Macroeconomics Factors that need attention Pakistan

Macroeconomics Factors that need attention Pakistan

Introduction

Over the past 50 years, Pakistan’s record on macroeconomic management has been mixed. In the face of a variety of internal and external shocks, the country has managed to avoid excessive macroeconomic instability in the form of hyperinflation or severe exchange rate volatility. While its internal and external public debt has grown as a share of gross domestic product (GDP), and is now approaching levels that warrant attention, Pakistan has so far managed this growth without resorting to sovereign defaults, which leave a long shadow on a country’s ability to access capital markets. Finally, Pakistan has also avoided the kind of large-scale banking crises that many other developing countries have experienced with lasting impact on credit availability and private sector development.

Alongside these positive features, however, Pakistan has demonstrated an almost unique proclivity to allow fiscal and balance of payments pressures to build up into a near-crisis situation every few years, which then must be dealt with through orthodox economic stabilization tools, often with the help of the International Monetary Fund (IMF). In general, these stresses have been contained before they could become a full-blown economic crisis, but the cumulative cost of these periodic crisis-aversion programs has been to slow down economic and social development, resulting in the mediocre—and in some cases, poor—comparative development indicators that we see today. And, because each episode was addressed with short-term actions that stabilized the economy without adequate follow-through on structural reforms, the underlying weaknesses simply manifested themselves again with the next external shock or period of internal economic mismanagement. Moreover, this preoccupation with managing short-term macroeconomic vulnerabilities has limited the attention that top policymakers can devote to more fundamental issues of economic development and structural transformation.

Over View

GDP continued to grow above 5 percent in each of the last 2 years reaching 5.79 percent highest in 13 years in the outgoing fiscal year FY2018 and 4 percent in each of the three preceding years. The most important achievements of the outgoing fiscal year include the fastest pace in real GDP growth on the back of strong growth in agriculture, impressive growth in manufacturing as well as in services.

Apart from these positive developments, risks/challenges remain on domestic and external fronts, particularly the unfavorable BOP position due to a widening Current Account Deficit (CAD) along with less than expected foreign inflows and a decline in exports in the last two to three years. Slow global growth in international trade flows was an external factor that contributed to the low export growth

The provisional information presents a mixed picture of Pakistan’s economy at the end of Q3-FY18.  Maintaining its upward trajectory, the real GDP growth is estimated at a 13-year high of 5.8 percent in FY18, along with a benign inflationary environment. However, deterioration in external balances and high fiscal deficit remains a major source of concern.

The estimates for FY18 also suggest that compared to FY17 all the three sectors remained vibrant  In the same encouraging vein, inflation remained within manageable and supportive levels, largely owing to decline in its food component.

The second impact relates to increased consumption, which along with recovering oil prices, further inflated the import payments.  Higher import bill, despite 10 consecutive months of exports growth and rising workers’ remittances, resulted in record widening of current account deficit.  Even higher financial inflows from IFIs, bilateral sources, and issuance of sovereign bonds remained insufficient. Thus, the remaining payment gap fell on the country’s FX reserves, which fell to only two months of import cover by end-March, 2018. The foreign exchange market also remained volatile and PKR depreciated by 9.2 percent against the US$ during Jul-Mar period of FY18.

These external sector developments started to impact inflation as well. The pass- through of rising global oil prices to domestic fuel prices pushed up the energy component of inflation, as the government passed on its impact to consumers. Similarly, the impact of PKR depreciation started to translate into costly imports and shoring up of inflationary expectations.

On the fiscal side, the healthy growth in revenue could not keep up pace with a sharp rise in fiscal expenditure in the Q3-FY18. Particularly, the development expenditure related to infrastructure and power projects increased sharply, with major contribution coming from provinces. As a result, the fiscal deficit in Q3- FY18 stood higher than corresponding period last year.

To finance the fiscal gap, the government had to rely both on SBP’s borrowing and external sources.  In particular, the government borrowings from SBP stood at Rs2.2 trillion in Q3-FY18 – the highest level in a quarter.  External debt, owing both to higher commercial loans and revaluation impact of the PKR depreciation, also rose considerably.

In short, ensuring the continuity of expansion in economic activities and low inflation would depend on containing of current account and fiscal deficits.  As these vulnerabilities are posing challenges to Pakistan’s current growth cycle, implementation of both short-term and medium term policies would be crucial in this regard.

In short-term, concerted efforts could be made to rationalize fiscal expenditures given the tax relief measures approved in budget FY19.  In the medium term reforms would be needed to expand tax base besides enhancing efficiency of the existing system.  Simultaneously, there is a need to arrange external financing in the short term.  Also, more policy measures are required to contain the widening trade deficit.  For this purpose, it is also crucial to resolve structural issues affecting exports competiveness.

