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.

Launch of Asian Development Outlook 2008
by Chief Economist Ifzal Ali

Foreign Correspondents’ Club
Hong Kong, China
2 April 2008


Saby Mitra: Good morning and welcome to the launch of Asian Development Outlook 2008. I am Saby Mitra from the Department of External Relations of Asian Development Bank.

We are delighted to be here in Hong Kong, China to launch the 20th edition of ADO 2008. As some of you may be aware, ADO is ADB's flagship economic publication.

We are pleased to have ADB's Chief Economist Dr. Ifzal Ali present the key findings of ADO 2008. Without further ado, let me now invite Dr Ali to make his presentation.

Dr. Ifzal Ali: 2007 was a stellar year for Asia. Developing Asia grew by 8.7%, which was the highest in two decades. In 2007, growth began to pervade in many areas of the region. But when I spoke about Asia testing speed levels, we saw signs of overheating emerge everywhere. There were skill shortages, infrastructure bottlenecks, and for the first time in many years, there were signs of inflation which got accentuated particularly in the third and the fourth quarters. The inflation numbers speak for themselves. Sri Lanka had double-digit inflation, while Viet Nam had inflation of 8.3%. By December, it had already reached 12.6% on an annualized basis. Enter 2008, on some concerns about the imperative to maintain and sustain macroeconomic stability. Now, riding with the fuel prices which aggravated some of the infrastructure constraints that I referred to will test the resilience of developing Asia in the coming years. Food and fuel together constitute nearly 60% of household budgets in Asia. For example, in South Asia-India, Pakistan, Bangladesh-food alone accounts for more than 50% of the budget. If you look at the People’s Republic of China (PRC), it accounts for 40% of the budget; Viet Nam, 44% of the budget. These two items are very important in the Asian context.

Countries responded to rising food and fuel prices through subsidies, tariff reductions, export taxes, export restrictions, and most importantly, price controls. And every move forward, these rising commodity prices, which have been suppressed through administrative measures, will have a high fiscal cost and add to inflation.

As we go forward to 2008 and 2009, the global context that faces Asia is worrisome. One of the fundamental changes we have made in our assessment of global environment is that, instead of a rapid slowdown only in the US, there will be slowdown which is coincident among the G3, namely, the US, the Eurozone, and Japan. This coincident nature of the slowdown will limit the options for Asian suppliers to switch to new markets. This is a fundamental departure from the past.

I have already referred to fuel and food prices emerging as an important factor particularly in the third and the fourth quarters of 2007. These same forces are likely to continue throughout 2008, and to at least the first part of 2009.

One thing that has to be very clear is that this thing did not happen all of a sudden. Food prices started their uptick in 2001. Fuel prices began rising in 2002. What has happened is that acceleration has been very rapid in 2007 and likely to continue in 2008. Oil prices will be lucrative. They have been increasing by approximately US$10 a barrel since 2002 and why they have already touched US$110 a barrel in March 2008. We have seen that they have retreated.

Our outlook is premised on the assumption of US$85 a barrel for 2008 for Brent crude oil. This is likely to go up to US$95 a barrel next year. Associated with high fuel oil prices and high natural gas prices, this translates into higher fertilizer prices. As you can see, fertilizer prices almost tripled in the last 2 years.

Rice prices, in turn, have increased very rapidly. In the course of March 2008, we have seen this rise from US$500 to US$700 a ton. Countries in Asia now are scrambling to find stocks of rice to buy at very inflated prices. For example, the Philippines recently bought rice from Cambodia at almost US$700 a ton. Wheat, as well, which is consumed increasingly in many parts of Asia, had doubled in price in the last 2 years. Edible oil prices, an important part of the household budget, have also increased very sharply.

As we enter into 2008–2009, both in terms of what is happening in the G3 and what is happening in primary commodity prices in global markets, this will test the resilience of developing Asia in the near future.

The outlook we have for developing Asia is while growth will ease, it will remain solid. Growth will remain solid because the domestic conditions continue to be favorable. The policy environment is generally positive; productivity growth leads to economic modernization and the structural transformation that we witnessed in the last 5 years and which have battled Asia forward are likely to continue.

