Pakistan Economy issues/problems and their Solutions




ADB started its operations for Pakistan in 1968. As of 31 December 2001, ADB's cumulative assistance to Pakistan totaled some $11.5 billion, of which $8.0 billion had been disbursed. Cumulatively, 47 percent of this assistance has been from our soft window, the Asian Development Fund (ADF), while the balance 53 percent came from our Ordinary Capital Resources (OCR) window. In addition, we have provided cumulative grant technical assistance of $92 million.

In the year 2001, our planned assistance level to Pakistan was $626 million. However, keeping in view the challenging circumstances facing Pakistan in the post 11 September 2001 era, ADB increased its assistance for 2001 to about $1 billion. Keeping in view Pakistan's development needs, we envisage providing assistance of similar magnitude for the next two to three years, subject of course to satisfactory utilization of this assistance. As of 31 December 2001, the sectoral composition of ADB's assistance to Pakistan is 29 percent each for the agriculture and energy sectors, 15 percent for industry and transport sectors, 14 percent for the financial sector, 10 percent for social sector development, and the balance was on account of multisector projects.

In recent years, ADB has provided policy-based program loans for supporting macro level reforms. Some recent examples include:

Trade and Industry Program Loan (TEPI)
Capital Market Development Program Loan (CMDPL)
Agriculture Sector Program Loan -II (ASPL-II), and
Access to Justice Program Loan
Our investment projects have a common theme of poverty reduction and recent examples include

Malakand Rural Development Project
NWFP Barani Area Development Project-II
Bahawalpur Rural Development Project
With the approval of the five loans in 2001, ADB operations in Pakistan comprise 39 Projects and an equal number of technical-assistance projects. Of these, 16 projects and two technical assistance projects are directly administered by the Pakistan Resident Mission.

In recent years, Pakistan has faced severe macroeconomic imbalances, declining economic growth, rising poverty, and poor social indicators. During the 1990s, the fiscal deficit and the current account deficit as a proportion of the gross domestic product (GDP) averaged 6.9 percent and 4.5 percent, respectively (compared with the 1980s average of 7.0 and 3.9 percent respectively). The average economic growth rate decelerated from 6.5 percent in the 1980s to 5.4 percent in the first half of the 1990s, and to 3.6 percent in the second half. The incidence of poverty increased from just over 20 percent in the late 1980s to 32 percent in 1998/99.

Crisis management of public finances and external balances dominated the economic policy agenda in Pakistan during the 1990s. However, despite all efforts, and three International Monetary Fund (IMF) programs between 1988 and 1999, little progress was made in addressing the macroeconomic imbalances. The result was a decade of stop-go stabilization policies, with the attendant negative impact on growth, but without the desired improvement of macroeconomic fundamentals. The imposition of economic sanctions following the nuclear tests of May 1998 further exposed the vulnerabilities of Pakistan's economy.

Chronic fiscal and external deficits resulted in the accumulation of large domestic and external debt. Total debt (both domestic and external) equaled 100 percent of GDP at the end of June 1998, and interest payments on the public debt accounted for 47 percent of the Government's total expenditure. Of Pakistan's "twin" debt problems, the external debt is the more critical issue for short-to-medium-term economic management. In fiscal year 1998, debt servicing exceeded 50 percent of export earnings, and even after debt rescheduling, debt servicing in 2001 was over 35 percent of export earnings. By end June 2001, Pakistan's external public sector debt, at $32.8 billion2 amounted to 55 percent of GDP, having grown at an average annual rate of 5.4 percent throughout the 1990s. The net present value (NPV) of public external debt was estimated at 260 percent of the value of total exports of goods and services at the end of fiscal year 2001.

Despite the Government's best efforts and the successful implementation of the IMF's Standby Arrangement (SBA), investors' confidence has still not been restored; the investment rate has plummeted to the lowest level since the 1950s. The falling investment rate has adversely impacted the economic growth rate, which averaged 3.5 percent over the last three years. As a result, given Pakistan's high population growth rate (2.2 percent), real per capita income increased only marginally over the three years. In dollar terms, per capita income declined from $473 in 1998 to $429 2001 because of the sharp depreciation in the Pakistan rupee.