Pakistan’s growth continues to accelerate but macroeconomic imbalances are widening. Macroeconomic stability is a major concern for the near-term economic outlook. Pakistan’s GDP growth increased by 0.8 percentage points over the previous year to reach 5.8 percent in FY18. Major impetus came from improved performance of services and agriculture sector. Industrial sector also saw some recovery. Low interest rate environment contributed to the growth in private sector credit, which supported businesses. On the demand side, private consumption made up almost 86 percent of GDP. Average headline inflation in FY18 remained contained at 3.8 percent compared to 4.2 percent in FY17, well below the central bank’s target of 6 percent for FY18. Inflation has been inching up and core inflation rose sharply in Q4 FY18 as a result of depreciation and demand-side pressures.

The balance of payments is under stress due to relatively high current account deficit (CAD) at 5.8 percent of GDP (US$18.1 billion) in FY18. Exports, after contracting for three consecutive fiscal years, grew by 12.6 percent in FY18, but relatively stronger import growth (14.7 percent) has resulted in a higher trade deficit. Government imposed regulatory duties on a large number of imports to slowdown import growth and the exchange rate has depreciated by a cumulative 18 percent in FY18. The policy interest rate was raised by 175 bps during the second half of FY18 to ease demand pressures. Despite this, official international reserves have declined to US$9.6 billion by early September 2018 (1.6 months of imports), compared to US$16.1 billion at end-June 2017. To support declining reserves, government has been tapping international markets issuing bonds and commercial and official loans.

The fiscal deficit further deteriorated in FY18 to 6.6 percent of GDP in the run up to the elections, 2.5 percentage points higher than the target set at the beginning of the FY. The main reasons for the fiscal slippage were a large increase in recurrent spending together with low revenue growth (non-tax revenues). Tax revenues of Federal Board of Revenue (FBR) during grew by 14.3 percent to PKR3,842 billion in FY18.

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Pakistani rupee has been devaluing since December 2017 and has lost almost 3.7pc of its value as of now. In December, the value of rupee per US dollar was almost 105 but it observed a steep rise reaching 119.84 in June 2018. This was a great shock to the macroeconomic situation as it gave rise to many more problems our economy is currently facing. According to data combined by Bloomberg, the Pakistani rupee was Asia’s worst-performing currency this year. Some analysts expect the currency to drop further. Standard Chartered PLC predicts that the rupee will fall to 125 per dollar by the end of the year and International Monetary Fund may request authorities to weaken it even further.

  Pakistan’s external debt is expected to climb up to 103 billion dollars by June 2019. Pakistan’s public debt would remain higher than the limit prescribed in the revised Fiscal Responsibility and Debt Limitation Act . The country requires paying $12 billion in first half of 2018 as per its liabilities. Gross fiscal financing needs will likely exceed 30pc of GDP from 2018-19 onwards, in part reflecting increased debt service obligations. All this has led to growing challenges to arrange foreign loans. The IMF also said that “While the level of external debt has remained moderate, continued mobilization of external financing at favorable rates could become more challenging in the period ahead against the background of rising international interest rates and increasing financing needs

MAJOR MACRO ECONOMIC INDICATORS

Main Economic Indicators	2015	2016	2017(f)	2018(f)
GDP growth (%)	4.5	5.3	5.8	5.0
Inflation (yearly average, %)	2.9	4.1	4,1	4.0
Budget balance (% GDP)*	-4.6	-5.8	-6.5	-6.0
Current account balance (% GDP)	-1.7	-4.1	-5.5	-4,0
Public debt (% GDP)	67.7	67.0	73.0	72.0

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New IMP Program

The next crisis is now approaching. After successfully containing macroeconomic imbalances under an IMF-supported program during 2013–16, irresponsible fiscal expansion has led to a large and unsustainable balance of payments imbalance, a steep decline in foreign exchange reserves, and a sharp buildup of external debt, some of it on short maturities and expensive terms. Most economists agree that the   government will have no alternative but to approach the IMF yet again for another bailout with associated policy conditionality, such a request has indeed been made.

Income and expenditure of the public sector

There has been a chronic imbalance between the income and expenditure of the public sector. This is not because Pakistan’s public budget is much larger, in relative terms, than that of other emerging markets. Rather, it is because the government’s income from taxes, fees, and other sources is strikingly low compared with other countries.

This is not to say that there is no waste in public spending, or that it could not be better allocated. There are well-documented studies that show how both current and capital spending by the federal and provincial governments and their associated bodies could be dramatically improved to get “more bang for the buck.” Similarly, the persistent losses made by some public sector enterprises,^[1] and the even larger losses made in the energy sector,^[2] provide additional scope for improving public finances. The case is all the more compelling given the comparatively low level of public spending on health and education, which explains, at least in part, why Pakistan lags woefully behind on social indicators of development. Finally, inadequate public investment in infrastructure constrains the potential for sustained high growth. There is, therefore, a clear need to rationalize and improve the effectiveness of public expenditure.

However, it is on the revenue side that Pakistan is among the weakest performing countries in the developing world. Despite 40 years of efforts to improve both tax policy and tax administration, the ratio of taxes to GDP remains stuck in the low teens, below the middle-income countries (MICs) average of around 18.5 percent.^[3] In addition, the tax system is complicated, distorting, and not sufficiently progressive.