The downside, as I had just mentioned, is: developing Asia’s strengthening linkages with the industrialized north will lead to global activity through trade and financial channels impacting negatively on our countries. Growth will remain solid but will ease.

As you can see from this chart (slide 9), while Asia will come off the heights of 2007, it will only be a fraction below the 5-year moving average for the coming 2 years. Basically, developing Asia will return to trend growth rates in the next 2 years.

Looking at some of our subregions, we see, except for Pacific which started at a low base, in all other parts of developing Asia growth will slow in 2008. In East Asia, it will come down to about 8.1% from about 9%; in South Asia, it will come down to about 7.8%, from about 8.4% last year; in Southeast Asia, growth will come down from about 7% to 6.7%. A slowing down in developing Asia is expected as we move forward.

However, inflationary pressures will mount. From this chart (slide 11) , we can see that inflation is moving significantly above trend. What we are projecting is in 2008, inflation will reach a decade-over high. That, I think, is the major change that we have introduced this year compared to the forecasts of the past.

Central Asia, which is basically the hydrocarbon economies, is benefiting from higher oil prices, break-neck investments in the hydrocarbon sector, and concerted efforts to move out and diversify into other sectors. But East Asia, South Asia, Southeast Asia, all will experience an uptick in inflation.

Moving to our major subregions, I will only focus on three subregions-East Asia, South Asia, and Southeast Asia-because of lack of time.

In East Asia, which is the most open to world trade, exports to industrialized countries will, to some extent, be compensated by higher domestic demand-mainly, household consumption and business investment. In this context, of the four major countries that we have depicted in this chart (slide 13) , the only one that will experience a slight uptick in growth in 2008, compared to 2007, is Korea. And, this is happening because with the advent of the new Government-both consumer and investor confidence are at all-time high. So it is domestic consumption and domestic investment, which together account for over 75% of aggregate demand, will compensate for slowing down of exports to the industrialized north. But in the other economies-Hong Kong, China; Taipei,China- there will be a slowdown in growth associated primarily with a slowdown in growth in the PRC. If you look at the right side of the chart (slide 13) , in all major countries in East Asia, we are projecting an uptick in inflation. The picture that emerges for all the other countries, except for the Republic of Korea, is that growth will moderate, inflation will pick up.

Now, if we focus on the PRC, we can see that we have moderated our growth projection to 10% and 9.8% (slide 14) basically resulting from two factors. There will be a slowdown in exports from about 26% in 2007 to 19% in 2008; and about 18% in 2007. What is worrisome about the PRC is the uptick in inflation. On an annualized basis, the wholesale price index went up by about 6.9% in December 2007. When we look up the January and February figures, it is about 8.9% on an annualized basis. The challenge here is to bring down inflation and, at the same time, avoid a hard landing. What we see in the PRC is a considerable tightening of monetary policy. Interest rates have been raised and reserve requirements have been raised repeatedly at an all-time high of 15.5% today. Looking forward, I think one of the major challenges facing the PRC is to resolve the current account surpluses which have become a source of considerable friction with its trading partners. On the increasing strains on energy and environment, 70% of energy is produced through coal which is very environment unfriendly, and the rapid increase in consumption of energy is beginning to strain the environment. Finally, of course, the social tensions arising out of income inequality between the rich and the poor; between urban and rural areas; between the coastal region and distant region are some major challenges the PRC will have to address going forward.

Turning to South Asia, relatively unlike East Asia, it is less vulnerable to a slowdown in the G3 because it is more closed than East Asia. But South Asia is going to be vulnerable to the high commodity prices. If you look at the left side of chart (slide 15) , we are seeing in India, Pakistan, Bangladesh a pickup in inflation. In Sri Lanka, where inflation touched over 20% in 2007, it will be reined in, inflation will be lower but will remain double digit. Our focus is inflation in South Asia. What is happening in South Asia is that there are lots of administrative controls on prices of basic commodities like food and fuel. What this indicates is that while inflation is expected to pick up, because of these controls, the inflationary pressures are grossly under the table. They do not come out in the numbers of wholesale and consumer price inflation. But the inflationary pressures are there and are building. Governments are very conscious of this. As a result, there is going to be considerable monetary tightening in South Asia.

