PAKISTAN ECONOMIC UPDATE

(JULY 2001 - JUNE 2002)

ASIAN DEVELOPMENT BANK

AUGUST 2002

Pakistan Resident Mission Asian Development Bank

ASIAN DEVELOPMENT BANK August 2002 Pakistan Resident Mission

OPF Building, Shahrah-e-Jamhuriyat G-5/2, Islamabad, GPO Box 1863 Islamabad, Pakistan. Tel : (92-51) 2825011-16 Fax: (92-51) 2823324 Fax: (92-51) 2274718 E-mail: adbprm@adb.org

The views expressed in the Economic Update are those of the authors and do not necessarily reflect the views of the ADB or its member governments.

FOREWORD

The Asian Development Bank is a long-standing development partner of Pakistan, having provided a total of US$11.5 billion to the country in development assistance since 1968. Of this amount, US$957 million were provided in 2001. The projected assistance for 2002 amounts to over US$1 billion, with an additional assistance of about $2.5 billion proposed for the period 20032005. Historically, the major sectors in which ADB has invested have included agriculture and rural development, energy, social sectors, finance, trade, and transport and communications. Under its Country Strategy and Program for Pakistan for 2002-2006, reduction of poverty is the central objective, which is operationalized through promoting sustainable pro-poor growth, inclusive social development, and good governance, with governance being the key area of focus. Together with this extensive lending portfolio, the Pakistan Resident Mission (PRM) is actively engaged in Economic and Sector Work to support analysis of important economic policy and sector concerns, particularly with regard to poverty and governance issues. PRM published, in July 2002, a country poverty assessment titled "Poverty in Pakistan: Issues, Causes, and Institutional Responses", after extensive consultations and dialogue with the key development partners. Support has also been extended to the Center for Research on Poverty Reduction and Income Distribution (CRPRID) at the Planning Commission to undertake research on poverty related issues. Earlier this year, PRM initiated a quarterly series to provide regular updates on the state of the national economy. The first Pakistan Economic Update covered the period July 2001-March 2002, and was published in April 2002. The present report is the second in this series and provides an analysis of economic trends in Pakistan in FY2002, covering both the domestic and external sectors of the economy. The report also presents a medium-term outlook of the economy based on existing trends. Finally, as a special topic, the report analyses the Federal Budget for FY2003. We hope that the contents of this report are of use to all stakeholders including Government, civil society, donors, academia, media, and others. We look forward to receiving comments on this report, and also suggestions for improvement of future reports in this series.

M. ALI SHAH
Country Director, Pakistan

PAKISTAN ECONOMIC UPDATE

(JULY 2001 - JUNE 2002)

The Pakistan economy performed reasonably well in FY2002, despite adverse effects of the global recession, post-September 2001 developments, tensions on borders with India, and continued drought. Its performance is expected to improve further in FY2003.

I. ECONOMIC DEVELOPMENTS
Introduction
The Pakistan economy demonstrated great resilience during FY2002 in the face of external shocks generated by the 11 September 2001 terrorist attacks in

the United States, subsequent war on terrorism in Afghanistan, increasing tensions with India, and global recession. The looming threat of war with India throughout the second half of the year and terrorist attacks in Karachi and Islamabad, together with the global recession, adversely impacted the country's economy. However, due to strong macroeconomic fundamentals achieved

through stabilization policies pursued in the preceding one and a half years, improvement in Pakistan's relations with G-7 countries after the 11 September 2001 events, and some fortuitous developments such as increased remittances and larger foreign grants, the economy was in a better position to absorb the external shocks. Lifting of sanctions by donor countries and signing of the Poverty Reduction and Growth Facility (PRGF) in December 2001 with the International Monetary Fund (IMF) opened up possibilities of inflow of substantial financial assistance from multilateral and bilateral donors in support of the ongoing reform program. The rescheduling of the country's bilateral debt by the Paris Club in December 2001 reduced the vulnerability of the Pakistan economy. Macroeconomic fundamentals

PAKISTAN ECONOMIC UPDATE

Macroeconomic fundamentals improved further during FY2002, as current account of the balance of payments recorded a substantial surplus, foreign exchange reserves crossed the $6 billion mark, and inflation decelerated.

improved further during FY2002, as the current account of the balance of payments recorded a substantial surplus, the underlying fiscal deficit remained more or less on track,1 foreign exchange reserves crossed the $6 billion mark, and inflation decelerated. Despite persistent problems, the performance of the real sector of the economy also was reasonably good.

DOMESTIC SECTOR Growth

The economy's overall growth performance improved in FY2002. The real GDP growth rate is estimated at 3.6 percent

compared with 2.5 percent in FY2001 and the original target of 4.0 percent (see table 1).2 Due to a sharp increase in net factor income from abroad,3 GNP grew by 5.4 percent compared with only 2.5 percent in the previous year. With an annual population growth of 2.2 percent, per-capita income increased by 3.2 percent as against almost zero growth in the previous year. The improvement in GDP growth performance was mainly because of the agriculture sector, which, despite continuing drought, performed better than the previous year. Value-added in the services sector, which contributes half of GDP, also grew at a marginally higher rate. The growth of the industry sector, of which large-scale

Table 1 Sectoral Growth and Inflation

%Growth Rate FY00 GNP GDP Agriculture Industry Of which: Large-scale Manufacturing Services CPI-based Inflation* 3.5 3.9 6.1 1.3 0.0 4.2 3.6 FY01 2.5 2.5 -2.6 3.1 8.6 4.8 4.4 FY02 5.4 3.6 1.4 2.8 4.0 5.1 2.8

* Based on comparison of the 12-month average of CPI with old 1990-91 base. Source: Pakistan Economic Survey 2001-2002.

1. 2. 3.

Fiscal deficit excluding one-time expenditures during the year. We had projected the real GDP growth for the year at around 3.5 percent in the Pakistan Economic Update: April 2002. The growth in net factor income from abroad resulted from a steep rise in the inflow of workers' remittances, discussed later in the section on external sector.

AUGUST 2002

manufacturing constitutes one half, declined slightly. The large-scale manufacturing sector was hurt the most by the postSeptember 2001 developments and the global recession, and its growth was markedly lower. The agriculture sector performed fairly well in the face of continuing drought. Growth of value-added in the sector in FY2002 is estimated at 1.4 percent in contrast with a contraction of 2.6 percent in FY2001. The growth estimate is based on a 3.4 percent expansion in the livestock subsector (compared with 4.9 percent in FY2001) and only a marginal decline of 0.5 percent in major crops (compared with a 9.8 4 percent contraction in the previous year). The loss in crop production during the year was much smaller than reduction in avail5 ability of water, as farmers have responded to drought experienced during the last 3-4 years by adopting water-saving techniques (see box 1). During FY2002, farmers shifted area from rice, a highly water-

intensive crop, to cotton, which requires relatively less water. As a result, cotton output increased by 1.9 percent to 10.9 million bales, despite a decline in its yield due to the bollworm attack in Punjab and late sowing in Sindh caused by shortage of water during the sowing season. Within the smaller area sown under rice, farmers tried to protect their income by switching to highpriced Basmati rice. Both reduced acreage and switch over to Basmati, which has a relatively lower yield, resulted in 19.2 percent decline in production of rice. However, in terms of value-added the decline was much smaller (-6.8 percent) because of change in the composition of rice output in favor of the high-value Basmati rice. Although sugarcane is a waterintensive crop, its production increased by 10.2 percent, as timely rains at the time of sowing and higher prices received in the previous year encouraged farmers to plant the crop on a larger area. Yield of sugarcane also went up by 5.9 percent.

The loss in crop production in FY2002 was much smaller than reduction in the availability of water, as farmers have adopted water-saving techniques in the last 3-4 years.

Box 1 Farmers' Response to Drought

Value-added in the crop sub-sector, which constitutes 57 percent of agriculture in Pakistan, has grown at an annual average rate of 0.4 percent in the last four years, despite a serious drought situation. It was generally observed that farmers were overusing water in irrigating their crops prior to the drought due to under-pricing of canal irrigation water. With decline in the availability of water, they have adopted water-saving irrigation techniques, like line-sowing (instead of broadcast sowing), furrow irrigation (instead of flood irrigation), laser leveling of fields, sprinkle irrigation in the case of vegetables and fruits, and even some drip irrigation in Balochistan. Economical use of water has particularly helped crops like wheat, which were damaged by over-use of water. Among other factors, like higher procurement prices, better application of water is also believed to have contributed to increase in the average yield of wheat for the last four years (2,325 kilograms per hectare in the 1999-2002 period compared with 2,098 kilograms in the preceding four years). Dry weather and resulting reduction in water logging has also helped cotton. Its yield increased from 548 kilograms of lint cotton to 593 kilograms over the same period.

4. 5.

Major crops and livestock contribute 40 percent and 38 percent, respectively, of value-added in agriculture. The availability of water in FY2002 was 60 percent less than normal compared with a shortfall of 40 percent in the previous year.

PAKISTAN ECONOMIC UPDATE

Modernization of the textile industry in the last couple of years enabled the industry to better face the global recession.

The growth of the industry sector (including mining, manufacturing, construction, and electricity and gas distribution sub-sectors) declined from 3.1 percent in FY2001 to 2.8 percent in FY2002, mainly because of a sharp deceleration in large-scale manufacturing. Growth of the mining sector, mainly comprising of crude oil, natural gas and coal, was also lower than in the previous year. Value-added in electricity and gas distribution declined for the third consecutive year because of a fall in hydroelectric production due to continued drought. Only the construction sector posted marginally higher growth. Value-added in the large-scale manufacturing sector increased by only 4.0 percent in FY2002, a sharp decline from the 8.6 percent growth achieved in FY2001. The quantum index of large-scale manufacturing for the latest three-month period (March-May 2002), for which data is available, shows an increase of 9.7 percent over the corresponding period of the previous year, indicating an upturn in production. Lower growth in large-scale manufacturing for the full year resulted from smaller increase in production of food, beverages and tobacco industry, which constitutes about 17 percent of the sector, and declines in production in fertilizers, metals, leather, automobiles and chemicals industries. On the other hand, textiles, petroleum products, pharmaceuticals and electronics showed an improvement. The data on the quantum index of large-scale manufacturing sector now available for the first 11 months of FY2002 shows that food, beverages and tobacco industry recorded a lower growth of 8.6 percent compared with 13.2 percent in the corresponding period of

FY2001,6 mainly because of a smaller increase in the production of sugar (10.6 percent compared with 13.1 percent in the previous year) and declines in production of vegetable ghee and cigarettes. Among better performing sectors, production of textiles, the single largest industry in the country which carries a weight of 19.1 percent in the quantum index for the large-scale manufacturing sector, increased by 4.3 percent in the first 11 months of FY2002 compared with an increase of 2.7 percent in FY2001. The ongoing modernization of the textile industry, reflected in large increases in imports of textile machinery in the last two years, enabled the industry to better face the global recession. Production of petroleum products increased by 25.1 percent compared with a 17.5 percent increase recorded in the previous year. Full-year production by the Pakistan Oil Refinery Company (PARCO), which started operations in September 2000, contributed to higher growth of petroleum products. The services sector grew by 5.1 percent in FY2002 compared with 4.8 percent in FY2001. Improvement in the growth performance of the sector was mainly due to a sharp increase in value-added in public administration and defense services (18.2 percent compared with 1.2 percent in the previous year). The large increase in salaries of government servants in FY2002 and higher expenditure on defense due to confrontation with India were the two factors responsible for the higher growth. Salaries of government servants were increased effective January 2002 as a part of the pay and pension reforms to compensate for erosion in their salaries over the past several years and to restore incentives.