Two features of the tax structure are worth noting in particular: the high proportion of taxes collected through indirect taxes (60 percent of total tax revenue) and the small number of individuals who file income tax returns. Indirect taxes—essentially excise taxes, import duties, and fees of various sorts—are generally more regressive than direct taxes; in other words, their burden falls disproportionately on the poor and less well-off households. A further problem is that the second-best system of withholding and presumptive taxes has grown very complex, adding to the negative perceptions of the overall tax system. Attempts to introduce a VAT, a more efficient indirect tax, have failed in the face of political opposition.

The low number of income tax filers (just over one million out of an estimated working population of 116 million^[4]), and the prevalent underreporting of income by those who do file, has important consequences. First, it limits total tax revenue for the government. Indeed, it is hard to envisage how the tax to GDP ratio could be increased by 50 percent (to reach the norm for developing countries) without a substantial increase in the number of filers in the tax net.

Second, tax avoidance or under payment undermines public confidence in the fairness of the tax system. The perception (and reality) that people who are known to have very high incomes pay little or no income tax fosters a sense that the system is rigged to protect the rich and powerful. The annual publication of tax payments by parliamentarians, demonstrating in many cases a clear disconnect between their declared tax payments and their visible standard of living has been a great advance in transparency, but, so far, it has not altered the underlying pattern of behavior.

Those who claim to derive their income from agriculture (on which no income taxes are paid), and those engaged in trading or professional services who are either unregistered as taxpayers or pay small amounts in relation to their perceived incomes, are also often viewed as benefiting from an inequitable system. Property is mostly undervalued for tax purposes, so the revenue from this potentially important source is also very low by international comparison.

Tax avoidance is also found in the corporate sector. Of the 72,500 firms registered with the Security and Exchange Commission of Pakistan in 2016, less than half filed a tax return and half of the filers had a “zero return.”^[5]

Many studies have considered the problems of tax policy and tax administration. On the policy side, the recommendations range from proposals to address specific anomalies or missed opportunities all the way to plans for a complete revamp, with a new simplified and efficient approach to setting up a tax system. Similarly, there are incremental as well as radical proposals to reform tax administration, which is generally seen as inefficient and plagued by corruption. There have also been a variety of projects over the years, many supported by international agencies with technical assistance and policy conditionality, to promote these recommendations.

Why have past programs failed to generate a substantial and lasting improvement in Pakistan’s tax outcomes? Many blame corruption and incompetence in the tax administration, and this is certainly part of the explanation. Others point to the large share of the informal sector in Pakistan’s economy, which makes it harder to track individual and small business incomes. Yet others will point to the fact that a large share of the working population would fall below any reasonable income threshold for paying taxes. Finally, there is the problem of lack of trust in the quality and integrity of government spending. Many observers point to the generous levels of private charity by people who pay little in taxes as demonstrating that people are willing to contribute to the larger social good if they are confident that the money will be put to good use. These observers maintain that lower levels of tax avoidance would naturally follow a demonstrated improvement in the coherence and effectiveness of government spending. All these points have some truth to them, but they also apply to other countries that have, nevertheless, succeeded in enrolling much larger numbers of their working population into the tax net.

The larger and more important explanation for Pakistan’s failure to improve its tax outcomes, in my view, is one of political economy. Pakistan simply lacks a powerful enough coalition of interests to raise more taxes and to push for real improvements in the quality of government spending. Normally, this would come from a combination of those in government who want to spend money without raising the deficit and private taxpayers who are increasingly resentful of the high tax rates they pay while their peers remain outside the tax net. While both groups exist in the country, they have not been able to come together and overcome the powerful interests on the other side.

In particular, governments have often backtracked on their efforts to widen the tax net when faced with opposition from their political constituencies or linked interests. As a result, in times of fiscal stress, it has proved easier to cut back on the already low level of public investment spending, with damaging—but lagged—consequences. Many donor agencies and international partners—including the World Bank, the IMF, and bilateral aid agencies—have tried to influence this process through a combination of carrots and sticks, but they too have not succeeded.

Until Pakistan can substantially raise tax revenue by broadening the base of direct taxpayers, it will remain constrained in its ability to expand the delivery of much-needed public services and infrastructure without building up unsustainable fiscal deficits. And without that extra infrastructure and improved human development, growth will remain elusive and the country’s place in an ever more competitive world economy will remain fragile. What events or forces will bring about the political consensus to overcome longstanding constraints in this regard remains a subject of discussion.

FOREX

Pakistan has seen foreign reserves dwindle to about $9 billion; barely enough to meet its external debt through the end of the year, and the rupee has lost more than 20 percent of its value since December. Pakistan still plans to seek a bailout from the International Monetary Fund (IMF) despite Saudi Arabia agreeing to offer a $6 billion rescue package, Pakistan's finance ministry said on Wednesday. Pakistan’s balance of payments remained under stress due to rising imports of capital equipment and fuel during July-March FY2018. Recovery in global oil prices also played a role in pushing up the import bill. The remarkable growth in exports earnings and remittances inflows was not sufficient to overcome the current account deficit gap. The SBP’s liquid foreign exchange reserves declined by US $ 4.5 billion during July-March FY2018.