Fiscal policies have continued to be expansionary in the light of imported commodity price inflation. There is no choice but to keep monetary policy tight. As a result, both household consumption and business investment will come under pressure in South Asia and that is the main reason we are projecting a slowdown in growth in South Asia from 8.4% in 2007 to 7.6% in 2008. Of the South Asian countries, the most important is India which produces 80% of the GDP of South Asia. Here, while inflation numbers appear to be moderate, what we are already witnessing is that by 15 March , on an annualized basis, the wholesale price index is close to 6.6%, significantly above the Reserve Bank of India’s target of 5%.

We have in 2007 experienced asset price inflation, food price inflation. Now in India, we are seeing signs of very high rates of inflation in selected states. Elections are forthcoming in a year’s time and the Indian election is highly sensitive to inflation. We are expecting tighter monetary policies to slow down in both household consumption on durable goods and in business investment. We are expecting that a part of the attempt to cool down the economy is to allow the rupee to appreciate more rapidly. Because of the forthcoming elections, while fiscal consolidation is absolutely necessary in terms of reining in subsidies for fuel and food, we do not expect these measures to be taken until the second or third quarters of 2009. So, here again, growth will slow down, the emergence of inflationary pressures will constrain monetary policy through a tighter stance. That will begin to cool the economy down.

Southeast Asia, which has been growing very moderately since the Asian financial crisis, had a good year in 2007 where growth was 6.5%. But this would slow to 5.7% in 2008. As I mentioned, both Indonesia and the Philippines did pick up in growth in 2007, but this is likely to slow down somewhat in 2008 for two reasons: their exports are going to be hurt because of a slowdown in G3, and the emergence of inflationary pressure. Inflation, which was very low even in the Philippines last year despite high growth rate, is already beginning to show signs of sharp rebound upwards . This is coming basically through loser monetary policies accompanied by higher prices of food imports, particularly rice. From this chart (slide 17) , you can see that inflation in Viet Nam, which is about 8.3%, is going to be major problem in 2008. It starts at 12.6% in December, and is likely to be close to 19%. This is a cause for concern.

In Viet Nam, the first order of business is to bring inflation under control. This will have to be done through very tight monetary policy and some consolidation on the fiscal front. I think it is time that Viet Nam allows some flexibility toward the appreciation of its currency. Now, this tight monetary policy could cause some perturbation in the banking system which is still quite underdeveloped. If Viet Nam does not rein in inflationary pressures under control and inflation becomes entrenched, this could lead to a deceleration in productivity improvement in the future and would undermine the basic sustainability of its growth process. So, the first order of business in Viet Nam has to be get inflation under control.

The thing we introduced last year, and which we have developed a great need for this year, is the myth of uncoupling. There is a school of thought that developing Asia is getting delinked from the G3. Let’s look at the data (slide 19) . If we look at computing equipment and compare quarter by quarter between what happened last 2006 and 2007, you can see that, except for one or two cases, there is a sharp tick downwards of exports from the PRC; Malaysia; Singapore; Taipei,China; Republic of Korea; the Philippines; and Indonesia to the US. So high-frequency data clearly indicate a slowdown of computing equipment exports to the US. The same thing is seen when you look at garments, textiles, footwear, toys, games, and equipment. Particularly, I highlight garment exports because low-cost countries like Bangladesh, Cambodia, Pakistan, India, and Indonesia get particularly hard hit when government is exposed.

We have introduced a new dimension into this uncoupling story. We started looking at what is happening in Asia, and here we find that growing trade in Asia cannot compensate for slowdown in the G3. This is happening because growing trade in Asia is an issue of intermediate input trade between various Asian countries being exported to the PRC, which then fabricates these things to export to the G3. If there is a slowdown in G3, you are likely to see a slowdown of intra-Asian trade.