6.

Though lower than the previous year, the growth of food industry was still quite high. High growth rates for the last two consecutive years should be seen in the background of a sharp decline of 24 percent two years ago, when sugar production declined by almost one-third. Sugar production, which has grown by 13.1 percent and 10.6 percent, respectively, in the last two years, is just regaining its earlier position. It also shows how growth of food industry has been driven by sugar industry, which carries 50 percent weight within the food industry.

AUGUST 2002

Growth in value-added in wholesale and retail trade, on the other hand, declined sharply from 5.2 percent to 2.2 percent, reflecting the depth of recession in the economy, lower imports and stagnant exports. Investment and Savings The post-September 2001 events and confrontation with India throughout the second half of FY2002 badly undermined investor confidence. Total investment declined from 15.9 percent to 13.9 percent of GDP, which is an all time low level. Fixed investment decreased from 14.3 percent to 12.3 percent. Although both public and private sectors shared the decline in fixed investment, as a percentage of GDP, the decline was much more pronounced in the case of the public sector. Despite a large increase in development expenditure under the Public Sector Development Program, the absolute amount of fixed investment in the public sector, in real terms, decreased by 9.4 percent, because of a sharp decline in investment by state-owned manufacturing enterprises and lower investment in the energy sector. The private sector investment recorded a small increase of 1.9 percent. The small increase in the private sector was due to higher investment in ownership of dwelling and construction, presumably financed by larger inflow of remittances. Investment in smallscale manufacturing, electricity and gas, and finance and insurance also recorded increases. On the other hand, investment in agriculture and large-scale manufacturing sectors declined.

Lifting of sanctions by the G-7 countries after Pakistan joined the US-led coalition to fight terrorism resulted in a sharp increase in total foreign investment from $182 million in FY2001 to $475 million in FY2002, which means a reversal of the declining trend seen in the preceding five years. This was a result of improvement in both foreign direct investment and portfolio investment compared to the previous year. Foreign direct investment increased from $322 million to $485 million. Two-thirds of direct investment came from the USA, compared with only 29 percent in FY2001. The net outflow on account of private foreign portfolio investment declined from $140 million to $10 million. The national savings as a percentage of GDP increased from 15.0 percent in FY2001 to 15.4 percent in FY2002 mainly because of substantial improvement in the 7 current account of the balance of payments. However, domestic savings at 14.7 percent of GDP was lower than 16.6 percent in the previous year. Prices Inflation decelerated significantly in FY2002. The annual inflation rate, based on a comparison of the 12-month average of the Consumer Price Index (CPI), declined to 2.8 percent from 4.4 percent experienced in the previous year. The other two indices namely, the Sensitive Price Index and Wholesale Price Index also showed a 8 significant decline in inflation. Comfortable supply position of essential 9 commodities like wheat and sugar, lower

There was a substantial increase in foreign investment in FY2002, indicating a reversal of the declining trend seen in the preceding five years.

7.

8. 9.

National savings in Pakistan is derived by first estimating total investment and then deducting from it the part financed by external inflow of resources, mainly reflected in deficit in the current account of the balance of payments. These comparisons are based on price indices constructed with the old 1990-91 base. Wheat prices remained stable throughout the year due to large stocks carried over from the previous year and large 2002 crop for third year in a row. Sugar prices during the year on the average were about 17 percent lower than in the preceding year due to large inventories built out of imports during the preceding year and higher production in the year under review.

PAKISTAN ECONOMIC UPDATE

Although the annual inflation rate declined from 4.4 percent in FY2001 to 2.8 percent in FY2002, there were indications of an upturn in the latter part of the year.

international prices of petroleum and petroleum products in the first half of the year, lower prices of cotton, and sharp appreciation of the Pakistan Rupee contributed to the low inflation. A point-to-point comparison of CPI of June 2002 with June 2001 gives an annual inflation rate for FY2002 (on the new 2000-01 base) of 4.4 percent as opposed to 3.5 percent based on comparison of period averages, indicating an upturn in inflation in the latter part of the year. Monetary Management The large accumulation of foreign exchange reserves in FY2002 led to a substantial increase in money supply. Given the slack in domestic economy, the State Bank of Pakistan (SBP) did not neutralize the expansionary impact of increase in foreign exchange reserves. As a result, money supply increased by 15.2 percent in FY2002 compared with a much smaller increase of 9.0 percent in FY2001. Monetary expansion during the year also exceeded the target of 9.5 percent set in the Annual Credit Plan. As part of SBP's easy monetary policy, the discount rate was lowered from 14 percent in June 2001 to 9 percent by January 2002 and was kept at that level during the next five months. The rate of return on 6-month Treasury Bills (TBs) also declined from 12.9 percent to 6.3 percent during the year. However, decline in lending rates charged by banks was relatively small, with the average rate declining from 14.0 percent in June 2001 to only 12.2 percent in May 2002. The SBP was able to adopt an accommodating approach, because monetary policy was no longer dictated by the need to stabilize the exchange rate. Stable domestic prices also made this monetary stance possible.

The bulk of the increase in money supply during FY2002 was accounted for by increase in the net foreign assets of the banking system, reflecting a sharp increase in foreign exchange reserves. Of the total increase in money supply, 85 percent was due to increase in net foreign assets and only 15 percent due to domestic credit expansion. In FY2001 also, the net foreign assets accounted for almost three-fifths of the total increase in money supply. Domestic credit increased by 2.3 percent compared with an increase of 3.7 percent in the previous year. Within domestic credit expansion, the Government borrowing from banks to finance the budget was much higher than in the previous year due to a larger fiscal deficit. The government had to borrow more from banks despite increased availability of foreign grants and greater resort to borrowing from domestic non-bank 10 sources. Smaller increase in domestic credit during FY2002 reflected lower demand for credit by the private sector and public sector enterprises, whose net borrowing from banks increased by only 2.4 percent compared with 6.7 percent in the previous year. The private sector borrowed less from banks due to a substantial improvement in it's cash flow position, as a result of exceptionally large tax refunds made by the Central Board of Revenue (CBR); faster conversion of export receipts by exporters into rupees, given the appreciating Rupee; and larger write-offs by banks of outstanding loans. Lower prices of petroleum and cotton, raw material for the country's largest industry, reduced the working capital requirements of the private sector. Besides, greater resort to the corporate debt market also reduced the corporate sector's need for borrowing from banks.

10. The Government borrowing from banks picked up in the fourth quarter of FY2002. In the first three quarters of the year, it actually paid back Rs 5.9 billion as against net borrowings of Rs 13.0 billion in the corresponding period of the previous year.

AUGUST 2002

Lower interest rates and greater liquidity with the banks in FY2002, failed to give the desired boost to the economy.11 Private investment, in real terms, in the large-scale manufacturing sector declined by 9.9 percent and total private investment was only marginally higher than the previous year. Expansionary monetary policy failed to have desired effect on the economy for the following reasons. One, in Pakistan lower interest rates do not stimulate home construction and consumer spending on durables, as banks traditionally have not been making mortgage loans for house building and consumer loans for durables.12 Two, the main channel through which lower interest rates affect spending in the economy is investment decisions by business firms, who were not interested in making new investments given the excess capacity in most industries, particularly sugar, cement, automobile assembly, and polyester and synthetic fiber industries. Besides, the law and order situation and general uncertainty are not very conducive for investment. Moreover, high utility prices, particularly electricity tariffs, because of mismanagement and pilferage in public sector utility companies have a dampening effect on investment. Three, because of low interest rates, banks were more interested in investing in low risk Government securities than extending credit to the more risky small and medium enterprises and new borrowers. This highlights the limitations of monetary policy in reviving the economy in a situation like the one Pakistan finds itself in.

Fiscal Policy13 The fiscal balance worsened in FY2002, with the consolidated budgetary deficit increasing to 7.1 percent of GDP compared with 5.2 percent in FY2001 (see table 2). However, after adjusting for one-off expenditures incurred during the year, the budget deficit was 5.7 percent of GDP, i.e. equal to the IMF program target. Consolidated expenditure of federal and provincial governments increased by 20 percent to Rs 874 billion, while revenues increased by only 12 percent to Rs 612 billion. During FY2001 expenditure had actually declined by 2.2 percent and revenues had increased nominally by 1.8 percent. The increase in the Government expenditure in FY2002 was mainly due to an increase in development expenditure, recapitalization of the Karachi Electric Supply Corporation (KESC), issue of bonds to banks in lieu of tax refunds due from CBR, and additional defense expenditure on account of mobilization of troops on the border with India in the second half of the year. Development expenditure by the federal and provincial governments in FY2002 at Rs 124.7 billion showed a large increase of 35 percent over FY2001, but fell short of the budget target of Rs 130 billion. Current expenditure increased by only 6.2 percent, with federal expenditure increasing by 4.6 percent and provincial expenditure by 11.4 percent. The increase in federal current expenditure resulted mainly from

Lower interest rates failed to give the desired boost to the economy, and the private investment in large-scale manufacturing declined by 9.9 percent.

After adjusting for one-time expenditures during the year, the consolidated fiscal deficit at 5.7 percent of GDP was equal to the IMF program target.

11. Since July 2001 banks have been awash with liquidity. As of end March 2002 banks' liquidity was 67 percent higher than the minimum required under the statutory liquidity requirement. 12. There has been a small increase of 3.7 percent in investment in house building, but that is probably due to shift from foreign currency deposits to real estate after appreciation of the Pak Rupee and increased inflow of overseas workers remittances. 13. See Part III for detailed analysis of the Federal Budget 2002-2003. This section is concerned with the consolidated fiscal position of the federal and provincial governments, and for that we have relied on numbers given in Pakistan: Second Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility, IMF, 11 July 2002. These numbers may differ slightly from those used in our analysis of the Federal Budget 2002-2003 in Part III.