Pakistan’s current account deficit contracted by 9.2 percent on month on month basis in March 2018 and reached to US $ 1.16 billion as compared to US $ 1.28 billion in February 2018. However, the current account deficit widened by 50.5 percent and reached to US$ 12.03 billion (3.8 percent of GDP) during July- March FY2018.  This was mainly due to 20.7 percent widening in the trade deficit, amounted US$ 22.3 billion. The widening of trade deficit is mainly due to surge in import bill by 16.6 percent   and   reached   to   US   $   40.6   billion overshadowed the increased in exports and workers’ remittances. The remittances registered a significant growth of 3.6 percent during July-March FY 2018 against the decline of 2.0 percent last year

During the last few years, Pakistan exports were not picking up and recorded a negative growth. The main reasons for declining of exports were global slowdown but now the global economy is on the track of recovery. Pakistan exports are also on the increasing and the negative effect started bottoming out.

Exports during July-March FY2018 reached to US$ 17.1 billion as compared to US$ 15.1 billion in July- March FY2017, registered a growth of 13.1 percent. Pakistan imports were up by 15.7 percent in the first nine months of the current fiscal year, rising from $ 38,369 million during FY2017 (July- March) to 44,379 million, showing an increase of $ 6010 million in absolute term. To slow down the imports, an additional regulatory duty was imposed to curtail the inflated imports.

Pakistan’s balance of payments remained under stress due to rising imports of capital equipment and fuel during July-March FY2018. Recovery in global oil prices also played a role in pushing up the import bill. The remarkable growth in exports earnings and remittances inflows was not sufficient to overcome the current account deficit gap. The SBP’s liquid foreign exchange reserves declined by US $ 4.5 billion during July-March FY2018. ,

The main  source of macroeconomic vulnerability for Pakistan has been its external sector. Most successful emerging markets followed a strategy of promoting both the quantity and quality of their exports. Starting from low export levels comprised mainly of relatively unprocessed commodities or low value-added manufactures, these countries have dramatically expanded the volume, diversity, and sophistication of their exports.  

In contrast, exports have remained a much smaller share of Pakistan’s economy since independence. And over the past three years, a combination of factors—security and energy supply problems, lower commodity prices, and an appreciating real exchange rate—have brought exports down to well below 10 percent of GDP.   exports from Pakistan would have to more than triple from their current level to match the average for MICs. Pakistan’s exports have also been remarkably concentrated in a few low value-added products. Cotton and cotton products, rice, and leather still account for over 70 percent of the country’s exports, and the bulk of exports in each of these categories is in primary or little processed form. Service exports, which have been a rapidly growing source of high value-added export revenue in many countries, remain a small fraction of Pakistan’s exports.

Given its low level of exports, Pakistan has relied in recent years on a large and growing volume of remittances and on official and private financing to cover its import bill. It is worth noting, however, that these international flows, especially private flows, can be volatile because they are subject to external and internal shocks. Pakistan has had a consistent rising trend of remittance flows for many years, but recent international economic developments suggest that this is unlikely to persist. Remittances from the Gulf countries, which have been a large and growing share of the total, are likely to plateau as these countries adjust their spending to the new lower price of oil. Pakistan will need to adjust to lower growth in remittances going forward.

In good years, these international inflows have been sufficient not only to meet the demands for foreign exchange—even with an appreciating real exchange rate—but also to lead to an increase in the country’s foreign exchange reserves. However, when there was an external shock—such as the increase in oil prices in the years leading up to 2014—or when an excessively loose fiscal stance or a misguided exchange rate policy translated into an increased demand for foreign exchange, as has been the case more recently, these reserves were drawn down, sometimes to a level that threatened a macroeconomic crisis and led to recourse to the IMF (figure 1). At the time of writing, after a few years of being on a positive trajectory, these reserves were again on a downward trend and hovering around $10 billion, below the three months of imports mark that is used by many institutions as a minimum for certain kinds of financial operations.

Growth  

Pakistan has seen a visible economic turnaround over the last five years,  due  to successful implementation of a comprehensive program of economic revival aimed at higher economic growth and macro-economic stability. The growth momentum remained above 5 percent for the last two years in a row and reached 5.79 percent in FY2018 which is 13 years high on However, the balance of payments issues, sharp decrease o the Dollar Rupee parity rate and the resulting inflation has promoted various agencies to revise the growth rate for the next two years to around 4%,

Growth and Investment

Pakistan has seen a visible economic turnaround over the  last  five  years,  due  to successful implementation of a comprehensive  n the same period last year. Credit demand for fixed investment contained to 12.03 billion (3.8 percent of GDP) during July- March FY2018.  This was mainly due to 20.7 percent widening in the trade deficit, amounted US$ 22.3 billion. The widening of trade deficit is mainly due to surge in import bill by 16.6 reached to US$ 14.6 billion during first nine month of current year as compared to US$ 14.4 billion during the same period last year. The trend will continue 

Increase in external debt contributed Rs 830 billion to the public debt, while, government borrowing for financing fiscal deficit from external sources was Rs 384 billion. Therefore, the increase in external debt signifies both borrowings for financing fiscal deficit as well as revaluation losses due to Pak Rupee depreciation against US Dollar as well as appreciation of other currencies against US Dollar. Pakistan's public debt dynamics witnessed various positive developments in the ongoing fiscal year,  

Consumption is the largest component of aggregate demand followed by investment and net exports. During FY 2018, households' average propensity to consume remained fairly constant at around 85.5 percent at constant prices and around 82.0 percent in current prices

Contained inflation helped increase in consumption by private and General Government. During July-March FY 2018, current account deficit remained US $ 12.0 billion and is expected that it will cross US $15.0 billion  at  the  end  of current  fiscal  year.