Economic growth in 2001 is estimated at 2.6 percent compared to 3.9 percent in 2000. The deceleration of the growth rate was primarily due to the drought-induced reduction in the agriculture sector's output, which posted a negative growth rate of 2.5 percent, as well as a reduction in hydroelectric power generation. The drought caused a loss in national income of about 2.0 percent. Nonagricultural GDP grew by 4.3 percent, as against 3.1 percent in the previous year. During the three-year period, average growth rates in all sectors have been low and there are wide year-to-year fluctuations as well.

The population growth rate is estimated to be 2.2 percent and total population at 140 million in 2001. The urban population, according to the 1998 census, is 33.4 percent of the whole but this is generally assumed to be an underestimate. A large number of areas, urban in nature but not in the purview of any municipality or corporation, are excluded from the urban population. The 1998 census also shows an increase in the share of females in the population, from 46.4 percent in 1981 to 48.4 percent in 1998, which may be a sign of some improvement in gender status.

Pakistan's labor force is growing at a rate of 2.4 percent. With the declining rate of economic growth, the capacity to generate employment has also fallen. With an employment elasticity of around 0.4, the growth in productive jobs during the last three years may have been no more than 1.4 percent per year.

Falling growth rates, accompanied by rising income inequality and increasing unemployment, have resulted in increasing poverty during the 1990s. Whereas the proportion of the poor estimated in various studies shows variation, in 1998-99 roughly one third of the population was below the poverty line, based on a minimum consumption requirement of 2550 calories per adult. The number of people living below the poverty line in terms of a minimum income of $1 a day was 31 percent in 1996. In terms of $2-a-day poverty line, the proportion of the poor in 1996 was 84.7 percent. Since 1998-99, economic growth has slowed further, the fiscal squeeze has intensified, development spending has declined, and the country has experienced a severe drought; therefore, the incidence of poverty in Pakistan today is likely to be significantly higher than it was in 1998-99.

Investment and savings rates in Pakistan have always been low, but they have now fallen to the lowest levels since the early 1950s. An important factor responsible for the continuous fall in the investment rate since 1993 has been the growing debt burden and the associated debt servicing requirements. Two factors that contributed to this secular decline in private investment was crowding out of private sector credit because of the borrowing requirements of the government associated with the high fiscal deficit, and the complementary relationship between public and private investment.

Total investment and fixed investment were 14.7 percent and 13.1 percent of GDP, respectively, in 2001, compared to 17.3 percent and 14.7 percent of GDP in 1998. The decline has, however, occurred only in private sector investment; public investment increased slightly, from 5.2 to 5.6 percent of GDP. Investment in real terms in 2001 was also less than that in 1998. The decline was observed in almost all the industrial sectors of the economy, such as manufacturing, mining and quarrying, construction, and electricity and gas. Since then a tight fiscal policy and weak macroeconomic indicators-including a low level of foreign exchange reserves, high debt, and a large fiscal deficit-have continued to adversely impact the investment rate.

Foreign investment peaked in 1995 at over $1.5 billion, mainly on account of investment in the power sector. As investment opportunities in the power sector became saturated and ongoing power projects were completed, foreign investment started declining. The East Asian financial crisis, and the economic sanctions imposed on Pakistan following the nuclear test in May 1998, further dampened foreign investment flows to Pakistan. Foreign investment was also hit by the Government's dispute with the independent power producers, particularly with HUBCO. The continued debt overhang and the associated vulnerability on the external account, have also impacted adversely the foreign investment levels. Consequently, total foreign investment declined from $823 million ($601 million foreign direct investment and $221 million portfolio) in 1998, to just $182 million ($322 million foreign direct investment and $140 million portfolio) in 2001.

National savings, a measure of financing available from the nation's own resources for investment, have declined from 14.3 percent of GDP in 1998 to 12.7 percent in 2001 While domestic savings are higher than national savings because net factor income from abroad is negative, they also show a declining trend. Domestic savings declined from 15.2 to 14.4 percent of GDP over the three-year period. The low levels of private savings are the result of various factors, including high dependency ratio, financial repression, unpredictable returns on savings, low and fluctuating growth rates of per capita incomes, and a poor investment climate. The overall rate of savings is reduced further because of negative government savings, which were a negative 1.8- percent of GDP in 2001.

Following the nuclear tests in May 1998, restrictions on cash margin requirements were imposed on imports, and the exchange rate regime underwent various changes. In 2000, the managed exchange rate system was adopted, and during the year the nominal exchange rate was kept almost unchanged. At the beginning of 2001, the managed float was abandoned, and a market-based, free-floating exchange rate system was put in its place. The currency came under several speculative attacks during the year, and in 2001, the rupee depreciated by 18.6 percent against the dollar. Because of the low rate of inflation in Pakistan, this resulted in a real depreciation of over 10 percent in 2001, which provided a much needed boost for exports.