Now, if we look at the financial side, there is a deepening integration between East Asia and Southeast Asia as well as the US. We see that there is much greater coordination in movement of equity prices between US and Asian markets. If we look at the data in the last 2 months, we see that credit spreads have widened in offshore markets; the debt issuance has become more expensive for the propagation. Equity markets have moved more closely in step with the US, and countries across Asia in the first quarter of 2008 have lost significantly. But the positive side to the story is that in developing Asia, credit is provided fundamentally through the banking system. Barring a few exceptions, there is very little exposure of Asian banks to the US subprime market and, in that sense, the banks in Asia, which are well capitalized, profitable, and not exposed to significant risk of leverage, will not impact negatively as a result of what is happening in the subprime markets.

Over the long term, Asia’s long-term growth trajectory depends basically on supply-side dynamics.

There are three issues which we have to be careful about : neglect of agriculture in Asia has to be corrected, agricultural productivity must rise; modernization, technological change, and productivity increases in manufacturing and services must continue; and finally, the demographic dividend, which is basically the “youth bulge” emerging in Asia, will have to be harnessed over the next two decades.

Looking forward in the next few years, what are the major risks facing Asia? Inflation will accelerate and could hit a decade-long high in 2008. We must tackle inflation immediately for two reasons: if inflation becomes entrenched, productivity levels will begin to taper off; and inflation is the most regressive of all taxes. It impacts much more on the poor than on the rich. So, socially and politically, they’re likely to be very divisive. Secondly, the short-term palliatives that have been put in place like subsidies and administrative controls put fiscal balances at risk. Therefore, we quickly need exit strategies for subsidies and administrative prices in developing Asia and replace them with targeted cash transfers for the really needy.

Finally, the slowdown in the G3 could lead to trade and investment protectionism and this poses a clear and present danger to an Asia which is continuing to open up. In this regard, internally, countries will have to continue to make efforts to liberalize their markets and basically have an open-trade stance.

In closing, the point I would like to make is that while Asia is not immune to a global slowdown, neither is it a hostage to what is happening in the G3.

Thank you very much.

Saby Mitra: We’d like to invite questions, I’d appreciate if you could identify yourself and your organization:

Cherry Chan, NOW TV: Why will the Hong Kong economy this year slow down from 6.3% to 4.5%? Will Hong Kong economy continue to be affected by this program? I want to ask about ADB’s projection on inflation for Hong Kong.

Dr. Ifzal Ali: Hong Kong, China had an excellent year in 2007; basically both household consumption and investment, particularly in the real estate sector, were very buoyant. Going forward, we have brought down our forecast for growth in Hong Kong, China for two fundamental reasons. Number one, the slowdown in the G3 will affect Hong Kong, China significantly. Secondly, and equally importantly, the slowdown in the PRC will affect Hong Kong, China; and the slowdown in exports from the PRC will impact negatively on the reexports from Hong Kong, China to other parts of the world. So these are the main reasons we have brought down the forecast for Hong Kong, China. This is basically the external side of the economy. Turning to the PRC, as I had briefly mentioned, there have been mainly increasing interest rates, basically by small steps, but what we are seeing in the reserve requirement last year was an increase of 5.5% points. This year, already in the first 2 months, we see another 1% increase in reserve requirements. So, this is 15.5%. Monetary tightening is under way. Secondly, I think there have been efforts to cool down the housing sector. If you buy a second house, what you have put up upfront has to come up from 30% to 40%; stamp duties on stock market operations have gone up. All these together, we expect, will constitute measures to control expansion of money supply as well as to put on some dampener on some of these speculative activities. This is the basic approach.

On the supply side, I think there are attempts to provide incentives particularly to increase more production; I think there have also been pass-through higher prices so that farm gate prices will go up. Weather permitting, we will likely see improved supply of agricultural commodities in the third and fourth quarters of this year. All of these, I think, have to be viewed as a package.

Min Lee, Associated Press: What can you say about governments suppressing unrest, or protest, or general unsatisfaction over price increases?

Dr. Ifzal Ali: I think the increase in subsidies, the imposition of administrative controls could be viewed generously as giving an indication to the population that inflation will not be tolerated. Entrenched corruption , however, does not do very much in terms of eliciting supplier responses over the next year or so. We think the opportunity cost of subsidies is enormous. There is no rational for having generalized subsidies which benefit vast segments of middle class. Therefore, what we are advocating is to let the price mechanism go up; let domestic and lower prices become aligned. However, the savings that result from this should be translated into highly targeted cash transfers to the really needy to help them overcome the pressures of high fuel and food prices. That is the stance we have taken in this Asian Development Outlook.