The national savings and domestic savings as percentage of GDP remained almost at same level of last year. National income remained less than expenditures during FY 2018 when compared with FY 2017  which  resulted increase in Saving-Investment gap. The increase in Saving-Investment gap in turn resulted in higher current-account deficit.

Gross Fixed Capital Formation (GFCF), considered as fixed investment stood at Rs 5,099.1 billion in FY 2018 compared to Rs 4,632.8 billion  last  year  posting  a  growth  of 10.1 percent. The private sector GFCF posted a growth 5.2 percent as it increased to Rs 3,371.2 billion compared to 3,205.5 billion last year while the public sector GFCF increased to Rs 373.3 billion compared to 339.5 billion last year showing a growth of 9.9 percent. The expenditure on GFCF incurred by federal, provincial and district governments has increased by 23.9 percent, 22.1 percent and 45.7 percent, respectively. During FY 2018, per capita income increased by 0.5 percent over last year to $1641.

FDI (China and Saudi)

China

China has made agreements with Pakistan under the CPEC umbrella. The Chinese have come forward with a planned investment of $35 billion or 70 per cent of the total CPEC allocation under the IPP policy, under this  funding has been made for coal power plants, hydropower plants, some of these projects have been commissioned . The remaining 15$ is earmarked for construction of roads and railways. This plan is a national plan approved by both Chinese and Pakistani governments.  This plan is effective until 2030, the short-term projects included will be considered up to 2020; medium-term projects up to 2025; and long-term projects up to 2030.Node cities that the corridor passes through include Kashgar, Atushi, Tumshuq, Shule, Shufu, Akto, Tashkurgan Tajik, Gilgit, Peshawar, Dera Ismail Khan, Islamabad, Lahore, Multan, Quetta, Sukkur, Hyderabad, Karachi and Gwadar.  

The Chinese and Pakistani governments are the advocator, planner and guider of the CPEC project. Considering the Chinese and Pakistani economic systems, commercial projects related to the CPEC should be operated in a market-oriented way; quasi-commercial major infrastructure projects could adopt the public private partnership mode; and non- commercial projects concerning people's livelihood should involve multiple participants and be implemented through fair competition.

Transport infrastructure is the basic and prerequisite condition for the construction of the CPEC. Construction and development of Kashgar-Islamabad, Peshawar-Islamabad- Karachi, Sukkur-Gwadar Port and Dera Ismail Khan-Quetta-Sohrab-Gwadar road infrastructure, to enhance road safety and service levels and expand traffic capacity. Capacity expansion of existing railway lines (specifically ML-1 that is of strategic nature under CPEC), and construction of new projects and promoting the modernization of the railway and build an integrated transport corridor.

Construction and development of Gwadar city and port; build a consolidation and distribution transport system, continuously improve the infrastructure of the port, accelerate the construction of East Bay

the construction of cross-border optical fibre cables between China and Pakistan and the construction of the backbone optical fiber networks in Pakistan. Upgrading of Pakistan's network facilities, including the national data center and the second submarine cable landing station.

Saudi Arabia has offered three facilities.

These are:

1. Setting up of a refinery at Gwadar : Pakistan wants to build an oil refinery near the deep-water port of Gwadar to reduce petroleum product imports Saudi Arabia   agreed in principle to set up a major refinery at Gwadar and showed serious commitment to make investments in other areas of energy sector 8B $ is the reported cost of the proposed refinery. Agreements on Reko Diq gold, copper mines and Gwadar oil refinery likely to be signed next week

2.  Saudi Arabia has agreed to loan Pakistan $3 billion for one year as balance of payment support and to provide a one-year deferred payment facility for oil payments, up to $3 billion.

3. Saudis have also offered 3 $B one year deferred payment oil import facility.

Pakistan’s debt and liabilities rose sharply to nearly Rs30 trillion or 87% of total size of the economy at the end of previous fiscal year, largely due to the last government’s expansionary fiscal policies and its failure to reform tax administration.

Of the Rs29.9 trillion, gross public debt, which is the direct responsibility of the government, stood at Rs25 trillion. It was equal to 72.5% of gross domestic product (GDP), far higher than the statutory limit of 60%, showed the statistics. The gross public debt grew Rs10.6 trillion or 74.5% in the past five years.

The main reason for the increase in the gross public debt was the PML-N government’s failure to contain expenditures and enhance tax-to-GDP ratio to a level that could have sustained the burden of additional expenditures.