Exports fell from $8.6 billion to $7.7 billion and imports from $10.1 billion to $9.3 billion in 1999. However, as a result of trade liberalization and economic restructuring policies followed by the new Government, in the next two years exports grew by 19 percent and imports by 15 percent. The degree of openness of the economy, as measured by the trade-to-GDP ratio, also increased from 30.2 to 32.9 percent during the three years. The growth of exports is quite impressive, especially in light of the slowdown in world markets during this period.

The export concentration ratio in Pakistan is 0.56, which is high3. Textiles account for almost 70 percent of total export earnings. While specialization in textiles may not be an obstacle to export growth, dependence on a narrow commodity base greatly increases balance-of-payments vulnerability.

The current account deficit has been kept in check in the last two years largely through open-market purchases of hard currency by SBP. These purchases show up in the balance of payments under private transfers. In 2001, these purchases were in excess of $2.2 billion, compared with $1.6 billion in 2000. These purchases have also helped SBP to build up its own foreign exchanges reserves, which by end-June 2001 had increased to $ 1,688 million i.e., equivalent to over 7 weeks of imports of goods and services.

Pakistan is suffering from a severe debt "overhang": total debt increased from PRs2,672 billion in 1998 to PRs4,003 billion in 2001. As a percentage of GDP, total debt increased from 100 to 115 percent, with domestic debt increasing from 44 to 49 percent, and external debt from 55 to 64 percent4. The increase in the external debt has been about $2.6 billion over the three-year period, but because of the sharp depreciation of the Pakistani Rupee, external debt-GDP ratio has increased sharply, particularly in 2001.

Servicing debt is the major problem affecting both the fiscal and the balance of payments situations. Total debt servicing increased from PRs278 billion to PRs325 billion and interest payments increased from PRs192 billion to PRs237 billion during 1997-98 to 2000-01. While interest payments on domestic debt are significantly higher than those on external debt, the growth is more rapid in external interest payments because of the rapid depreciation of the currency. Because of reduction in the interest rates on national savings schemes, interest payments on domestic debt also declined in 2001.

An examination of the ratio of debt servicing to total revenue and export earnings is quite revealing. External debt servicing accounted for as much as 55.4 percent of total export earnings and 34.9 percent of total foreign exchange earnings in 1998; because of debt rescheduling, these declined to 37.4 and 23.3 percent in 2000). Total debt servicing as a percentage of tax revenue has also declined from 78.4 to 68.9 percent. It is evident that despite the two debt rescheduling during 1998 to 2001, the external debt servicing burden remains very high. Moreover, with total debt servicing preempting 57 percent of total government revenue, the Government is hard-pressed to accelerate its poverty reduction activities. For Pakistan to successfully address its problems of rising poverty and falling economic growth, a long-term approach for dealing with its debt burden has to be found. Pakistan has prepared a debt reduction and management strategy that focuses on continuing strong fiscal adjustment to limit public borrowing, boosting exports through structural reform, seeking new borrowing on concessional terms, and writing off or rescheduling debt5.

Pakistan first went to the Paris Club in January 1999 for rescheduling of bilateral loans, which were contracted up to September 30, 19976. The country was granted debt service relief of $3 billion for the first consolidation period, which extended from January 1, 1999 to December 31, 2000. At the end of this period, Pakistan signed a second rescheduling agreement in January 2001, which covered debt service payments due in the period from January 1, 2001 to September 30, 2001. The repayment period on Official Development Assistance (ODA) debt falling due during this period was lengthened to 20 years according to the terms of this agreement and $1.8 billion of the total bilateral (pre cutoff date) debt was re-scheduled. While the debt servicing relief provided to Pakistan during the last three years has been substantial, these agreements did not address the underlying problem of the unsustainable debt burden.

The December 2001 agreement with the Paris Club7 is significant in that it involves the restructuring of the entire pre cutoff date debt stock of $12.5 billion owed to members of the Paris Club. According to the terms of the agreement, commercial credits will be repaid over a period of 23 years, with a 5 year grace period, while ODA credits will be repaid over a period of 38 years, with a 15 year grace period8. The Ministry of Finance estimates that the Paris Club agreement will lead to cash flow savings of $2.7 billion during the period of the recently approved 3-year IMF PRGF, with further significant savings during the subsequent decade. At existing interest rates, the stock re-profiling of Pakistan's bilateral debt is expected to amount to a 30 percent reduction in NPV of external debt.