Susan Fenton, Reuters: If you have inflation, it should affect consumer demand?

Dr. Ifzal Ali: What will happen with these high rates of inflation is that with a greater part of budget going to fuel and food, discretionary spending on other parts will necessarily come down. I would like you to remember that in the vast sections of developing Asia, there is a growing and a highly buoyant middle class who will continue to spend their way out. The only dampener for them is tight monetary policy. As you can see i n a country like India, consumer durable demand has come down to heights of 2006 because of monetary tightening. Yes, I think you’re right. This inflation will eventually seek its way through a lower demand for consumer durables. But the other aspect which has to be remembered is that Asia is really straining at its leash because of very high growth rates over many years. So both public investments and private investments will have to be put in place very quickly to overcome some of these supply constraints. In that sense, it is a balance. But what we have seen right across Asia, especially in parts of East Asia and Southeast Asia, the domestic demand is becoming progressively more important. It is a very healthy sign.

Allen Cheng, Institutional Investor: What has made Asia immune from this credit crunch in the US?

Dr. Ifzal Ali: I think what I said is that developing Asia is not immune to a slowdown in the G3. It is not hostage to it. This is the point I would like to bring across very clearly. Alternatively while growth in Asia will moderate, it will not lurch down as a result of the G3 slowdown. This is a significant difference from 10 to 20 years ago. Earlier, to use an analogy, if the US caught cold, Asia would catch pneumonia; it will have to take an antibiotic; now probably it will just catch a cold itself and aspirin will do. This is the analogy I want to give in terms of decoupling. It’s a relative issue. And what we are seeing is the increased importance of domestic demand, particularly higher household consumption, that is coming out as a result of a more prosperous Asia, as a result of higher investments to meet both domestic needs and keep economies competitive. These forces together will protect Asia very significantly from a slowdown in G3. Lastly, while financial integration has followed, the nature of credit supply to developing Asia is mainly from the banking system. The banking system has been revived, resuscitated, and strengthened a great deal after the 1997 financial crisis. In that sense, since the banking system of Asia does not have to have the kind of exposure to the subprime market as that in Europe, developing Asia will be insulated, in terms of credit availability to the business sector . So, these are some of the reasons.

Allen Cheng, Institutional Investor: How can intra-Asian trade compensate a decline in growth in G3 countries? Do you expect decoupling?

Dr. Ifzal Ali: Intra-Asian trade is basically driven by vertical integration of its supply chain. Extra-Asian trade is driven by meeting the final demand of G3. If you look at trade from Asia in its totality, 75% of trade from Asia meets final demand directly from outside Asia. Out of the 75%, 61.3% meets final demand directly of the G3. So, trade within Asia meets final demand of about 20% within Asia. I think these are basic facts which we have to remember. In that sense, against this backdrop, if demand from the G3 drops (I’ve shown you high frequency data which indicate that has already occurred), we are likely to see a slowdown of intra-Asian trade which is mainly in the form of intermediate inputs and markets. So, in that sense, I think we will see a slowdown in the G3 affecting intra-Asian trade. That is part 1 of the answer to your question.

On part 2 of the answer to your question, we in this particular report took a look at if US final demand goes down by 1% point, to compensate for that, total Asian growth will have to go up by 1.2% points. Whereas, we are projecting developing Asia growth will fall by about that percentage point in this year alone. So, I don’t think that is likely to happen-that intra-Asian growth, growth within Asia, can compensate for that.

Saby Mitra: By the way, there’s a whole section on this uncoupling myth, including a subsection on whether the PRC is uncoupling from developing Asia in the report.

Raphael Minder, Financial Times: I haven’t seen the section you just referred to. But in the highlights produced, one aspect you touched on, the myth of uncoupling, focuses heavily on US. My question is: what about G3 rebalancing and growing exports to Middle East and other parts of the world?