PAKISTAN ECONOMIC UPDATE

Table 2 Consolidated Federal and Provincial Fiscal Position

(Billion Rs) FY2001 (Revised Actuals) FY2002 (Revised Projections) Change (%) in FY2002 Over FY2001 18.1 12.0 1.8 1.7 5.7 47.2 42.4 51.6 3.6 92.8 20.2 6.2 4.6 6.6 14.0 11.5 11.4 34.8 37.2 27.5 45.0 16.2 FY2003 (Projections) Change (%) in FY2003 Over FY2002 7.4 13.4 15.0 15.0 14.1 34.7 2.1 1.0 9.3 -34.7 -0.2 6.4 4.5 5.5 -2.4 6.3 12.3 15.5 0.5 64.4 -31.9 -15.0 -

Total Revenue and Grants Total Revenue Tax Revenue Of which: Federal Taxes Provincial Taxes Surcharges Nontax Revenue Federal Provincial Grants Total Expenditure Current Expenditure Federal Of which: Interest Defense Running of Civil Government Provincial Development Expenditure Federal Provincial Net Lending by Federal Government KESC Recapitalization and CBR Bonds Issued to Banks Budget Deficit Budget Deficit (Excluding Onetime Expenditure As % of GDP Budget Deficit Budget Deficit (Excluding Onetime Expenditure)

591.1 546.4 413.3 393.9 19.4 30.5 102.6 82.9 19.7 44.7 726.9 650.7 500.8 234.7 131.2 76.8 149.9 92.5 69.6 22.9 -16.3 0.0 -180.5 -180.5 -5.2 -5.2

698.2 611.9 420.9 400.4 20.5 44.9 146.1 125.7 20.4 86.2 873.8 690.7 523.7 250.2 149.6 85.6 167.0 124.7 95.5 29.2 6.4 52.0 -261.8 -209.8 -7.1 -5.7

750.0 693.7 484.0 460.6 23.4 60.5 149.2 126.9 22.3 56.3 872.0 735.0 547.4 264.0 146.0 91.0 187.6 144.0 96.0 48.0 -7.0 -178.4 -178.4 -4.4 -4.4

Source: Pakistan: Second Review Under the Three-Year Arrangement Under Poverty Reduction and Growth Facility, IMF, 11 July 2002.

AUGUST 2002

higher defense expenditure. The Government incurred large expenditure of Rs 52 billion on recapitalization of KESC (Rs 30 billion) and issuance of bonds to banks (Rs 20 billion), which is treated as one-time expenditure by the IMF. The Government revenues in FY2002 increased mainly on account of large increases in non-tax revenues and surcharges on petroleum and gas. Tax revenues, which constitute the bulk of government revenues, increased by only 2 percent. The Federal Government's non-tax revenues rose by 52 percent to Rs 126 billion due to large payments received for the use of country's civil aviation facilities by the coalition forces for operations in Afghanistan. The Provincial Government's non-tax receipts increased only by 3.6 percent. Receipts from surcharges increased by 47 percent to Rs 45 billion (see Part III). The Budget for FY2003 aims at further fiscal stabilization, while protecting social and development expenditures. The overall budgetary deficit will be reduced to 4.4 percent of GDP, 2.7 percentage points lower than that in FY2002. The efforts to reduce the fiscal deficit rely mostly on expenditure control, which will contribute 2.1 percentage points to reduction in the 14 deficit. Consolidated expenditure of the federal and provincial governments for FY2003 is projected to decline marginally by 0.2 percent to Rs 872 billion and revenue to

increase by 13 percent to Rs 694 billion. The slight decrease in expenditure is mainly due to the base effect of large expenditure on recapitalization of KESC and issuance of bonds to banks in FY2002. Significant increases are projected in development and poverty related expenditures. Development expenditure is budgeted to increase by 15.5 percent to Rs 144 billion, while current expenditure will increase by only 6.4 percent to Rs 735 billion. Because of ongoing devolution of responsibilities, the entire increase in development expenditure will be at the provincial and local governments level, which is envisaged to increase by 64 percent to Rs 48 billion. Expenditure for reducing poverty, crosscutting objective of all Government policies, is targeted to increase by 18% to Rs 161 billion in 15 FY2003. There is also a provision for additional poverty related expenditure of up to 0.5 percent of GDP (and thus for a deficit, excluding grants, of 4.9 percent of GDP), to the extent that cash budgetary grants plus cancellation of debt or debt swaps exceed the budgeted baseline of Rs 10 billion. Poverty related expenditures relate to social sectors (primary education, basic health, rural water supply, etc.), farm to market roads, and small development schemes in low-income areas to generate employment opportunities for the poor as well as create physical infrastructure in these areas. Provincial and district governments undertake these expenditures. Although poverty related expenditures are being increased, certain other measures may be offsetting their positive impact on incidence of poverty in the country (see box 2).

The Government's efforts to reduce fiscal deficit continue to rely mostly on expenditure control.

14. Compared with the fiscal deficit in FY2002 adjusted for one-time expenditures, the FY2003 fiscal deficit will be lower by 1.3 percentage points. Of this, 0.7 percentage points will be contributed by reduction in expenditure and 0.6 percentage points by increase in revenues. 15. For the first time, the Government has started tracking poverty related expenditures.

10

PAKISTAN ECONOMIC UPDATE

Box 2 Inequitable Policy Measures

The positive impact of poverty related expenditures is offset by a number of other policy measures taken by the Government. The Government's policies regarding pricing of utilities like electricity and gas have hurt the poor. A significant part of the increase in utility prices is due to inefficiencies in the operations of public sector utility companies and this can be avoided by improving their efficiency. There are also some inequities inherent in the ongoing tax reforms. For instance, although the extension of GST to almost all goods and services is required for revenue generation, its actual sequencing is being generally perceived as inequitable. While most of the services sector, which constitutes about half of the economy, is exempt from GST, it has been extended to products such as vegetable ghee and medicines.1 By bringing the services sector in the GST net, the Government can start taxing some affluent selfemployed professionals, who generally under-report their incomes for income tax. Besides, the extension of GST to the services sector can lead to documentation of the sector. 1. GST on medicines was withdrawn on 22 August 2002.

The last two budgets prepared by the current Government have pushed forward structural reforms and further consolidated fiscal stabilization.

Increase in Government revenues in FY2003 is expected to be broad-based, as receipts from all three revenue heads are envisaged to increase. Various tax reforms announced by the Government and improvements in tax administration, including those at the provincial level, are expected to yield additional revenues equivalent of 0.4 percent of GDP. Additional improvement in tax revenues equal to 0.4 percent of GDP will come from the base effect of the one-time payment made in FY2002 to clear the backlog of tax refunds to exporters.16 Federal taxes, the largest source of revenues, are projected to go up by 15 percent to 461 billion and surcharges on petroleum and gas by 35 percent to Rs 61 billion. Provincial taxes, too, are budgeted to increase by 14 percent to Rs 23 billion. At the time of announcing the FY2003 Budget, the Government circulated a draft Fiscal Responsibility Law to solicit comments from stakeholders. The law will require the Government to progressively reduce its borrowing, so that after five years the Government borrowing in any year will not exceed its development expenditure

(see box 3). The last two budgets prepared by the current Government have pushed forward structural reforms and further consolidated fiscal stabilization. As pointed out above, stabilization has relied more on expenditure controls than mobilization of revenues. Hence, it has had a dampening effect on growth in the short run. As expenditure cuts were largely confined to development expenditure, medium and long-term effects of stabilization may also be damaging for growth. Structural reforms, too, depress growth initially as businesses used to operating on subsidies and behind the protection walls adjust to the new environment of exposure to foreign competition. A view has been generally expressed in the print media that relentless pursuit of fiscal deficit targets on the back of expenditure controls is depriving the economy of fiscal jump-start needed to get it out of recession, and that the Government should adopt an expansionary fiscal policy to raise aggregate demand. The decision to increase public expenditure to jump-start the economy is not a

16. Exporters are entitled to rebates for import duty and GST paid on raw materials and utilities. As a result of exceptionally large payment of such rebates in FY2002, tax revenues for the year were understated.

AUGUST 2002

11

Box 3 Fiscal Responsibility Law

Article 166 of the Constitution of Pakistan empowers the Federal Government to borrow for financing its budgetary expenditures within such limits as the Parliament may fix from time to time. The Parliament never enacted a law to prescribe these limits. As a result, successive governments demonstrated complete lack of fiscal responsibility, particularly during the 1980s and 1990s. The outstanding public debt increased from 66 percent of GDP in 1980 to 102 percent in 1999, at which level it was unsustainable. The Government has circulated a draft of the Fiscal Responsibility and Debt Limitation Ordinance, 2002 to solicit comments from interested individuals and institutions. After incorporating comments the law will be enacted by 31 August 2002. The draft Ordinance requires the Government: - To eliminate revenue deficit by 30 June 2007.1 - To reduce the outstanding public debt to 60 percent of GDP by 30 June 2012. - To reduce the outstanding public debt by at least 2.5 percent of GDP in every fiscal year, while ensuring that social and poverty related expenditures are not reduced below four percent of GDP. - To not issue guarantees, including those on rupee borrowing by public sector enterprises (PSEs), minimum rates of return, output purchase agreements, and all other claims and commitments for any amount exceeding two percent of GDP. According to the proposed Fiscal Responsibility Law, the Government can deviate from the above targets only on grounds of unforeseen demand on its resources due to national security or national calamity, which is to be determined by the National Assembly. To ensure transparency of its performance in the area of debt management, the Government will be required to submit annual and mid-year reports to the National Assembly. The draft Ordinance provides for the establishment of a Debt Policy Coordination Office (DPCO) to serve as a Secretariat to prepare a ten-year debt reduction path to be followed by the Government. The DPCO will be responsible for monitoring and analyzing the performance of the Government against this path and submitting annual reports to the cabinet. If the Government fails to meet the target debt-to-GDP ratios over any two-year period, it would be required to take all necessary actions to return to the debt reduction path delineated by the DPCO by the end of the next two years. These remedial actions, among other things, will include suspension of salaries of cabinet members. 1. This means that there will be no borrowing to finance current expenditure.

simple one for a number of reasons. One, it is not clear whether additional government expenditures can provide a sufficient boost to the economy, given other impediments to investment, such as poor law and order situation, political uncertainty, high utility tariffs, and the state of the global economy. Two, Pakistan's current economic slowdown is not simply cyclical in nature but is also a manifestation of structural problems, which include a huge overhang of public debt. Therefore, counter cyclical spending may provide a short-term boost to the economy that will not be sustainable. Three, higher fiscal and current account deficits, resulting from additional public spending, will not be viewed favorably by the donor community, and may also adversely affect the confidence of foreign investors. Four,

governments' failures in the past to efficiently identify, prioritize, plan and execute development projects casts doubts on the efficacy of government expenditure in generating growth. The only way to increase public expenditure without worsening fiscal and current account balance is through additional revenue mobilization. However, weakness of the tax collection machinery has not so far allowed this to happen. One area where the government can increase expenditure without alienating the donor community is poverty reduction program. Poverty-related expenditures can also boost aggregate demand and generate employment. In the medium to long term, only improvement in governance and greater efficiency in public sector utility companies can increase

In the medium to long term, only improvement in governance and greater efficiency in public sector utility companies can increase investment and put the economy on a higher growth path.