Before September 2001, the Government had projected GDP growth for 2002 at 4.0 percent on the basis of a modest recovery in agricultural output and related improvement in private consumption. More recent data, however, suggest that this winter season's wheat crop could be adversely affected by a shortage of irrigation water supply. The attacks on the US on 11 September 2001, coming on top of an already weakening global economy, are also likely to have significant negative implications for Pakistan's economy in the short term. An immediate consequence of the attacks has been to increase freight charges to and from Pakistan due to the perception that the country is in a war zone. Several airlines stopped services to the country, leading to a reduction in available air cargo capacity. At the same time, domestic textile and garment manufacturers suffered cancellations of export orders and a sharp drop in new orders stemming from weaker external demand, partly based on importers' anxieties that manufacturers will be unable to maintain their existing production schedules. The Ministry of Commerce has estimated that if Pakistan does not receive more favorable access to the US and EU markets now for its exports, the loss of export earnings (stemming from current events) would be in excess of $1.5 billion.

The atmosphere of uncertainty is also having an adverse budgetary impact, as the Government has incurred additional expenses associated with an increased number of refugees, with maintaining law and order, and with defense. Risk premiums increased sharply on sovereign debt in the aftermath of the 11 September attacks. The ramifications of these attacks have also led to a shortfall in revenue collections due to a slowdown in imports. Loss of investor confidence and the depressed state of the domestic stock market have led the Government to defer its privatization program, which was expected to bring in $500 million in 2001. Actual private capital inflows are also now expected to be considerably below the Government's initial projection of some $600 million. Although the economy is likely to gain from the recent removal of the remaining nuclear test-related sanctions, enhanced debt relief, and increased access to concessional aid, these are likely to be felt only with a lag.

While it is early to gauge the full impact of the events of 11 September, under the assumption of a full-year loss to the economy of $1 billion, GDP growth in 2002 is projected to slow to around 3.0 percent from earlier government projections of 4.0 percent. The current account deficit is also likely to widen somewhat in 2002 owing to more subdued export growth and reduced inflows of worker remittances and other private transfers. Even in the event that exports are granted free access to the US and EU, this is likely to be partly offset by reduced import demand resulting from depressed consumer sentiment in these markets. Inflation during 2002 is expected to pick up somewhat on account of rupee depreciation and an increase in utility prices.

Pakistan's economic situation is likely to remain weak over 2002-2004. During this period the key challenges facing the Government include:

restoring economic growth-constrained further by a drought-affected agriculture sector
managing the large debt burden
promoting domestic and foreign investors' confidence
increasing exports to generate foreign exchange, and
maintaining a level of social development spending to stem the deteriorating social indicators.
Faced with such a daunting task, the Government has accelerated its reform programs (ranging from agriculture sector liberalization to privatization of state-owned enterprises [SOEs] and banks) but much more remains to be done.

The major causes of poverty in Pakistan include (i) lack of employment opportunities, which in the rural setting is caused by the absence of rural-urban linkages; (ii) a slowdown in the pace of economic growth in the 1990s; and (iii) with the burgeoning debt obligations, a decline in the public sector development program. ADB's poverty analysis, undertaken during 2000 as part of its Poverty Reduction Strategy in Pakistan, indicates that the failure of governance is a key determinant of poverty. ADB's poverty analysis and approaches to poverty reduction in Pakistan were discussed at the High Level Forum on Poverty Reduction on 23 April 2001. The forum generally supported the findings of ADB's poverty analysis, including the causes, trends, and severity of poverty in Pakistan; the development priorities needed to reduce poverty; and the policy and institutional constraints to poverty reduction.

Priorities that emerged from the poverty analysis and forum included (i) the need to achieve broad-based growth through development of small and medium enterprises (SMEs) and promotion of exports of higher value added agricultural products; (ii) promotion of physical assets for the poor through support of microcredit and poverty reduction programs; (iii) social asset creation, including social sector programs for education and health; (iv) social safety nets with targeted programs for excluded groups; and (v) improved governance that covers judiciary reforms and public sector efficiency.

