 14.9%. In addition, the FY2005 trade policy liberalized the import of used machinery to encourage the relocation of plants from abroad, mainly aimed at the textile and garment industries.

As part of the tax administration reforms, the Government plans to organize operations of the entire Central Board of Revenue on functional lines, separating the functions for collection, audit, assessment, and enforcement. It started the process in FY2003 by establishing a Large Taxpayers’ Unit in Karachi, and subsequently a Medium Taxpayers’ Unit in Lahore, both organized along functional lines. In these units, large and medium taxpayers can pay all their taxes in one place. Seeing the success of these experimental offices, the FY2005 budget announced the establishment of one more Large Taxpayers’ Unit and five more Medium Taxpayers’ Units in different cities across the country.

The FY2005 budget announced measures to shorten delays in payment of tax refunds, streamline general sales tax (GST) registration, rationalize the GST rate structure, and facilitate imports and exports. In the area of tax refunds, all GST refund claims are to be categorized as reliable, average, and risky based on past history, and prompt and full payment will be made in the case of claims categorized as reliable.

A new system of GST registration was introduced effective 1 July 2004, which does away with the requirement to submit a large number of documents with the registration application. The GST rate structure has been simplified, and now has one standard rate of 15% (from multiple rates ranging from 15% to 23%). Also, to make GST a tax that genuinely accounts for value added, offsetting adjustment has now been allowed for tax on almost all intermediate payment items, including diesel used in generators for producing electric power by registered taxpayers. To facilitate exports and imports, a pilot project for an automated clearance of export and import consignments is being launched in Karachi. It will entail only selective examination of goods, based on the concept of risk management.

The telecoms deregulation policy was announced in July 2003 followed by the cellular phone policy in January 2004, to promote the availability of high-quality and cost-effective telephone services in a competitive market. Since then, the Pakistan Telecommunication Authority has issued 12 licenses to various national and international companies for long-distance international services and 73 fixed-line local loop licenses for services in 14 regions of the country. To provide telecoms services to rural areas, 106 wireless local loop licenses have been awarded to 28 companies through open bidding. Two licenses have also been issued for cellular services (in addition to those held by the four existing operators).

As a result of deregulation, telecoms is probably the fastest-expanding sector in the economy, having a significant impact on investment and employment. Cellular phone and Internet services have expanded at a phenomenal speed in recent years, with the number of cellular phone subscribers doubling almost every year since FY2000. The total number of such subscribers, at 5.0 million in June 2004, has exceeded that of fixed-line subscribers. The number of Internet users more than tripled from 0.5 million in June 2000 to 1.6 million in June 2004 and the number of cities linked to the Internet soared from 29 to 1,900. Growth in the telecoms sector is likely to accelerate further in FY2005, reflecting the impact of the recently issued new licenses.

The Government has made substantial progress in privatization in recent years, with the financial sector largely privatized and all telecoms services opened to the private sector. The focus has now shifted to the energy sector; 73% of the shares of the Karachi Electric Supply Company were sold to a Saudi group in February 2005. In addition, 20% of the shares of the Kot Addu Power Company have been divested through the stock market. The Privatization Commission has also initiated the process of privatizing the Pakistan Telecommunication Company Limited (PTCL) and has invited expressions of interest for the sale of 26% of its shares, along with management control. Expected to be the largest privatization transaction so far, the bidding for PTCL shares is planned for the third quarter of 2005.

Outlook for 2005-2007 and medium-term trends

A robust performance in the real sectors of the economy in the first half of the fiscal year, the steep rise in imports of machinery and industrial raw materials, and continuing high domestic demand all indicate that GDP growth is likely to improve to 7.0% in FY2005. An important factor is agriculture’s envisaged strong performance. Output of cotton, the most important cash crop, is likely to be as much as 50% higher than in FY2004. Also, wheat, the largest crop in terms of value added, is expected to be boosted by prevailing high market prices, relatively early sowing, and timely rains. Moreover, an over 65% surge in imports of agricultural machinery and a 50% rise in gross disbursement of agricultural credit in the first half of FY2005 point to better prospects for agriculture. Accordingly, sector growth is forecast at 5.0% in FY2005.

The growth of the industry sector in FY2005 is estimated at 10.0%, given the strong recovery in investment in manufacturing seen in FY2004 and continuing high domestic demand. Reduction in import duties on machinery and liberalization of import of second-hand machinery, announced in the FY2005 budget, will further stimulate investment in manufacturing. Continuing modernization of the textile industry, as reflected in a 69.9% surge in imports of textile machinery in the first half of FY2005, and cheaper and abundant cotton, also augur well for manufacturing production. In the first 6 months of the year, the quantum index of manufacturing climbed by 16.1% compared with the corresponding period of FY2004. Of the two other important subsectors in industry, expansion will be sustained in construction, though electricity generation and distribution is likely to suffer a setback due to water shortages.