12

PAKISTAN ECONOMIC UPDATE

investment and put the economy on a higher growth path. Stock Market The Pakistan stock market maintained a rising trend during FY2002, while experiencing wide fluctuations due to the traumatic events of 11 September 2001 and tension on border with India (see figure 1). The year-on-year comparison shows that share prices in the Karachi Stock Exchange increased by 29.5 percent and market capitalization rose by 20.2 percent. Weak domestic investor confidence and continued exit of foreign portfolio investors had kept the stock market mostly subdued during the two and half months preceding 11 September 2001. The 11 September 2001 events gave a severe jolt to the already weak market. The KSE-100 Index lost 116 points in just three trading days following 11

Share prices in the Karachi Stock Exchange increased by 29.5 percent and market capitalization rose by 20.2 percent in FY2002.

September and declined to 1075 on 2 October, the lowest point in two years. Subsequently, expectations of significant economic benefits by way of debt rescheduling and inflow of foreign assistance after Pakistan joined the coalition against terrorism gave a boost to market sentiments. The KSE-100 Index rose above 1400 level on 29 October and hovered around that level until the terrorist attack on the Indian Parliament building on 13 December. The fear of war between the two countries triggered by mobilization of troops on their common border again depressed the equity market. However, investor confidence revived as the fear of war receded due to international diplomatic efforts, and the KSE-100 Index crossed the 1900 level on 14 March 2002. Thereafter, the KSE-100 index fluctuated between 1500 and 1900 mainly due to tension on border with India and stood at 1770 as of end-June 2002.

Figure 1 Stock Market Performance September 2001-July 2002

1900 1800 1700 KSE-100 Index 1600 1500 1400 1300 1200 1100 1000
00 18 1 /2 10 001 /3 / 10 200 /1 1 8/ 20 11 0 /2 1 / 11 200 /1 1 7/ 20 12 0 /2 1 / 12 200 /1 1 7/ 20 01 1/ 1/ 2 1/ 002 16 /2 1/ 002 31 /2 2/ 002 15 /2 0 3/ 02 2/ 20 3/ 0 17 2 /2 0 4/ 02 1/ 20 4/ 0 16 2 /2 0 5/ 02 1/ 20 5/ 0 16 2 /2 5/ 002 31 /2 6/ 002 15 /2 6/ 002 30 /2 7/ 002 15 /2 00 2 9/ 9/ 3/ 2

Date

AUGUST 2002

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The corporate debt market remained very active in FY2002, and sixteen term finance certificates (TFCs) were floated for a total amount of Rs 10,171 million compared with ten issues for Rs 6,469 million in FY2001. All issues, except two, were fully subscribed. In a number of cases, there was over-subscription and the green shoe option was invoked. Improvement in the corporate debt market since the fourth quarter of FY2001 has resulted mainly from reforms in National Saving Schemes and the launch of the Pakistan Investment Bond (PIB) by the Government.17

use of civil aviation facilities by the coalition forces against terrorism. The trade balance, though still in deficit, improved due to larger decline in imports than in exports. The deficit in the current account, which had persisted throughout the last two decades, turned into a large surplus in the first eleven months of FY2002. As a result, the country's foreign exchange reserves almost doubled during the year. Exports, which had started slowing down in the fourth quarter of FY2001 due to global recession, were further hurt by the post-11 September developments, and their marginal growth in the first quarter of FY2002 turned into outright declines in the second and third quarters (see figure 2). Only in the fourth quarter did exports rebound and register a growth of 4.2 percent. Although the turnaround in exports was shared by all major export categories, the sharpest recovery was seen in export of Basmati rice and textiles. The upturn was

Pakistan's balance of payments improved significantly during FY2002 due to a sharp increase in remittances and larger inflow of foreign grants.

EXTERNAL SECTOR
Despite the adverse impact of the global economic recession and post-11 September 2001 developments on Pakistan's exports, the country's balance of payments improved significantly during FY2002 due to a sharp increase in workers' remittances, larger inflow of foreign grants, and receipts for the

Exports rebounded in the fourth quarter of FY2002 after declining in the previous two quarters.

Figure 2 Quarterly Trends in Exports & Imports During FY2001 & FY2002 (% Change over Corresponding Quarters of the Previous Year)

20 15 10 % Change 5 0
Q1,01 Q2,01 Q3,01 Q4,01 Q1,02 Q2,02 Q3,02 Q4,02

-5 -10 -15 Exports Imports

17. The rate of return settled in the auction of PIBs serves as a benchmark for TFC issues. For some TFCs, the coupon rate was quoted as rate of return on PIBs plus some margin, with floor and ceiling rates of return.

14

PAKISTAN ECONOMIC UPDATE

Volume of textile exports, which account for two thirds of total export earnings, increased by 5.4 percent in FY2002, despite recession in the global economy.

presumably caused by two factors: one, the adverse impact of the 11 September 2001 events (cancellation of export orders, increase in war risk premium on freight, etc) was over; and two, the global economy started coming out of recession. For the full FY2002, exports declined by a small margin of 0.8 percent (from $9,202 million to $9124 million) in contrast with an increase of 7.4 percent in FY2001. Decline in exports in value terms was caused by both stagnation of export volumes and lower prices, reflecting global recession. Quantum and price indices of exports, for which quantity data is available, show that there was a marginal increase (0.4 percent) in the volume of such exports and decline of 3.0 percent in their prices during FY2002 18 compared with FY2001. In FY2001 also export prices had declined 6.9 percent, but volume had increased sharply by 14.1 percent. The stagnation in exports during FY2002 resulted mainly because of large decline of $150 million, or 15.8 percent in the export of primary products. Non-textile manufactures exports also declined by $38 million. Exports of textile manufactures and miscellaneous items, on the other hand, recorded increases of $39 million and $70 million, respectively. Major contributors to decline in primary commodity exports were cotton, coarse rice, and fish. Export of cotton declined by 82 percent (from $139.3 million to $24.6 million) and that of coarse rice by 36 percent (from $289.1 million to $186.2 million). Sharp decline in cotton exports resulted from lower international prices as well as smaller exportable surplus due to increase in its consumption by the domestic textile industry. Higher domestic prices due to lower production of coarse rice and sharp

appreciation of the Pakistani Rupee rendered Pakistani coarse rice export uncompetitive. However, export of high quality Basmati rice increased by 7.9 percent, increasing its share in total earnings from rice exports from 45 percent in FY2001 to 58 percent in FY2002. Export of fish and fish preparations declined by 8.7 percent in value terms (from $138 million to $126 million), because of lower prices. The decrease in the export of above items was partly offset by increases in exports of wheat and fruits. For the first time, Pakistan exported a significant amount of wheat ($68 million). Textile exports, which account for 87 percent of manufactured exports and almost two thirds of total exports, showed a nominal increase of 0.7 percent during FY2002. Unlike most other exports whose volume had stagnated or declined during the year, volume of textile exports showed an increase. Decomposition of change in export value of textile manufactures, for which quantity data is available, into price and volume effects reveals that quantity of these items increased by 5.4 percent during FY2002, while prices declined by 4.8 percent. Another positive development in textile exports in FY2002 was a shift in their composition from export of low valueadded yarn to higher value-added items. The share of the latter in textile exports increased from 81 percent to 84 percent. The value of exports of a number of value-added textile manufactures showed significant increases during FY2002 due to increase in their volume. Volume increases were quite substantial in some cases. For instance, quantum exports of bedwear, readymade garments, towels, and cotton fabrics increased by 22 percent, 18 percent, 18 percent, and 13 percent, respectively.

18. Exports, for which quantity data is available, accounted for 83.2 percent of the total value of exports in FY2002.

AUGUST 2002

15

Despite decline in prices in most cases, total exports of these four items increased by 12.6 percent (from $2,845 million to $3,203 million). Increase in the volume of exports of cotton fabrics and bedwear in the second half of the year was higher than in the first half, reflecting greater access to the European Union markets. Growth in exports of towels and readymade garments, however, slowed down in the second half of the year. Increases in the above items were almost completely offset by decreases in art silk and synthetic textiles and knitwear, which showed large declines of 21.9 percent and 8.6 percent, respectively, in their quantum exports. In value terms their exports declined 24.8 percent and 7.7 percent. Knitwear, the bulk of which goes to the USA, was adversely affected by the post-11 September 2001 developments. The decline in its export occurred largely in the second and third quarters of the year. Export of non-textile manufactures, which include carpets, leather and leather manufactures, sports goods, and petroleum and petroleum products, experienced a decline as a group in FY2002 after doing well in the previous year. Of these, carpets and leather manufactures, excluding shoes, suffered large declines of 19 percent (from $289 million to $233 million) and 13 percent ($426 million to $370 million), respectively, in FY2002. Since carpets and leather manufactures are generally considered as luxuries, the impact of the global recession on their exports was most severe. However, petroleum products recorded an increase of 18 percent due to the full year operation of the Pak Arab Refinery Company, which started production in September 2000. Deceleration of imports, which had started in the beginning of FY2001, continued through the second quarter of FY2002. Upturn came in the third quarter, although growth was still negative, which turned into outright increase of 11 percent in the fourth quarter (see figure 2). The turnaround in

imports was broad-based, with the sharpest upturn occurring in the case of food group (mainly because of a sharp increase in palm oil imports), machinery, petroleum products, and raw materials and intermediate goods. In most cases, where quantity data is available, quantity also showed an increase in the fourth quarter. The upsurge in imports took place despite the knowledge that the maximum rate of tariff would be reduced from 30 percent to 25 percent effective July 2002. For the full year, however, total imports declined by 3.7 percent (from $10,729 million to $10,336 million). The decline in imports is accounted for by declines in the food group (17.7 percent, from $990 million to $815 million), petroleum and petroleum products (16.6 percent, from $3,361 million to $2,802 million) and fertilizers and chemicals - including medicines (2.3 percent, from $1,902 million to $1,858 million). These declines were partly counterbalanced by increases in imports of machinery, metals, and raw materials for textiles, which rose by 6.7 percent, 19.1 percent, and 13.8 percent, respectively. The decline in imports of food items is mainly attributable to sugar, which declined to $23 million from $252 million in FY2001. Large stocks carried over from the previous year and higher domestic production during FY2002 contributed to decrease in sugar imports. Imports of palm oil and pulses, on the other hand, recorded increases. Import of palm oil increased by 33 percent, mainly due to higher international prices, although volume of imports also increased. Because of insufficient domestic production of pulses over the last several years due to continuing drought, their imports increased by 18 percent in FY2002. Import of machinery, which had plummeted in the second and third quarters

The upturn in imports in the fourth quarter was broad-based.