Interest payments on debt, which stood at Rs996 billion five years ago, increased to Rs1.6 trillion at the end of last fiscal year. The government paid Rs1.33 trillion in interest payments on domestic debt and Rs172.4 billion on external debt, which is quite a high figure.

Pakistan’s total debt and liabilities have pushed up sharply and touched at Rs29.861 trillion or 86.8 percent of GDP till June 30, 2018  The external debt and liabilities (EDL) peaked to $95.097 billion on June 30, 2018, posing a serious threat for the country on repayment of its foreign obligations. The external debt servicing consumed $7.479 billion in last fiscal year 2017-18 including principle amount of $5.186 billion and interest payment of $2.293 billion. The EDL in percentage of GDP stands at 33.6 percent.

Debt

Public Debt

Total public debt stood at Rs 22,820 billion at end December 2017 while Total Debt of the government was Rs 20,878 billion. Total public debt recorded an increase of Rs 1,413 billion during first six months of current fiscal year the bifurcation of this increase is explained below:

·                   Domestic debt registered an increase of Rs 582 billion while government borrowing for financing fiscal deficit from domestic sources was Rs 412 billion, indicating an increase in government credit balances with the banking system during the period under review; and

·                   Increase in external debt contributed Rs 830 billion to the public debt, while, government borrowing for financing fiscal deficit from external sources was Rs 384 billion. Therefore, the increase in external debt signifies both borrowings for financing fiscal deficit as well as revaluation losses due to Pak Rupee depreciation against US Dollar as well as appreciation of other currencies against US Dollar.

Pakistan's public debt dynamics witnessed various positive developments in the ongoing fiscal year; some of these are highlighted below:

·                   The government continued to adhere to the targets set forth in Medium Term Debt Management Strategy (MTDS) to ensure public debt sustainability.

·                   Weighted average interest rate on the domestic debt portfolio has been reduced further while cost of external loans contracted by the government are mostly concessional as well as dominated by long term funding;

·                   The government successfully raised US$ 2.5 billion in December 2017 through a 5- year Sukuk and 10-year conventional bond with the latter issued at the lowest rate for a Pakistan bond.

Encouragingly, cost and most of the risk indicators of public debt portfolio improved over last four years. Average cost of gross public debt reduced by over 100 basis points owing to smooth execution of the Medium Term Debt Management Strategy. Refinancing Risk of domestic debt portfolio reduced from 64.2 percent in 2013 to 55.6 percent in 2017. Exposure to interest rate risk also reduced, as the percentage of debt re-fixing in one year decreased to 47.8 percent in 2017 compared to 52.4   percent   in   2013.   Similarly,   share   of external loans maturing within one year was equal to around 27.7 percent of official liquid reserves in 2017 compared with around 68.5 percent in 2013, indicating improvement in foreign exchange stability and repayment capacity.

EDL stock stood at US$ 88.9 billion at end December 2017 out of which external public debt was US$ 66.9 billion. External public debt increased by US$ 4.4 billion during first half of the current fiscal year. In addition to net external inflows, translational losses on account of depreciation of US Dollar against other international currencies contributed towards increase in external public debt during the said period.

Recent Developments in Public Debt

Total public debt provisionally stood at Rs 23,608 billion at end February 2018 while total debt of the government was Rs 21,552 billion. Gross domestic debt recorded an increase of Rs 1,093 billion during first eight  months  of current fiscal year while external debt increased by Rs 1,107 billion. In addition to financing of fiscal deficit, (i) increase in credit balances of the government with banking system; (ii) depreciation of Pak Rupee against US Dollar; and (iii) depreciation of US Dollar against other international currencies contributed towards the increase in debt.

EDL stock provisionally stood  at  US$  91 billion at end February 2018 out of which external  public  debt  was  US$  69.3  billion Disbursements against external public  debt were cumulatively recorded at around US$ 7,300 million  during first eight months  of current fiscal year while external public debt servicing was US$ 3,338 million during  the said period.

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·                  The impressive growth in revenue collection witnessed during the first two quarters could not be sustained in Q3-FY18. Yet, on a cumulative basis during Jul-Mar FY18, it remained considerably higher compared to corresponding period of last year. On the other hand, building on the momentum seen in first two quarters, expenditures grew sharply in Q3-FY18

Together these have resulted in fiscal deficit rising to 4.3 percent of GDP during Jul-Mar FY18, against full year target of 4.1 percent and 3.9 percent deficit recorded in the corresponding period of last year. Similar to overall fiscal balance, the improvement in primary balance could not be sustained either, signifying that the non-interest expenditure grew at a faster pace relative to last year. The improvements in revenue balance, nevertheless, shows that revenue growth still managed to outpace the increase in current expenditures Thus, acceleration in growth of expenditures was more due to development spending, both at federal and provincial level. The provincial governments in particular, revved up the pace of development spending to fast track completion of the ongoing projects before the term of current assemblies came to an end. The growth in federal development spending, albeit slightly lower compared to last year, still remained high, above 24 percent  

Fiscal

A sharp increase in expenditures, amid a slower growth in revenue in Q3-FY18, led the fiscal deficit rising to 4.3 percent of GDP during Jul-Mar FY18 compared with 3.9 percent last year, and a full year target of 4.1 percent.  The growth in revenue, though remained higher compared to last year, slowed down in Q3-FY18 compared to first two quarters of FY18.  On the other hand, growth in expenditures accelerated from 12.4 percent in Q1-FY18 to 23.4 percent in Q3- FY18.