Dr. Ifzal Ali: I think one of the bright spots we have witnessed in 2007 and going into 2008 is Asia’s strengthening links of trade with Russia and the Middle East. But compared to G3, these are minnows; while this is a welcome movement, it cannot compensate for G3. Regarding the issue raised on rebalancing, particularly about relative movements in exchange rates, one point that I emphasized in this report is the coincident slowdown in the G3. It is going to be very difficult for Asia to switch from, say, recession or near recession in the US to Eurozone or to Japan. In Japan, we are already seeing a rapid slowdown; in the Eurozone, there’s a significant decline in consumer confidence already. If you have a coincident slowdown, I don’t think you can switch markets, notwithstanding relative movements in exchange rates.

Finally, what we have shown in this report that, given the projections, we have moved forward in 2008 - about 20% of world growth- basically the contribution will come from, growth in developing Asia. While this is a positive step, it cannot and will not compensate for this rapidly slowing growth in the G3.

Ernst Herb, Finanz Und Wirtschaft: Seems Asia is fixed if they keep employment; they have imported inflation through energy and food. On the other hand, they have to keep their exports competitive, especially on slow down?

Dr. Ifzal Ali: This is a very difficult time for policy makers in Asia. One point which I hope I have made-and maybe I was not clear-is that part of the inflationary pressures we are seeing in Asia today is coming from high fuel and food prices. But equally important is that a part of it is home grown. Some of the structural deficiencies I spoke about are coming from home-grown pressures arising from overheating; skills shortage is coming from that. Finally, and very importantly, the rapid supply in money arising out of rapid build-up of international reserves will give monetary policy makers greater increase of freedom.

What we foresee and forecast in this ADO is that Asian currencies will appreciate. On the last point you have raised: “Will this affect competitiveness?” I think a very good case we have portrayed in this ADO is that of the Republic of Korea. If we look at Korea over the last 7–8 years, there has been a monetary depreciation of the won. At the same time, we see that exports have been very volatile, and their productivity improvements have increased their competitiveness . And there lies the key that Asia has to remain on the reformist part, in terms of investment and business climate, which will impact positively on firm level behavior and firm level productivity.

Lillian Liu, China Daily: I’ve two questions. How would China’s growing inflation impact Hong Kong as a result? Second, on [Taipei,China], how to establish closer economic partnership with mainland China and how would that help the region’s economy. Thank you.

Dr. Ifzal Ali: I think on the chapter on Taipei,China, we have looked very favorably at some of the initiatives likely to be forthcoming in the near future in terms of banking and trade relationship and direct relationship between Taipei,China and the PRC. Regarding inflation in the PRC, that is certainly going to seep into inflationary pressures here in Hong Kong, China. In a nutshell, these are the two quick responses concerning the principle.

Irene Lee, Apple Daily: How’s your expectation about the appreciation of renminbi this year and what’s the reason behind this?

Dr. Ifzal Ali: If you look at the January 2008 annualized depreciation, the yuan comes to almost 20%. Basically, we will probably see an acceleration in the appreciation of the yuan.

V.G. Kulkarni, Freelance Journalist: Dr. Ali, if the US recession is going to be a very short but shallow one, or a deep and long one, how will it affect growth change this year? In relation to that, what is the time lag in declining demand of G3 and exports from Asian countries? Have major developing countries like China , India lost control over their exchange rates?

Dr. Ifzal Ali: From our perspective, whether it is technical recession or not isn’t important. What is important is that there is a rapid slowdown in the G3 and the ripple effects of it immediately seen in consumer behavior in these countries, and the demand for exports of computer, garment, textile, footwear, toys, and other things.

On the second question on currency, what we have seen here is just-in-time delivery systems in place. We can see the effect of it in almost a month. Within a quarter, you will see the effect. The central banks in the PRC and India continue to play a major role in influencing exchange rates. They have not lost control. What has happened is that the difficulties of sterilization have, I think, forced them to let currencies appreciate.

Saby Mitra: That will bring this conference to a close. Dr. Ali is in Hong Kong, China this afternoon. Those who would like to talk to him, just drop us an e-mail and we will get back to you. Thank you for joining us today.

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Engr.Aftab