16

PAKISTAN ECONOMIC UPDATE

There was an unprecedented surplus of $2.7 billion in the current account of the balance of payments in the first 11 months of FY2002.

of FY2002, reflecting erosion of investor confidence after the 11 September 2001 events, recorded a sharp increase of 33 percent in the fourth quarter. Substantial increases were seen in the imports of aircraft, ships and boats (300 percent), power generating machinery (31 percent), office equipment including computing machines (23 percent), and electric machinery (8.1 percent). However, import of textile machinery, which had shown substantial increases in the first three quarters, declined by 10 percent in the fourth quarter. Growth in the import of construction machinery also slowed down in the final quarter, although it still remained positive at 9 percent. Imports of intermediate goods and raw materials recorded strong growth in FY2002, particularly in the fourth quarter of the year. Only in the case of metals, was there a slowdown in the fourth quarter due to the build-up of inventories in the first three quarters of the year. For the year, as a whole, inputs for the textile sector showed a 16 percent increase in imports. Import of iron and steel, iron and steel scrap, and aluminum increased by 20 percent, 16 percent, and 15 percent, respectively. Import of motor vehicles, mostly knocked down kits for local assembly, picked up in the second half of the year due to stepped up production by the domestic assembly plants in response to an upsurge in demand for automobiles. Their import increased by 26 percent in the second half of the year, in contrast with a decline of 19 percent in the first half. Quantum import of fertilizers and insecticides recorded large increases of 24 percent and 45 percent, respectively. The quarterly analysis shows that the largest increase in the import of fertilizers and insecticides in terms of volume occurred in

the fourth quarter of the year. Increase in the volume of fertilizer imports may be due to discontinuation of production of DiAmmonium Phosphate by FFC-Jordan Fertilizer Company. An upturn in imports, particularly those of raw materials, intermediate goods and machinery, provides signs of a turnaround in the economy. Current Account The balance of payments data available for the first 11 months of FY2002 shows a large surplus of $2.7 billion in the current account compared with a very nominal surplus of $0.1 billion recorded in the previous year (see table 3). The improvement in the current account of the balance of payments was broad-based, as all the three components of the current account showed improvement. The movements in various components are discussed below.

The trade deficit declined to $262 million in the first 11 months of FY2002 compared with a deficit of $1,238 million in the corresponding period of FY2001.19 The trade deficit based on physical movements of goods was $1,196 million for the first 11 months of FY2002 compared to $1,554 million in corresponding period of FY2001. The difference between trade balance derived through these two methods for FY2002 is too large to be explained by leads and lags. Without information on earlier realization of export bills, triggered by significant appreciation of the Rupee after September, it is hard to explain this large difference. In any case, it does imply that the current account balance (surplus) in FY2001 is probably understated and that in

19. The trade balance numbers quoted here are derived from export receipts and import payments based on foreign exchange transactions and, because of leads and lags, differ from trade numbers based on the physical movement of goods across the borders discussed earlier.

AUGUST 2002

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Table 3 Balance of Payments

(Million $) July - June FY00 Trade Balance Services (Net) Current Transfers (Net) Of which: Workers Remittances Official Transfers Purchases from Kerb Market Current Account Balance Current Account Balance (Excluding Official Transfers) Capital Account (Net) Changes in Reserves (-Inc/+Dec) Errors and Omissions Exceptional Financing
* Provisional Source: www.sbp.org.pk : 29 July 2002.

% Change

July - May FY01 FY02* -262 -2,362 5,288 2,123 1,366 1,376 2,664 1,298 -1,608 -2,050 788 206

% Change

FY01 -1,269 -3,142 4,737 1,087 839 2,157 326 -513 -644 -1,000 626 692 -10 12 19 11 -9 29 -55 -85 1,289 25 -83

-1,412 -2,794 3,989 983 926 1,673 -217 -1,143 -4,176 -72 499 3,966

-1,238 -2,877 4,227 1,001 786 1,891 112 -674 -1,102 -181 494 677

-79 -18 25 112 74 -27 2,279 46 1,033 60 -70

FY2002 overstated.

There was a substantial reduction of $515 million (or 18 percent) in the deficit in the services account, mainly reflecting receipts of about $350 million from the USA against logistic support provided for war in Afghanistan. Reduction in interest payments, due to the falling stock of foreign private loans and FE45 deposits, and lower payments for shipping due to smaller trade volumes also contributed to a smaller deficit in the services account. Net current transfers increased to $5.3 billion in the first 11 months of FY2002 (compared with of $4.2 billion in the corresponding period of FY2001) mainly due to a sharp increase in

workers' remittances and official transfers in the post-September 2001 period. For the first 11 months of the year, remittances at $2,123 million showed an increase of 112 percent over the previous year, and official transfers at $1,366 million were 76 percent higher. (For detailed analysis of factors contributing to higher remittances, see Pakistan Economic Update: April 2002.) While official transfers dropped to more or less their normal level in the second half of the year, growth in remittances continued unabated. The SBP's outright purchase of foreign exchange from the kerb market declined to $1,376 million compared with $1,891 million purchased in the previous year, reflecting the

The sharp increase in workers' remittances, which started in the second quarter of FY2002, continued unabated during the second half of the year.

18

PAKISTAN ECONOMIC UPDATE

reduced need for building up reserves (see box 4).20 Capital Account
The capital account balance worsened in FY2002 mainly because of a deliberate policy of the SBP to pay off expensive debt and short-term liabilities.

The capital account balance worsened in the second half of FY2002, resulting in a cumulative deficit in the capital account of $1,608 million in the first 11 months of the year compared with $1,102 million in the same period of the previous year. The deterioration resulted mainly from a deliberate policy of the SBP to pay off expensive debt and short-term liabilities. For instance, SBP repaid $250 million maturing Special US Dollar Bonds in the third quarter of the year. Also, there were larger net outflows under long-term capital,

including project aid and food aid, and a net outflow of $254 million under official assistance in contrast with an inflow of $157 million. Net foreign direct investment, on the other hand, increased to $331 million in the first eleven months of FY2002 compared with $289 million in the corresponding period of FY2001. Foreign Exchange Reserves Foreign exchange reserves of the SBP, which had almost doubled in the second quarter, continued to increase in the third and fourth quarters of FY2002, albeit at a slower pace. The slowdown in the build up of reserves in the second half of the year reflected the SBP's greater emphasis on

Box 4 SBP's Purchases from the Kerb Market

The SBP has been undertaking purchases of foreign exchange from the kerb market to replenish foreign exchange reserves since the imposition of sanctions on Pakistan by G-7 countries following the May 1998 nuclear tests. Prior to that also substantial amount of foreign exchange was available in the kerb market and was being purchased by individuals and institutions and kept in their resident foreign currency accounts (FCAs). At that time, banks had to surrender (swap) the foreign exchange deposited in FCAs to the SBP in exchange for Pakistan rupees. The foreign exchange thus acquired by the SBP was used to finance imports. However, the SBP was under obligation to return the foreign exchange to banks when demanded by FCA holders. This increased the vulnerability of the SBP, as it accumulated liabilities in foreign exchange without building up matching assets. Thus when the crunch came after the nuclear tests in 1998, the SBP had to default on FCAs, which were frozen in May 1998. Under the present arrangement, the SBP is undertaking direct and outright purchases (instead of previous swaps through banks) of foreign exchange in the kerb market. In a way, this is an improvement over the previous arrangement, as no liabilities in foreign exchange are being accumulated. This practice has also been justified as a means of capturing remittances of overseas Pakistani workers, which came through the Hundi system due to a large differential between exchange rates prevailing in the kerb and inter-bank markets prior to 11 September 2001. A positive development in the post-September period has been that the bulk of foreign exchange has been purchased by the SBP from the inter-bank market. The purpose of these purchases in the inter-bank market is to prevent further appreciation of the Pak Rupee, which would have undermined the competitiveness of Pakistan's exports. This is a normal activity undertaken by central banks all over the world. Purchases from the inter-bank market do not add to the country's total foreign exchange reserves; they only change the composition of reserves by adding to reserves with the SBP and reducing by an equivalent amount the reserves held by commercial banks.1

1.

Purchases from the inter-bank market are made from a pool of foreign exchange already included in inflows in the current account. Hence these purchases do not form part of current transfers shown in balance of payments.

20. SBP's purchases from the kerb market are shown under current transfers in the balance of payments.

AUGUST 2002

19

settling expensive debt and short-term liabilities, which will improve the country's future cash flows. As of end-June 2002, SBP's reserves stood at $4,333 million compared with $1,677 million on 30 June 2001. Reserves increased further to $4,883 21 by 3 August 2002. The underlying factors responsible for the large build-up of foreign exchange reserves during the year are the same as discussed earlier in the context of improvement in balance of payments. Besides providing stability to exchange rate, higher level of reserves can be a source of comfort to foreign investors. External Debt Restructuring In December 2001 Pakistan signed the debt restructuring agreement with the Paris Club. Unlike the two earlier agreements that provided relief only against debt service payments, the new agreement covers the entire stock of debt owed to the Paris Club creditors on the cut-off date of September 1997. Pakistan was granted a repayment period of 38 years with a grace period of 15 years for ODA loans and 23 years with a grace period of 5 years for non-ODA loans. The Paris Club creditors also decided to defer for three years all amortization payments on post cut-off date debts and interest on restructured loans falling due between 30 November 2001 and 30 June 2002. In addition, 20 percent of interest payments due in the next two years will also be deferred. It is estimated that Pakistan will get a saving of $2.7-3.0 billion in the 3-year PRGF period and $8.5-11.1 billion over the grace period. Expected reduction in the net present value ranges from 27 percent to 43 percent. (For details see Pakistan Economic Update: April 2002).