The slowdown in revenue collection was primarily due to direct taxes. More specifically, the drag came from a decline in voluntary payments, while withholding taxes and collection on demand increased considerably compared to last year. The decline in voluntary payments can partially be attributed to reduction in corporate tax rate and lower bank profitability.  Meanwhile, growth in indirect and provincial taxes remained buoyant in line with expanding economic activity, and the pass-through of rise in the oil prices to domestic consumers. The non-tax revenue also recovered strongly, bolstered by a jump in provincial non-tax revenue, higher markup payment, dividend income and PTA /postal service profit.

The acceleration in growth of expenditures was more due to higher provincial spending, with both current and development expenditures growing sharply.  The provincial development spending grew by 36.7 percent during Jul-Mar FY18 compared to 13.6 percent in the corresponding period of last year. Growth in federal development spending also remained high, close to 25 percent compared to 28.9 percent in last year. The push has come from urgency to complete the ongoing project before the terms of assemblies came to an end. Similar to growth in development expenditure, major contribution to a sharp increase in current expenditure came from provinces, especially in Q3-FY18. Higher debt servicing and defense spending at federal level and general public services, economic affairs, and public order and safety in case of provinces contributed to the increase in current expenditures.

The resulting higher fiscal deficit was largely financed through borrowing from SBP and external sources. In case of external financing, government heavily relied on commercial loans and sovereign bonds. Moreover, the revaluation losses, resulting from appreciation of major currencies against US$ and the depreciation of rupee against US$ also added significantly to external debt. Overall, these developments led to considerable increase in public debt, with record accumulation in Q3-FY18 since FY14.

Risk Analysis

One of the most dynamic economies of South Asia…

Activity will likely continue to remain strong in 2018, even if a slight deceleration is likely to occur in the second half of the year. Household consumption (81% of GDP) is set to remain dynamic. After suffering in 2017 due to the slowdown of construction in Gulf Cooperation Council countries, expatriate transfers from the region (62% of the total) should benefit from its recovery, particularly marked in the United Arab Emirates (22% of flows). This will offset the tightening of monetary policy (leading rate was risen from 5.75% to 7.5% between January and July 2018) aimed at moderating demand and inflationary pressures linked to the depreciation of the rupee and the rise in energy prices. On the other hand, investment (only 15% of GDP), already constrained by a mediocre business environment, could decelerate further due to a drop in confidence in the face of deteriorating balances. This would also affect investment in transport and electricity infrastructures under the China-Pakistan Economic Corridor (CPEC) between the Chinese region of Xinjiang and the port of Gwadar (South-West Pakistan). On a more positive note, services (60% of GDP), industry (20%) – notably mining and automotive –, and agriculture (20% of GDP) – with sugar cane, cotton, rice, and wheat – will benefit from the vitality of consumption.

Thanks to the measures recommended by the International Monetary Fund, the budget position improved markedly during the period of the latest financing agreement between 2013 and 2016. The fiscal deficit (excluding grants) fell from 8.5% to 4.6% of GDP. However, this trend has since reversed, due to a less sustained increase in tax receipts, largely due to the fall in household taxation in April 2018, combined with an increase in expenditure before the July 2018 legislative elections. At the same time, the deterioration could be temporary and fiscal efforts could resume. Public debt, still 60% domestic and denominated in local currency despite increased recourse to external financing, has increased considerably and will continue to weigh heavily on the much-solicited banking system, leading to a crowding out effect on private business investment, which is in great demand.

The current account deficit deepened in 2017-18 because of a widening trade deficit. This latter should decrease with the recovery in exports encouraged by the devaluation of the rupee, and the sharp deceleration in imports linked to the stabilisation of oil prices and the reduction in purchases linked to the CPEC. The trade deficit (10% of GDP in 2018) will remain the main contributor to the imbalance. This is explained by weak Pakistani exports (less than 10% of GDP), more than half of which consists of textile products (home linen, clothing, cotton yarn), and the rest broken down between agricultural products (sugar, rice) and a small share of manufactured products. Competition from low-cost neighboring countries in the textile sector is exacerbated by the overvaluation of the real effective exchange rate, despite the fact that the Pakistani central bank allowed the rupee to depreciate by 16% against the US dollar between January and July 2018. This is in addition to import pressure resulting from strong domestic demand exceeding growth potential.

Remittances from expatriate workers (7% of GDP) will partially offset the trade deficit. The remaining deficit, as well as the deficit (3%) associated with services and outgoing dividends and interest payments, is financed by the increasing recourse to indebtedness since 2016 with China and, incidentally, on the markets, as well as by a drawdown on reserves (which fell to the equivalent of 1.7 months of imports in June 2018). However, the external debt – 80% owed by the public sector – still represents only 31% of GDP, and is largely long-term and subscribed at concessional rates. FDI is minimal, with most CPEC investments financed by Chinese loans. The new government plans to conclude a new financing program with the IMF in order to ease the external accounts. The United States has indicated that the financing should not be used to service China-owed debt.  

