ATTACHMENT I. PAKISTAN: MEMORANDUM OF ECONOMIC AND FINANCIAL POLICIES FOR
2008/09–2009/10

The Government of Pakistan has adopted a comprehensive program of macroeconomic
stabilization and sustainable development. This memorandum sets out Pakistan’s economic
and financial policies for November 2008–June 2010, to be supported by the International
Monetary Fund (IMF) under a 23-month Stand-By Arrangement (SBA).

I. RECENT ECONOMIC DEVELOPMENTS
1. In the last decade, Pakistan’s economy witnessed a major economic
transformation. The country’s real GDP increased from $60 billion in 2000/01 to
$170 billion in 2007/08 (fiscal year starts July 1st), with per capita income rising from under
$500 to over $1,000. During the same period, the volume of international trade increased
from about $20 billion to nearly $60 billion. For most of this period, real GDP grew at more
than 7 percent a year with relative price stability. The improved macroeconomic performance
enabled Pakistan to re-enter the international capital markets in the mid-2000s. Large capital
inflows financed the current account deficit and contributed to an increase in gross official
reserves to $14.3 billion (3.8 months of imports) at end-June 2007. Buoyant output growth,
low inflation, and the government’s social policies contributed to a reduction in poverty and
an improvement in many social indicators.
2. This strong macroeconomic performance resulted from the implementation of a
series of important structural reforms. In the early 2000s, with financial support from
international financial institutions (IFIs), including the IMF, the World Bank, and the Asian
Development Bank, the government expanded the role of markets in the economy, privatized
a number of large state-owned enterprises, established market-based regulatory bodies, and
took steps to reduce the cost of doing business in Pakistan.
3. The macroeconomic situation, however, deteriorated significantly in 2007/08 and
the first four months of 2008/09 owing to adverse security developments, large exogenous
price shocks (oil and food), global financial turmoil, and policy inaction during the political
transition to the new government. Specifically:
• Real GDP growth slowed to 5.8 percent in 2007/08 (6.8 percent in 2006/07),
reflecting weaker performance of the agricultural and manufacturing sectors.
• Headline CPI 12-month inflation rose to 25 percent in October 2008, with core
inflation (excluding energy and food) increasing to 18 percent.
• The external current account deficit widened to about $14 billion or 8½ percent
of GDP in 2007/08. The growth of exports and workers’ remittances recovered, but
total imports rose by more than 30 percent owing to an increase of $4 billion
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(2½ percent of GDP) in the value of oil imports and strong aggregate demand growth.
With the surplus in the financial account of the balance of payments declining to
$7.7 billion, from $10.1 billion in 2006/07, this led to a decline in the gross
international reserves of the State Bank of Pakistan (SBP) of $5.7 billion, to
$8.6 billion at end-June 2008. Reserves dwindled further to $3.4 billion (less than
one month of imports) as of end-October 2008.
• The fiscal deficit (excluding grants) is estimated to have risen to 7.4 percent of GDP
in 2007/08, from 4.3 percent in 2006/07, mainly because of a substantial increase in
energy and food subsidies (in a context of rising international prices that were not
passed through to consumers), higher than envisaged interest payments, and
additional security-related expenditures. The deficit was largely covered through SBP
financing.
• To contain inflationary pressures, between July 2007 and July 2008 the SBP
increased its discount rate in several steps by 350 basis points, to 13 percent. Despite
these increases, SBP financing of the government continued in July–October 2008.
• The banking system was well capitalized and liquid as of end-June 2008, but liquidity
problems have emerged recently. Domestic pressures and the global financial crisis
led to rising dollarization and an outflow of deposits from the system during
July-October, which contributed to a deterioration of liquidity conditions. In response
to an escalation of liquidity pressures in October, the SBP recently reduced the
reserve requirement by 4 percentage points and eased liquidity requirements. In
addition, the SBP has encouraged the merger of four small banks. These measures
have stabilized liquidity conditions in recent weeks.
• Financial market indicators have deteriorated. After climbing to new record highs
by end-April 2008, the Karachi KSE-100 index dropped by one third, prompting the
Karachi Stock Exchange Board to impose a floor on the decline of all stock prices on
August 27, 2008. The EMBIG spread has increased to over 2,000 basis points. The
rupee has depreciated by 30 percent since end-March 2008, reflecting growing
foreign exchange market pressures. In May 2008, the SBP adopted, on a temporary
basis, several exchange measures aimed at reducing these pressures. In addition, the
government has recently imposed regulatory duties on imports of luxury items.