OUTLOOK
Pakistan made further progress in economic stabilization during FY2002, despite adverse effects of global recession, post-11 September 2001 developments, and tensions on border with India. Inflation was lower, the current account balance recorded unprecedented improvement, and foreign exchange reserves rose to a level never achieved before. The underlying fiscal deficit also remained more or less on track. With sound macroeconomic fundamentals, the economy should be able to realize the growth target of 4.5 percent in FY2003. Given that inflation has shown an upturn toward the end of FY2002 and petroleum prices have risen, inflation is expected to rise to around 5 percent in FY2003. The budgetary deficit target of 4.4 percent, however, seems very ambitious and will be difficult to achieve. Recent heavy rains throughout Pakistan, and the more rains forecast for the remaining part of August, have improved the prospects of the rice and sugarcane crops, standing in the fields at present. Wheat to be sown in November-December and other winter crops will benefit from greater availability of water (than in the past three years) in the two major water reservoirs. Impact of heavy rains on cotton is somewhat uncertain, as greater moisture provides better environment for breeding of pests and viruses, which damage the cotton crop. Nevertheless, the overall outlook for the agriculture sector has improved, and the sector is likely to grow by around 3 percent in FY2003.
Foreign exchange reserves of the SBP increased by more than two and half times during the year.

With sound macroeconomic fundamentals and improved outlook for agriculture after recent rains, the economy should be able to realize a growth rate of 4.5 percent in FY2003.

21. The country's total foreign exchange reserves, including reserves held by commercial banks, stood at $7,047 million on 3 August 2002.

20

PAKISTAN ECONOMIC UPDATE

If the Government continues to pursue sound macroeconomic policies and implement economic and governance reforms, it should be possible to achieve a growth rate of 5.0 percent in FY2004.

Growth of the industry sector is expected to improve to around 5 percent in FY2003 because of improvement projected in the performance of its main components. For instance, the upturn in large-scale manufacturing, observed in the MarchApril 2002 period, is likely to continue in FY2003. Electricity generation also will benefit from greater availability of water in reservoirs. The sharp increase in remittances last year, which is likely to continue in FY2003, will give boost to construction activity. The services sector also may get boost from election spending. Both exports and imports seem to have bottomed out and experienced a significant upturn in the last quarter of FY2002, which 22 is likely to continue in FY2003. If the global economy picks up, the country's exports will further benefit. In addition, greater access to the European Union markets available since January will help. With anticipated revival of domestic economic activity and higher oil prices, imports will also increase. However, trade deficit is likely to remain within the target of around $1 billion, or 1.5 percent of GDP.23 Some exceptional current transfers like grants will not be available next year, but remittances are likely to be sustained at high level achieved in FY2002, as these have mostly resulted from a shift from the hundi system to the banking channels. Overall, the large surplus recorded in the current account in FY2002 is not likely to repeated in FY2003. The medium-term prospects for the Pakistan economy have improved. Investor

confidence has been partly restored by a number of post-September 2001 developments. Increased access to European Union markets and rescheduling of debt are likely to have the greatest medium- and long-term benefits for the economy. Besides, modernization of the textile industry underway for the last couple of years has started showing results in the form of substantial increase in the industry's output and in export volumes despite global recession. If the Government continues to pursue sound macroeconomic policies and to implement the planned economic and governance reforms, it should be possible to achieve the growth target of 5.0 percent, set for FY2004 in the medium-term macroecoomic framework under the PRGF (see table 4). The risks to the above scenario are posed by the possibility of continuing tensions on border with India, political uncertainties regarding the outcome of general elections to be held in October, and ambiguities surrounding the future course of the global economy. Although tensions with India have cooled down for the time being, the armed forces of the two countries have not been withdrawn from the border. Consequently, any mishap can again raise tensions between the two countries. On the domestic front, there is no certainty that the Government, which comes to power after the October elections, will continue with the policies of the present Government. There are mixed signals on the short-term prospects of the global economy and its slow recovery from recession could continue to depress Pakistan's exports.

22. Preliminary trade data, now available for July 2002, shows a 19 percent increase in exports and 17 percent increase in imports over the corresponding month of last year, indicating continuation of the uptrend observed in the fourth quarter of FY2002. 23. The Government has set target of 13.4 percent growth in exports, 7.4 percent growth in imports and a trade account deficit of $700 million for FY2003 in its recently announced Trade Policy. We think exports will grow at lower rate.

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Table 4 Medium-term Outlook

Projections FY2002 FY2003 FY2004

(Annual changes in percent) Real GDP Agriculture Industry Of which: Large-Scale Manufacturing Services Merchandise Exports Merchandise Imports Inflation Rate (CPI) 3.6 1.4 2.8 4.0 5.1 -0.8 -3.7 2.8 4.5 3.0 5.0 6.0 5.5 10.0 7.0 5.0 (In percent of GDP) Consolidated Budgetary Deficit Trade Balance Current Account Balance (Excluding Official Transfers) -7.1 -2.0 2.3 -5.0 -1.5 1.0 -4.0 -1.2 0.3 5.0 4.0 5.0 6.0 5.5 10.0 8.0 5.0

Source: 1. Pakistan Economic Survey 2001-2002. 2. Pakistan: Second Review Under Three-Year Arrangement Under Poverty Reduction and Growth Facility,IMF, 11 July 2002. 3. ADB Staff Estimates.

II. SPECIAL TOPIC FEDERAL BUDGET 2003

The federal budget for FY2003, announced on 15 June, is the first budget prepared within the parameters set in the medium-term macroeconomic framework agreed, under the PRGF FY2002-2004, with the IMF. As such, it reflects the continuation of efforts at consolidating macroeconomic stability and further deepening of structural reforms initiated in FY2001. For the first time in the country's history, Federal Government's expenditure is projected to decrease during FY2003 compared with revised estimates for the outgoing year. This is mainly due to three

factors: (1) the base effect of one-time expenditures incurred during FY2002; (2) the ongoing devolution of fiscal responsibilities and resources to lower levels of government; and (3) a decline in defense expenditure.

FISCAL OUTCOME FY2002

The post-September 2001 developments put Pakistan's fiscal situation under severe strain. Even prior to the 11 September 2001 events, receipts from traderelated taxes had started declining due to a sharp fall in imports resulting from the global recession. Other tax receipts also fell short of the target set in the budget as

The federal budget for FY2003 reflects the continuation of efforts at macroeconomic stabilization and further deepening of structural reforms.

22

PAKISTAN ECONOMIC UPDATE

Net tax receipts of the CBR in FY2002, at Rs 404 billion, were 11.8 percent lower than the budget estimates.

domestic economic activity, particularly the large-scale manufacturing sector, slowed down. On the expenditure side, there were large overruns mainly due to an increase in defense expenditure resulting from tensions on the borders and some large one-time expenditures like equity investment in KESC (shown under net lending) and clearing of accumulated backlog of tax refund claims of banks (appearing under grants, table 5). Total revenues of the Government in FY2002 fell short of the original budget estimates, mainly because of lower tax receipts. The shortfall in tax receipts was partly offset by increases in receipts from petroleum surcharge and non-tax receipts. The latest available data show that net tax receipts of the CBR, at Rs 404 billion, were 11.8 percent lower than the budget esti24 mates. There was only a nominal increase of 3.0 percent over the FY2001 collection, compared with an increase of 13.5 percent in FY2001. Gross tax revenues, however, increased by 6.7 percent in FY2002 compared with an increase of 11.3 percent in FY2001. The greater slowdown in net tax collection during FY2002 was due to a sharp increase in payment of rebates to clear the backlog, which resulted from the government's policy to provide support to exporters under difficult external conditions. As a percentage of GDP, federal tax receipts declined from 11.5 to 10.8. To compensate for lower tax receipts the government increased petroleum surcharge as petroleum prices declined. Receipts from petroleum surcharge were 21.9 percent higher than budget estimates and more than double that in FY2001. Non-tax receipts also showed a

sharp increase of 46.7 percent compared with the last year, mainly because of large payments received for the use of the country's civil aviation facilities by the coalition forces in their war in Afghanistan, and larger dividend receipts from the Oil and Gas Development Corporation 25 (OGDC). Non-tax receipts were also 18.4 percent higher than the budget estimates. As a result, total revenues of the Government in FY2002 increased by 16.3 percent compared with FY2001, but fell short of the original budget estimates by 3.3 percent. The ratio of total revenues to GDP increased from 15.7 percent in FY2001 to 16.7 percent in FY2002. Shortfalls in tax receipts during FY2002 were shared by all CBR taxes, with receipts from custom duties being as much as 38.2 percent below the budget estimates and 33.8 percent below actual collection in FY2001. In addition to decline in imports, lowering of the maximum rate of import tariff from 35 percent to 30 percent in the last year's budget, and substantial appreciation of the Pakistan rupee after September 2001 contributed to smaller customs receipts. Receipts from sales tax, which has been the star performer in the ongoing tax reforms, also failed to reach the budgetary target (falling short by 12.0 percent), because of the continued slowdown of economic activity. Sales tax collection was, however, 6.1 percent higher than in the preceding year. Direct taxes, which showed an increase of 12.3 percent over FY2001, also fell short of budget estimates by 6.6 percent. The Government's total expenditure in FY2002 exceeded the budget estimates by

Federal tax receipts declined from 11.5 percent of GDP in FY2001 to 10.8 percent in FY2002.

24. Net receipts from CBR taxes in FY2002, according to revised estimates given in budget documents, were Rs 414 billion -- 9.5 percent lower than budget estimates, but 5.6 percent higher than actual collection in FY2001. However, it is now obvious that the Government had overestimated its tax collection at the time of preparing the FY2003 budget and the actual tax receipts were only Rs 404 billion, according to the latest data released by the CBR. The analysis of tax receipts in this note is based on the latter number. 25. Higher profits of OGDC in FY2001 due to higher international prices of oil resulted in larger dividend receipts for the federal government in FY2002.

AUGUST 2002

23

Table 5 Summary of Federal Government Fiscal Operations

Prov. Actual 2000 - 01 Budget Estimate 2001 - 02 Revised Estimate* 2002 - 02 Billion Rs Total Revenue Receipts Tax Revenue Direct Taxes Indirect Taxes Of which: Sales Tax Surcharges Of which: Petroleum Non Tax Revenue Provincial Share in Taxes Net Federal Revenue Total Expenditure Current Expenditure Of which: Interest Payments Defense Running of Civil Govt. Grants Subsidies Development Expenditure Net Lending Federal Budget Deficit Nominal GDP (MP) 535.1 392.2 124.6 267.7 153.6 30.5 17.9 112.3 163.1 372.0 577.2 527.9 234.7 131.1 83.2 36.9 20.4 66.9 -17.6 -205.2 3411.3 643.8 457.7 149.8 307.9 185.2 47.0 32.0 139.1 190.0 453.8 655.9 552.6 260.1 131.6 80.6 49.3 20.7 100.0 3.3 -202.1 3726.6 632.8 (622.5) 414.2 (403.9) 146.5 (142.6) 267.7 (261.3) 170.1 (166.3) 53.9 39.0 164.7 175.1 (170.4) 457.7 (452.1) 716.4 581.8 253.3 151.7 84.7 66.3 25.6 95.5 39.1 -258.7 (-264.3) 3726.6 674.9 460.6 148.4 312.2 205.7 60.5 45.5 153.8 193.5 481.4 660.9 563.2 244.9 146.0 92.7 56.3 20.8 90.0 7.7 -179.5 4080.6 Budget Estimate 2002 - 03

Percentage of GDP Total Revenue Tax Revenue Net Federal Revenue Total Expenditure Current Expenditure Interest Payments Defense Development Expenditure Fiscal Deficit 15.7 11.5 10.9 16.9 15.5 6.9 3.8 2.0 -6.0 17.3 12.3 12.2 17.6 14.8 7.0 3.5 2.7 -5.4 17.0 (16.7) 11.1 (10.8) 12.3 (12.1) 19.2 15.6 6.8 4.1 2.6 -6.9 (-7.1) 16.7 11.4 11.9 16.3 13.9 6.1 3.6 2.2 -4.4

* As per budget documents. Figures in parentheses are based on latest estimates of tax receipts released by the CBR.