Services sector growth is also forecast to improve in FY2005. The expansion of the telecoms sector will accelerate further, as companies given licenses for various types of telephone services earlier in the year start their operations. Strengthened through reforms and privatization, the financial sector is also expected to expand robustly. Finally, wholesale and retail trade will be bolstered by a stronger performance in commodity-producing sectors and by burgeoning imports.

However, rising inflation is a major concern for FY2005. The 12-month moving average of CPI inflation pushed up further to 7.4% in December 2004 from 4.6% in June (Figure 2.19). Core inflation, which is more amenable to monetary policy, also picked up, from 3.7% to 6.5% during this period. To reduce inflationary pressure, SBP changed its stance from accommodative to a “measured tightening” of monetary policy in the first half of FY2005. Interest rates on 6-month treasury bills have risen from 2.5% in July 2004 to 5.2% in March 2005. The average interest rate on new loans disbursed by banks also increased, but at a slower pace, from 5.1% in June 2004 to 5.9% in December. However, monetary expansion in the first half of the year, at 9.8%, was somewhat larger than in the equivalent period a year earlier. Moreover, because real interest rates have remained negative, private sector credit is booming, while heavy government borrowing from SBP pushed up reserve money by 19% in the first half of FY2005. Reflecting these developments, inflation in FY2005 is put at 7.5%.

Despite an adverse effect of the increase in international oil prices, the fiscal deficit target of 3.1% of GDP should be achieved in FY2005. Tax collection by the Central Board of Revenue, which exceeded the target in the first half of FY2005, should remain above target for the year. Nontax revenues, such as dividends from the PTCL and Oil and Gas Development Corporation, as well as license fees for telephone services, are also expected to exceed the target. However, a shortfall in receipts from a surcharge on petroleum products will be seen, as the Government did not pass on the increase in oil prices to domestic consumers until very late in 2004. Still, total revenues are likely to be higher than budget estimates. As regards spending, only that on subsidies will be larger than budgeted. This is explained by additional losses from state-owned power utilities (due to higher fuel prices) and substitution of high-cost thermal power for low-cost hydropower (due to water shortages). Also, the Trading Corporation of Pakistan will require higher subsidies to cover losses in its trading operations pertaining to imports of wheat and urea, and procurement of cotton. On balance, though, the rise in expenditures due to higher subsidies is expected to be offset by the increase in revenue receipts.

In the first 6 months of FY2005, the trade deficit grew much more sharply than expected because of an unprecedented surge in imports of 47.7% compared with the same period in the previous year. Thus, despite an above-target rise in exports (14.6%), the trade deficit leaped from $159 million to $2.3 billion. This, along with an almost ninefold increase in the deficit on the services account to $1.5 billion, turned the current account into a deficit of $0.9 billion from a comfortable surplus of $1.8 billion in the first 6 months of FY2004. With high economic growth and the planned import of 1.5 million tons of wheat, imports are still expected to rise, though at a somewhat slower pace in the remaining 6 months of the year. The phaseout of textile and clothing quotas in January 2005, together with substantial investment in modernizing the textile industry in recent years, as well as the present cheaper, abundant supply of cotton, should boost the industry’s exports. Nevertheless, imports will significantly outstrip exports, and the trade deficit will continue to widen. Consequently, it is estimated that the deficit on the balance-of-payments current account in FY2005 could be as high as 1.7% of GDP.

On the basis of the ADO 2005 global outlook and continued sound macroeconomic policies, supported particularly by the low fiscal deficit and a much-improved public debt profile, the medium-term economic prospects look good. It is projected that GDP growth in FY2006 and FY2007 will remain at 7% or more, inflation will be brought down to 5% after the sharp increase in FY2005, and the fiscal deficit will be sustained at around 3% of GDP. Moreover, the current account deficit is expected to stabilize at less than 2% of GDP and, at this level, should not be difficult to finance.

The Government’s active debt management policy and tax reforms are expected, respectively, to further reduce the debt service burden and to boost revenues. The resulting fiscal space will allow it to increase investment in physical infrastructure and to allocate more resources for operation and maintenance, as well as to raise allocations for basic social services, such as education, health, and safe drinking water.

The financial system, greatly strengthened by aggressively implemented reforms over the past several years, is also well positioned to support higher economic growth over the medium term. Such reforms, together with privatization, have resulted in a more resilient and efficient system that is better placed both to absorb macroeconomic shocks and to mobilize and allocate financial resources more efficiently. With four fifths of the assets of the banking system in the control of the private sector, political interference in the working of the system has been brought down to a minimum and, by and large, banks’ lending decisions are based on economic considerations. As a result, the volume of NPLs has fallen significantly. Banks are extending their lending operations to new areas, such as consumer finance, which is propelling production of consumer durables such as automobiles and electronics. They are also helping growth in agriculture by sharply increasing both production and investment loans to farmers.

A significant improvement in Pakistan’s relations with India in the last year has also enhanced the economic outlook, by reducing security concerns and by improving prospects of intraregional trade in South Asia.

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