II. STABILIZATION POLICIES
A. Macroeconomic outlook and policies
4. The government’s financial policies for the remainder of 2008/09 and for
2009/10 are aimed at stabilizing the macroeconomic situation and restoring investor
confidence. The government’s program envisages a significant fiscal consolidation, and the
SBP will tighten monetary policy to lower inflation and strengthen the international reserves
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position. As a result of these policies, the 12-month inflation rate is projected to decline to
20 percent at end-June 2009, even after taking into account the impact of significant
increases in administered energy prices. Real GDP growth would slow further to
3-3½ percent in 2008/09 in response to the tightening of macroeconomic policies and a
deceleration of growth in Pakistan’s trading partners.
5. The tighter financial policies, higher disbursements from IFIs, lower commodity
prices, and restored confidence are expected to contribute to a significant strengthening
of the external position in 2008/09. Specifically, the external current account deficit is
projected to narrow to $10.6 billion (6.5 percent of GDP) owing mainly to slower aggregate
demand growth and lower oil import prices. At the same time, the surplus in the financial
account would decline to $6.2 billion, as an increase in disbursements from IFIs (to about
$4 billion) would be more than offset by weaker FDI and portfolio flows relative to 2007/08,
reflecting in part the impact of the global financial turmoil. Given the target to increase gross
official reserves to $8.6 billion by end-June 2009 (the level prevailing at end-June 2008), the
residual financing gap of $4.7 billion will be covered by drawing on IMF resources. To
further bolster confidence, the government is seeking additional financial support from
donors.
6. The government’s medium-term strategy seeks to achieve high sustained growth
and significantly reduce poverty, while ensuring external and fiscal sustainability.
Following the initial stabilization effort in 2008/09, real GDP growth would increase to
5 percent in 2009/10, and is projected to rise gradually to 6½–7 percent a year by 2012/13,
based on a significant increase in investment and further progress in structural reforms.
Average inflation is targeted to decline to 13 percent in 2009/10, and to 5 percent by
2012/13. Prudent demand management policies would contribute to a gradual decline in the
external current account deficit to 5.7 percent of GDP in 2009/10, and further to 3.6 percent
of GDP by 2012/13. This, along with the expected pickup in capital inflows, would help
increase gross international reserves to $14.5 billion (2.6 months of projected imports) by
2012/13, while reducing the external debt to 29 percent of GDP. The external financing gap
for 2009/10, which is projected at $3.6 billion, will be covered by disbursements from the
IMF and GDR proceeds. External financing gaps will be fully eliminated by the end of the
SBA.
B. Fiscal policy
7. The fiscal deficit (excluding grants) is targeted to decline to 4.2 percent of GDP
(PRs 562 billion) in 2008/09, from 7.4 percent in 2007/08. This fiscal effort is necessary to
help reduce the external current account deficit, move toward a sustainable fiscal position,
and eliminate SBP financing of the government. To achieve the 2008/09 deficit target, the
government will increase tax revenue by 0.6 percentage points of GDP and reduce
non-interest current expenditure by about 1½ percentage points of GDP, mainly through the
elimination of oil subsidies by December 2008 and electricity subsidies by June 2009. At the
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same time, domestically-financed development spending will be reduced by about
1 percentage point of GDP through better project prioritization.
8. The government has already implemented a number of measures consistent with
the envisaged fiscal adjustment in 2008/09. Specifically, petroleum prices have been
adjusted three times since June 2008, which has led to the complete elimination of petroleum
subsidies. At the same time, electricity tariffs were adjusted by an average of 18 percent
effective September 5, 2008. In addition, steps have been taken to slow the pace of
development spending, the research and development subsidy for the textile industry has
been fully eliminated, wheat procurement prices have been raised to international levels, and
the general sales tax (GST) rate has been raised by one percentage point to 16 percent.
9. The government plans to take additional fiscal measures in 2008/09. As noted
above, electricity tariff differential subsidies will be fully eliminated by end-June 2009. To
achieve this objective, the average base tariff will be further increased during 2008/09
according to a schedule to be agreed with the World Bank by end-December 2008 (structural
benchmark), and the government will use fuel and other surcharges, as necessary. The
implementation of the electricity tariff increases will be followed up in the context of the
program reviews. On the revenue side, further steps will be taken during the remainder of the
fiscal year to strengthen tax enforcement. Moreover, fuel prices will continue to be adjusted
to pass through changes in international prices.