24

PAKISTAN ECONOMIC UPDATE

9.2 percent and was 24.1 percent higher than actual expenditure in FY2001. There were overruns in the current expenditure (5.3 percent) and net lending to provincial governments, local authorities and PSEs. Development expenditure showed a shortfall of 4.5 percent compared with budget estimates, but exceeded actual expenditure in FY2001 by 42.8 percent. As a percentage of GDP, total expenditure increased from 16.9 in FY2001 to 19.2 in FY2002.
Due to mobilization of forces on border with India, defense expenditure increased for the first time in eight years from 3.8 percent of GDP to 4.1 percent.

in the GST allowed to consumers. The overrun in current expenditure would have been larger but for saving in interest payments on both domestic and foreign debt, which were 2.6 percent lower than budget estimates. Overruns in net lending of the Government to provincial governments, PSEs and local authorities resulted from a large equity investment in, and loans to, KESC (Rs 87 billion compared with Rs 19 billion provided in the budget). On the other hand, loans to WAPDA and Pakistan Insurance Corporation were lower than provided for in the budget. There was nil disbursement to WAPDA on account of an ADB loan budgeted at Rs 2.5 billion and no lending to Pakistan Insurance Corporation compared with Rs 0.6 billion envisaged in the budget. In the absence of detailed revised estimates for FY2002, it is not possible to comment on the large increase in development expenditure during the year under the Federal Public Sector Development Program (PSDP) compared with the previous year. Similarly, it is not possible to fully discuss reasons for the shortfall compared with the budget estimates for the year. On the basis of very sketchy information, it appears that the shortfall was primarily due to delays in implementation of donor-funded projects. The utilization of project aid was 14.3 percent lower than the budget estimates. The Federal Government's fiscal deficit during FY2002 was much larger than originally envisaged in the budget. At 7.1 percent of GDP, it was the highest since FY1998 and exceeded the budget estimate for the year by 1.7 percentage points. The deficit included one-time expenditure of Rs 52 billion. These one-off expenditures were

Among the current expenditures, defense expenditure in FY2002 was 15.3 percent higher than the budget estimate for the year because of mobilization of armed forces on borders with India in the second half of the year. There was also deployment of forces on borders with Afghanistan. As a percentage of GDP, defense expenditure increased for the first time in the last eight years from 3.8 in FY2001 to 4.1 in FY2002. Grants to provincial governments, local authorities and PSEs showed a large increase of 34.5 percent over the budget estimates and 79.7 percent compared with FY2001. The increase in grants resulted mainly from an issue of Rs 22 billion bonds to banks to clear their accumulated claims for income tax refunds. No provision had been made for this purpose in the budget. The overrun was partly offset by lower outlays on the banking sector reforms. The Government's grant to the Pakistan Railways also exceeded the budget estimates by 25 percent. Subsidies also showed a substantial overrun (23.7 percent) compared with both budget estimates for the year and actual outlay in the preceding year, mainly due to increase in subsidy paid to oil refineries and payment of arrears to WAPDA on behalf of the Azad Kashmir Government. The Government also paid Rs 9.5 billion to WAPDA (14 percent higher than budget estimate) on account of subsidy

AUGUST 2002

25

on account of Rs 30 billion equity injection in KESC 26and Rs 22 billion bonds issued to banks to clear the backlog of their income tax refund claims. After adjusting for these one-time expenditures, the overall fiscal deficit at 5.7 percent of GDP is only marginally higher than the target of 5.4 percent, set in the FY2002 budget. However, expenditures like equity injection in KESC may not be one off expenditures. As long as loss making PSEs are not privatized, their accumulated losses (and non-performing loans of financial institu-

tions) remain the contingent liabilities of the Government which will have to be absorbed in the future budgets (see box 5).

BUDGET FY2003
The FY2003 federal budget clearly reflects the Government's commitment to continue macroeconomic stabilization and structural reforms. The fiscal deficit is projected to decline 4.4 percent of GDP. Additional reforms have been introduced in the area of income tax, sales tax and import

As long as loss making PSEs are not privatized, their accumulated losses will have to be absorbed in the future budgets.

Box 5 Government's Contingent Liabilities

The Government has been issuing financial guarantees in the past, mainly on loans contracted by PSEs and rate of return on investments in certain businesses like oil refineries. On the average, the Government issued guarantees amounting to 0.7 percent of GDP per annum during the last 11 years. Although these guarantees do not appear as expenditure in the Government's budget when they are issued, they become part of the budget as soon as guarantees are called. Hence these are explicit contingent liabilities of the Government. Due to persistent losses incurred by major PSEs, they have not been able to service their debt and consequently more and more government guarantees are being called. The Government incurred an expenditure of Rs 17.6 billion in FY2002 on account of its explicit contingent liabilities and another Rs 22.5 billion has been allocated in the FY2003 budget for the purpose. In addition, there are implicit contingent liabilities of the Government, which are not its legal obligations, but do accrue due to the necessity of bailing out strategically important corporations and banks. If these corporations, like WAPDA and KESC, and banks are allowed to go bankrupt, there will be a serious disruption of economic activity. The impact of these bailouts, mainly on account of equity injections in KESC and WAPDA (mainly by converting their debt into equity) and failure of these two public sector energy companies to service their debt to the Government, was to the tune of Rs 117.6 billion in FY2002. This was meant to clean up for the past losses of these enterprises. The FY2003 budget envisages an expenditure of Rs 13.1 billion on this account. Non-performing loans (NPLs) of banks and development finance institutions (DFIs) in the public sector are another major source of implicit contingent liabilities of the Government. As of end-March 2002, NPLs of state-owned banks and DFIs stand at Rs 223 billion. It is evident that the financial guarantees provided by the Government in the past are coming home to roost and are putting a burden on the budget. As the Government tries to privatize some loss-making enterprises, their accumulated losses will have to be absorbed. Some of their liabilities also may have to be assumed by the Government to prepare them for sale to the private sector, as happened in the case of KESC last year. With the opening up of the economy, financial losses of some PSEs, operating behind the protection wall of high tariffs in the past, may increase unless they improve their productivity. Past efforts to improve productivity have not worked. The Government must privatize these PSEs as quickly as possible. Failure to improve productivity of PSEs or privatize them could result in more and more contingent liabilities becoming actual liabilities of the Government and drain on the budget.

26. Equity injection in KESC given in budget documents, at Rs 83 billion, exceeded the budget estimate by Rs 65 billion. However, according to the Ministry of Finance officials, one-off equity investment in KESC was only Rs 30 billion. Therefore, it is not clear how the remaining excess investment in KESC can be characterized.

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PAKISTAN ECONOMIC UPDATE

tariffs, besides rationalizing labor levies and improving the rules governing corporate mergers.

budgeted to decline by as much as 80 percent because of the base effect of a very large expenditure under this head last year because of the equity injection in KESC. Within current expenditure, which accounts for 85 percent of total federal expenditure, debt servicing, defense expenditure, grants, and subsidies are to decline by substantial margins. Reprofiling of bilateral foreign debt approved by the Paris Club of creditors in December 2001, and substitution of expensive short-term debt with loans on concessionary terms are expected to result in a decrease of 12.7 percent in interest payments on foreign debt. Interest payments on domestic debt also are to decline marginally because of lower interest rates prevailing in the domestic market. Defense expenditure is projected to decline by 3.8 percent following the sharp increase in this category last year. This decrease, however, is contingent on easing of tensions with India. Development expenditure of the Federal Government is budgeted to decline in FY2003, as responsibilities for development are devolved to provincial and district governments (see box 6).28

Fiscal Stabilization
Stabilization efforts in FY2003 will rely largely on expenditure control and devolution of some federal expenditure to provincial and district governments. The decline of 2.7 percentage points in federal fiscal deficit is less than the 2.9 percentage point reduction in expenditure. Net revenues of the Federal Government (i.e., net of transfers to provinces) are projected to decline marginally by 0.2 percent of GDP. Even after adjusting for the impact of exceptional receipts on account of the use of civil aviation facilities by coalition forces for war in Afghanistan, there will be only a marginal increase in revenues as a percentage of GDP.27 The Government's total expenditure is projected to decline by 7.7 percent to Rs 661 billion in FY2003. The decrease in expenditure will be shared by both current and development expenditure, which will decline by 3.2 percent and 5.8 percent, respectively. Net lending to provincial governments, local bodies, and PSEs is

Reprofiling of bilateral foreign debt and retirement of expensive shortterm debt are expected to result in a decrease of 12.7 percent in interest payments on foreign debt in FY2003.

Box 6 Devolution of Fiscal Responsibilities and Resources

As part of the ongoing devolution program, the Federal Government has shifted some additional financial responsibilities along with funds to provincial and district governments. Khushal Pakistan Program, under which small development schemes are undertaken in low-income areas, was funded by the Federal Government last year and implemented by the local governments. This year responsibility for financing the program also has been shifted to the provincial and and local governments. As such the allocation for this program in the Federal Public Sector Development Program for FY2003 is nil compared with Rs 7 billion in FY2002. Similarly, funding responsibility for the village electrification (Rs 500 million in FY2002) has been devolved to provincial and district governments. On the resource side, the Federal Government will transfer additional revenues of Rs 13 billion to provincial and local governments.

27. After excluding exceptional receipts, net revenue receipts as a percentage of GDP are projected to increase from 11.6 in FY2002 to 11.9 in FY2003. 28. The size of the provincial Public Sector Development Program is to increase by 46.7 percent to Rs 44 billion in FY2003.