Pakistan faces daunting governance challenges. Analyses of linkages between poverty and governance highlight five issues of priority concern: (i) poor fiscal performance, including management of external and domestic debt, and budget planning and expenditure for pro-poor investments; (ii) political and social exclusion of the poor, women, and minorities from access to basic services and entitlements; (iii) persistent failure to address accountability, corruption, and poor public sector performance; (iv) ineffective and inefficient intergovernmental relations between federal and provincial levels and marginalization of local governments; and (v) loss of trust by the common citizenry in public institutions.

The Government has identified "good governance" as one of the five "strategic pillars" of its poverty reduction strategy. Good governance includes improved strategies and management for external and domestic debt; medium-term budget and expenditure management and financing for pro-poor public services; restructuring of intergovernmental relations, including devolution and civil service reform; access to justice, including legal, judicial, and police reform; and capital markets development. The main thrust of ADB's assistance for governance reform will be on decentralization, devolution, and governmental restructuring. Closely linked with devolution and public sector restructuring, will be efforts to improve the performance of legal and judicial services to enhance access to civil, criminal, administrative, and social justice-in accordance with the Government's motto "to bring justice to the doorstep" of all citizens.

Pakistan ranked 138th out of 174 countries in the 1999 human development ranking of the United Nations Development Program (UNDP). Despite the efforts of the Social Action Plan launched in 1993 with broad-based external support, the impact on the social indicators was mixed. One of the major challenges facing Pakistan remains the improvement of prevailing low levels of human development. This will prove more daunting due to the severe fiscal situation of the country. In addition, the issues of good governance, quality of social workers (such as teachers and health workers), and institutional capacity are all clearly recognized as key factors in improving the poor delivery and quality of social services. ADB's operational program will continue to prioritize direct social interventions to address these challenges. This approach will also support the Government's ongoing plans to devolve powers to the district levels.

The primary economic policy issue for Pakistan is reduction of its debt burden, which constrains economic growth, and the Government's capacity to fund poverty reduction and social sector expenditures. This in turn requires that the fiscal deficit be reduced to a sustainable level. The Government has been able to increase tax revenues in the last two years, but as a proportion of GDP they are well below the average ratio for the 1990s. The burden of adjustment in the 1990s has been largely borne by development expenditure, which as a proportion of the GDP is now at the lowest level ever (i.e., at 3.0 percent of GDP). Given Pakistan's high and rising levels of poverty and its low level of human development, there is a need to increase development spending. Therefore, the Government needs to focus more on reforms to improve revenue collection by broadening the tax base and strengthening tax administration.

In addition, it must improve public expenditure management, and stop the massive hemorrhaging of public resources to loss-making state-owned enterprises. The Government has announced an ambitious privatization program; if implemented it will help to reduce the fiscal burden of the loss-making enterprises, and generate resources for debt retirement and poverty reduction. However, thus far the Government has been concentrating on measures to create an enabling environment for privatization. To demonstrate its seriousness and commitment, the Government now needs to focus on completing some of the major privatization planned for this fiscal year such as that of Pakistan State Oil (PSO), Pakistan Telecommunications Corporation Limited (PTCL) and Karachi Electric Supply Corporation (KESC).

Another important economic policy issue is restructuring the economy to enhance the efficiency and outward orientation of the agriculture and manufacturing sectors. This is necessary for Pakistan to improve its external balance, service its huge external debt, and meet the challenges of globalization. During the 1990s, the Government implemented a program of trade liberalization: the maximum tariff rate, which stood at 90 percent in 1991, was reduced to 45 percent in 1997 and to 30 percent in 2001. As a result, the effective tariff rate (i.e., tax revenues from international trade as a proportion of total imports) declined from 30 percent in 1991 to 12 percent in 2000. However, the trade liberalization policies have had a limited impact on the structure of the economy thus far because of the low level of private investment and slow economic growth in recent years. But the export performance of the last two years gives some hope that the restructuring process is beginning to have an effect.

Elected local governments took power on 14 August 2001, but there is still some confusion regarding the powers and roles of the various levels of government, as well between the elected representatives and government officials. Since delivery of almost all public services has been devolved to the local governments, successful implementation of the reforms will have far reaching implications for accelerating poverty reduction and human development. However, the implementation will need to be closely monitored because fiscal decentralization has implications for the country's overall fiscal management and thus could put at risk the ongoing stabilization program of the Government.