10. An expanded and effective social safety net constitutes an integral part of the
authorities’ program. In this regard, several measures are envisaged to protect vulnerable
groups that might be adversely affected by inflation and the economic slowdown. The fiscal
program for 2008/09 envisages an increase in social safety net spending of 0.6 percentage
points of GDP, to 0.9 percent of GDP. To this end, the government has launched the Benazir
Income Support Program (BISP), for which the budget already allocated PRs 34 billion
(0.3 percent of GDP). The design of the BISP, in particular the targeting of transfers and the
delivery mechanism, will be reviewed in the first half of 2009, in consultation with the World
Bank. The government also plans to expand social safety net spending by an additional
0.3 percent of GDP, for which further external assistance (mainly in the form of grants) is
being sought from donors. While a more comprehensive and better-targeted social safety net
is being designed, these additional funds will be allocated to scale up other existing
programs, in particular cash transfers under the Bait-ul-Mal program. Also, part of the
additional resources could be used to cover larger than envisaged electricity subsidies for
poor households.
11. Putting in place a more comprehensive and well-targeted social safety net is a
key priority under the program. To that end, in close cooperation with the World Bank, the
government will prepare, by end-March 2009, a strategy and a time-bound action plan for the
adoption of specific measures. The first program review will assess progress in this area.
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The resources allocated to the short-term protection measures described above will be used
for funding the newly designed social safety net in 2009/10.
12. The government will prepare, by end-March 2009, a plan for eliminating the
inter-corporate circular debt within the fiscal deficit target. The plan will clearly identify
all elements of circular debt, including (i) the identification of all debts owed and due among
the corporations, duly reconciled; (ii) the determination of the validity of the claims;
(iii) a schedule by which respective entities will discharge their liabilities to each other; and
(iv) a timeframe during which the Federal Adjuster will use his powers to make adjustments,
in case of failure, to adhere to the approved schedule.
13. The targeted reduction in the fiscal deficit in 2008/09 will help eliminate SBP
financing of the budget. The government is committed to limiting SBP financing of the
budget to zero on a cumulative basis during October 1, 2008–June 30, 2009. During this
period, the fiscal deficit will be fully financed by available external disbursements (which
have already been committed), the acceleration of the privatization process, the issuance of
treasury bills, and other domestic financing instruments, including Pakistan Investment
Bonds, Ijara Sukuk, and National Savings Scheme (NSS) instruments.
14. A further reduction in the fiscal deficit to 3.3 percent of GDP is envisaged for
2009/10. The fiscal effort will be facilitated by the full-year effect of the elimination of
energy subsidies by end-2008/09 and declining interest payments, following large bullet
payments in the three-year period ending in 2009/10.
15. Consistent with the government’s objective of substantially increasing tax
revenue, a number of tax policy and administration measures are envisaged during the
program period. Specifically, an integrated tax administration organization on a functional
basis will be established at the Federal Board of Revenue (FBR) (integrating both the income
tax and sales tax administration). In addition, audits will be reintroduced as part of a
risk-based audit strategy that will be implemented by end-December 2008. A full description
of the required reforms, together with an action plan will be provided to the IMF by
end-December 2008, following a planned seminar to review tax policy and administration.
As part of this process, the government plans to harmonize the income tax and GST laws,
including for tax administration purposes, and reduce exemptions for both taxes. To that
end, it will submit legislative amendments to parliament by end-June 2009. In addition, the
excises on tobacco will be increased in the context of the 2009/10 budget. Following the
seminar in December 2008, the government will initiate a process to implement a full VAT
with minimal exemptions, to be administered by the FBR. Draft legislation for the VAT is
expected to be ready for public debate by end-2009. The first program review will focus on
the progress in developing the government’s tax reform agenda.
16. The government’s fiscal consolidation efforts will continue over the medium
term. The government’s fiscal framework assumes a further reduction in the fiscal deficit to
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2–2½ percent of GDP by 2012/13. Fiscal consolidation will be supported by a strong tax
effort, which will allow for higher spending in infrastructure and the social sectors.
Specifically, the government is committed to increasing tax revenue by at least
3½ percentage points of GDP over the medium term as a result of measures to broaden the
GST base, significantly reduce income tax exemptions, and further improve tax enforcement.