AUGUST 2002

27

Gross revenue receipts are projected to increase by 8.4 percent to Rs 675 billion, and net revenue receipts (after adjusting for transfers to provincial governments) by 6.5 percent to Rs 481 billion in FY2003. The increase in revenues is to come from a 14.0 percent increase in receipts from CBR taxes and a 12.2 percent increase in surcharges. After adjusting last year's net CBR tax receipts for about Rs 15 billion one-time expenditure to clear the backlog of tax refunds, tax receipts are projected to increase by 10.0 percent. Non-tax revenues are projected to decline by 6.6 percent. The bulk of the increase in tax receipts is to come from GST, which is expected to increase by 23.7 percent because of anticipated revival of economic activity and extension of its coverage to vegetable ghee and medicines. Receipts from import duties, which have shown a declining trend over the last six years, are budgeted to increase by 17.5 percent mainly due to exceptionally large payments of tax refunds in FY2002 to clear the backlog (see footnote 17, p. 12). After making adjustment for the base effect, receipts from customs will stay more or less at the FY2002 level, which is realistic, considering a 5-percentage point reduction in maximum tariff rates and a 7 percent increase expected in imports. However, the increase in GST even after adjusting for the base effect is about 21 percent. With about 6-7 percent increase expected to come from growth in large-scale manufacturing and imports, extension of coverage will be required to contribute a 14-15 percent increase in GST receipts, which is too optimistic. Collections from excise duty are budgeted to increase by 6.6 percent after declining continuously over the last four years. Considering that excise duty on ten more items is being withdrawn this year, the projected increase in receipts from excise duty also seems too optimistic to be realized. The lowest increase (4.1 percent) is forecast in direct taxes. This is much less

than last year, but realistic given reduction in corporate tax rates and teething problems expected in the implementation of the newly introduced self-assessment system. Non-tax revenues are projected to decline mainly because of lower receipts from civil aviation facilities, as their use by coalition forces for war in Afghanistan tapers off. Government's dividend receipts from its investment in PSEs, included in non-tax receipts, are also budgeted to decline mainly due to lower transfers from OGDC. Lower international prices of oil last year reduced OGDC's profits, which will result in smaller dividends for the Government during the current year. The unrealistically high projection of receipts from GST makes doubtful the realization of the fiscal deficit of 4.4 percent of GDP in FY2003. Also, as pointed out above, some items, treated as one-time expenditures in FY2002, may be required again during the current fiscal year, which would further raise the deficit. Structural Reforms The FY2003 budget further deepens the structural reforms, particularly in the area of taxation. Additional tax reforms, like introduction of the self-assessment scheme and a program to rationalize the corporate tax rate structure, were announced, while continuing reduction in import tariffs. The vision of the federal budget regarding the tax policy is based on four principles: (1) simplification of the tax regime by gradually eliminating withholding taxes, withdrawing exemptions, and reducing the number of the Statutory Regulatory Orders (SROs); (2) reform of the income tax; (3) expansion of the GST base; and (4) continuing trade reform through tariff reduction. The measures announced in the budget will result in a further improvement in taxation structure, which plays a major role in
The unrealistically high projections for tax receipts make doubtful the realization of the Federal Government's fiscal deficit of 4.4 percent of GDP in FY2003.

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PAKISTAN ECONOMIC UPDATE

resource allocation, mobilization of revenues, and redistribution of incomes. As a result of ongoing tax reforms, GST is emerging as the tax of the future. It will contribute 45 percent of total CBR tax collections in FY2003, up from 41 percent in FY2002 and only 20 percent six years ago (see figure 3). The share of direct taxes is

budgeted to decline temporarily from 35.4 percent to 32.2 percent because of the teething problems expected in the implementation of the self-assessment scheme and reduction in corporate tax rates. However, their share still remains on the rising trend line and is higher than in any of the five years preceding FY2002. The share of taxes on international trade will stay more

Figure 3 Composition of CBR Taxes

FY1997
Customs 30% Direct Taxes 30%

Central Excise 20%

Sales Tax 20%

FY2002
Customs 12% Central Excise 12% Central Excise 11% Customs 12%

FY2003

Direct Taxes 35%

Direct Taxes 32%

Sales Tax 41%

Sales Tax 45%

AUGUST 2002

29

or less unchanged at 12 percent, but will be less than half of what it was six years ago. To make income tax system taxpayer friendly and reduce opportunities for corruption, self-assessment system has been introduced for income earned from 1 July 2002 onward. Under this new system, the responsibility for determining the tax liability is placed on the taxpayer and not on the assessing officer, as was the case in the past. All income tax returns will become assessment orders on the date they are filed. No tax official will have the powers to change the income or tax liability, except in 20 percent of cases, selected through the parametric random method for audit to verify the accuracy of the contents of the 29 return. The corporate tax rates for banks and privately incorporated companies are much higher than for public companies, putting some economic activities (finance) and forms of organization at an unwarranted

disadvantage vis--vis others. The tax rates for banks and private companies are also higher than those in other countries of the region. To remove these distortions, the Finance Minister in his budget speech announced a plan to progressively reduce the tax rate for banks by 3 percentage points per year, and for private companies by 2 percentage points, over the next five years to bring these rates down to 35 percent (see table 6). Continuing the process of progressive elimination of withholding taxes, which have the characteristics of indirect taxes, a number of such taxes were withdrawn or rates reduced in the Budget. For example, the withholding tax on out-station bank checks, the 10 percent tax on bonus shares in the hands of shareholders, and the tax on commission on petroleum products have been withdrawn. The withholding tax on commission and brokerage income is being halved from 10 percent to 5 percent, and the 30 percent withholding tax on banks'

The Finance Minister announced a plan to reduce tax rate for banks by 3 percentage points per year, and for private companies by 2 percentage points, over the next five years to lower these rates to 35 percent by FY2007.

Table 6 Corporate Tax Rates

Public Companies Other than Banks 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 38%* 35% 35% 35% 35% 35% 35% Private Companies Other than Banks 48%* 45% 43% 41% 39% 37% 35% Banks

58% 50% 47% 44% 41% 38% 35%

* Including surcharge @ 5%

29. There will be a two-step selection. In the first step, the computer will identify tax returns, which deviate from the norms (parameters), like normal ratio of value of production to cost of electricity in a given industry, average rates of profit, etc. In the second step, 20 percent of returns will be randomly selected for audit out of those identified in the first step.

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PAKISTAN ECONOMIC UPDATE

income from interest on securities has been reduced to 20 percent. Withholding taxes are basically arbitrary in nature. Some of these taxes, which are adjustable against total tax liability of the taxpayer, also breed corruption as adjustment and refund claims are approved by tax officials on a case-tocase basis. Abolition of tax on out-station checks will also remove a hurdle in the way of documentation of transactions. Similarly, withdrawal of tax on bonus shares and reduction in tax on commission and brokerage income will strengthen the capital market. The coverage of GST is being extended further by bringing vegetable ghee and cooking oil in the net. (Import of edible oil used in the production of vegetable ghee and cooking oil is already subject to GST). Last year, the Government increased the GST rate from 15 to 20 percent on about 200 raw materials and intermediate products to create on incentive for unregistered businesses to register under the sales tax net. Six more items, including edible oil and solvent oil, were added to the list this year. Excise duty is being phased out gradually and only products whose consumption is considered undesirable will remain subject to this "vice" tax. Last year, excise on ten items was withdrawn. This year, the tax is being withdrawn on another ten items. Moreover, the process of equalization of incidence of excise duty on imports and local production is being completed this year. Continuing the process of trade liberalization, the maximum import tariff rate has been reduced from 30 to 25 percent. The import duties on raw materials and intermediate goods have been further reduced. These measures are expected to help industries, which have a comparative

advantage, by reducing the cost of their imported inputs. Simultaneously, pressure will be exerted on inefficient industries to improve their productivity as they are exposed to foreign competition. S R O s , w h i c h g r a n t c o n c e ssions/exemptions to specific manufacturers and importers, create distortions in the tax structure, besides giving rise to corruption. Last year, the number of SROs was reduced from 120 to 56; this year they are being further reduced to only 30. The remaining SROs mostly cover the Government's commitments to foreign investors and various policy commitments for shipping, petroleum and agriculture sectors. To facilitate mergers of banks and nonbank financial institutions, the merged institutions were allowed to transfer and carry forward their losses. The FY2003 budget also proposes a number of reforms in labor levies, which will save the entrepreneurs from harassment. The Government has set up a ministerial level committee, which will recommend ways to reduce irritants in the way of smooth functioning of businesses.

CONCLUSIONS
The FY2003 Federal Budget fully reflects the Government's commitment to fiscal stabilization and structural reforms. However, with revenues projected to decline as a percentage of GDP, fiscal stabilization efforts will rely exclusively on expenditure control and transfer of expenditure to lower tiers of the government. As expenditure has already been severely cut, the focus of fiscal correction must shift to revenue mobilization. Despite tax reforms and efforts to broaden the tax base, the tax-to-GDP ratio

Continuing the process of phased reduction in import tariffs, the maximum tariff rate has been reduced from 30 to 25 percent.

AUGUST 2002

31

has stagnated at 12-13 percent in the last five years.30 This highlights the need for stepping up revenue mobilization efforts through broadening the tax base and reforming the tax administration. Initial steps in this area, like setting up a Large Taxpayers Unit at Karachi, appointment of five new members of CBR from the private sector (to look after human resource development, use of information technology, audit, fiscal research, and taxpayer education), and constitution of the high level Supervisory Council to determine the policies of CBR, have recently been taken. However, a lot more needs to be done to plug the leakages of revenues. CBR's audit capability needs to be strengthened for proper functioning of the recently introduced universal selfassessment system. Similarly, many more potential taxpayers have to be identified and brought in the tax net through effective use of the results of the tax survey launched in May 2000. In addition, the services sector, which accounts for half of GDP and is grossly under-taxed, has to be fully taxed

through documentation of transactions in the sector and bringing it in the GST net. The accumulated losses of PSEs have increasingly burdened the federal government's budget in recent years as guarantees on their loans and minimum rates of return are being called. The balance sheets of PSEs need to be improved before these entities can be privatized. It is a positive development that the government is taking the hard decisions to absorb the past losses of PSEs. However, the progress in increasing efficiency in the working of these enterprises by subjecting them to market discipline has been slow because of resistance from vested interests within these organizations. The increasing drain on the public exchequer imposed by these enterprises highlights the need for improving their operational efficiency and for the Government not to issue unnecessary guarantees in future. Otherwise, this hemorrhaging will continue to undermine fiscal stability of the country.

The increasing drain on the public exchequer imposed by PSEs highlights the need for improving their professional efficiency and privatizing them where possible.

30. For calculating tax-to-GDP ratio, surcharges on petroleum and gas have been included.