Government needs to pay attention (1) to the control of inflation through effective and efficient monetary policy, (2) to increase employment chances by the supporting and establishing new industries and (3) advancing infrastructure. Government of Pakistan should also support Pakistani export in order to mitigate increasing imports  and always encourage foreign direct investments. These outcomes will be helpful in managing the economic growth rate of Pakistan.

Economic outlook

A slowdown is expected this fiscal year as the country grapples with economic imbalances and both fiscal and monetary policy tightening takes hold.   Forecast   see growth of 4.7% in FY 2019,   and 4.7% in FY 2020.

The government has set a 6.2 percent real GDP growth target for the growing external vulnerability and high fiscal deficit will continue to pose major down side risks to the achievement of this target domestic demand, lagged impact of adjustment in energy prices, and PKR depreciation are likely to contribute to higher CPI inflation in FY19.  Smooth supply of staple food items and soft oil price on the other hand could offset these underlying pressures and help keep inflation around the target of 6 percent set for FY19.

The government has set fiscal deficit target at 4.9 percent of GDP for FY19, which is based on a 12.7 percent anticipated growth in FBR tax revenues and a 10.0 percent increase in expenditures, with greater emphasis on current expenditure. While the current budget has reduced tax rates without rationalizing expenditure, achieving the fiscal deficit target in this backdrop appears challenging.

On the external side, the exports growth prospects remains encouraging on the back of PKR depreciation; recovery in global demand; fiscal incentives for exports; ease in power supply; and improved price outlook of rice and cotton in the international markets. Also, the growth in workers’ remittances is expected to further gather some pace, partly on account of the steps taken by the government and SBP to attract inflows through the official channels.  At the same time, a deceleration in imports is expected due to proactive monetary management by SBP, PKR depreciation and the continuation of administrative measures to dampen the domestic demand for non-essential import items.

However, the import bill is likely to stay high owing to a notable increase in international commodity prices, especially of oil.  This would keep the trade deficit high in FY19 as well.  Furthermore, the FDI inflows are expected to remain lower in FY19 than last year as a number of CPEC energy projects are in their advance stages of completion. Therefore, in overall terms, the high current account deficit, together with limited financial inflows, would continue to keep the balance of payments under pressure

Structural Reforms: Feb., 10, 2019: Irrespective of whether we get IMF funds or not, Pakistan will have to borrow money internationally to ensure we can survive the adjustment period. The IMF’s stamp of approval will allow Pakistan to secure better terms from other lenders as well. IMF money, a few billion dollars and released in small tranches, is not of much importance for Pakistan but the Fund’s stamp of approval is. The bigger worry, though, lies elsewhere. We have, historically, been able to stabilize the economy whenever we have faced a macroeconomic crisis. And this has been quite often. But we have been, every time without fail, unable to turn that stabilization into sustained growth. We have not been able to find the path from stabilization to growth. This has been the cause of repeated crises for us.   The main problem here is that our economy needs very basic structural reforms. Successive governments have been unable and/or unwilling to risk carrying out basic reforms. The needed reforms are going to be quite disruptive and they require a lot of management skills and competence. The state seems to lack the will and the skill to manage such reforms. These reforms are also quite micro. We are talking about basic changes in how we tax and whom we tax. We have to get our property rights regime overhauled. It includes deep reforms in contract enforcement, rule of law and access to justice. Bureaucracy needs very deep reforms. The regime of subsidies needs to be overhauled. Entrenched interest groups, whether they are industrialists, agriculturalists or traders, need to be toppled from their position of privilege and power. The military needs to be taken out of commercial activities or brought under the same rules as civilian businesses. Old and outdated rules and laws need to be changed. This is true of most of our laws but it is also true of the way the state does its business and hires and manages its people. In other words, the state needs, to put it mildly, rebooting after major changes have been made in its ‘programmes’. And it is going to be a hard reboot. Is the state ready for this? Is this government, which has come with public expectations of change, ready for this? These changes, if implemented, will have lots of losers and gainers. The losers will resist changes as much as they can. The government will need allies to implement change and compensate or resist losers. Given the current political scene, allies are not easy to come by for this government. How can the agenda of reform survive in such conditions? Even the debate on the mini-budget was hard for the government to manage. If major reforms are presented in such conditions, how is the government going to manage these? The needed structural reforms will also need very detailed plans for change and they will need high levels of competence for the state machinery to be able to implement these reforms. Leave aside issues of competence, meaning if we can get good reform plans in place, the bureaucracy, currently, stands politicized and disheartened. The threat of NAB and judicial overreach has paralyzed decision-making.   There is the issue of sequencing too. Not all reforms can or should be undertaken at the same time the time of each reform should be carefully worked out. Currently, we do not see any plans in place.. A lot more focus of the government should be on working out the plans for these reforms and how they are going to be sequenced and implemented.