17. The government will continue to press ahead with public financial management
reforms, in line with fiscal ROSC recommendations. Immediate priority will be given to
completing the on-going gradual implementation of a single treasury account. This will
involve the consolidation of government funds in its account with the SBP, from which
withdrawals will be made only when actual payments are due. Existing funds held outside
the SBP account will be transferred by end-June 2009. Furthermore, the coordination
between the Planning Commission, which manages the developmental budget, and the
Ministry of Finance will be strengthened in the context of the implementation of the
medium-term budget framework.
C. Monetary policy, exchange rate policy, and financial sector issues
18. The program envisages a significant tightening of monetary policy. To that end,
the SBP recently increased its discount rate by 200 basis points, to 15 percent. Following this
first step, interest rate policy will be sufficiently flexible to protect the reserves position,
bring down inflation, and allow the government to place T-bills and other securities with
commercial banks and non-banks in order to avoid further central bank financing of the
budget. A further increase in the discount rate will be considered at the time of the monetary
policy statement scheduled for end-January 2009. However, the discount rate will be raised
earlier if the actual reserves for end-November and end-December 2008 fall short of the
program monthly floors on the SBP’s net foreign assets. In addition, if the volume of T-bills
placed in the auction scheduled for November 19 falls short of the announced target,
understandings will be reached with Fund staff on corrective measures in order to meet the
program targets.
19. The conduct of monetary policy will be facilitated by significant improvements
in liquidity management, including by improving the forecasting of the government’s
cash flow position. As part of these efforts, the SBP and the Ministry of Finance have agreed
on quarterly volumes of treasury bill placements consistent with zero SBP financing of the
budget during October 1, 2008–June 30, 2009. The SBP has issued an auction calendar for
November-December 2008 on November 1st, 2008, and in the future will issue a calendar
every quarter one month in advance. In addition, the SBP will review the current procedures
for liquidity management, and will adopt and publicize a transparent liquidity management
framework by end-July 2009 as part of its Monetary Policy Statement. This framework will
contain the following key elements:
• The announcement of an explicit corridor for money market interest rates: the SBP’s
reverse repo rate will be the ceiling, and a standing repo facility to absorb excess
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liquidity from commercial banks will serve as the floor of the proposed explicit
corridor;
• The treasury will provide the SBP with T-bills, as needed, to conduct its open market
operations.
20. The SBP is committed to pursuing a flexible exchange rate policy. To that end,
intervention in the foreign exchange market (including the provision of foreign exchange for
oil imports) will be aimed at meeting the program’s reserve targets. This primary objective
will be facilitated by phasing out the SBP’s provision of foreign exchange for oil imports
according to the following schedule:
• Furnace oil—by February 1, 2009.
• Diesel and other refined products—by August 1, 2009.
• Crude oil—by February 1, 2010.
21. During the program period, the SBP intends to eliminate any exchange
restriction subject to approval under Article VIII of the IMF’s Articles of Agreement.
Specifically, the exchange restriction on advance import payments against letters of credit
will be eliminated by end-January 2010, subject to a marked improvement in the balance of
payments position. No intensification of existing restrictions and no new exchange
restrictions or multiple currency practices will be introduced during the program period.
22. The SBP will prepare a contingency plan to deal with problem private banks by
end-December 2008. The plan will contain criteria for SBP liquidity support, assessment of
bank problems, and intervention procedures. The SBP has already dealt with problem banks
through mergers. Looking ahead, if there are severe strains in the interbank market and
interbank lending guarantees appear necessary, these guarantees will be provided in limited
amounts only to solvent banks.
23. To enhance the effectiveness of SBP enforcement powers, necessary amendments
to the Banking Companies Ordinance will be submitted to Parliament by end-June
2009. These amendments will strengthen the SBP’s ability to (i) change management in
banks; (ii) impose losses on shareholders by writing down their capital; (iii) intervene and
take ownership of banks; (iv) appoint administrators to operate banks; and (v) restructure
banks.
24. The legal provisions relating to the operational independence of the SBP will be
reviewed. These provisions will be strengthened based on the recommendations of an
interagency committee that will be established by mid-November 2008, and taking into
account technical recommendations from the IMF. The second program review will focus on
specific details regarding required legislative changes in this area.
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25. The government believes that market confidence will improve significantly once
the Fund-supported program is approved and the international reserves position is
strengthened. Therefore, it does not intend to remove the current floor on stock prices until
after the program is in place. In any event, the timing and terms under which the floor on
stock prices will be removed, including any use of public funds to support the stock market,
will be decided after reaching understandings with Fund staff.
III. RISKS AND CONTINGENCIES
26. Larger-than-expected external budget support may become available in 2008/09
and 2009/10. In such a case, any additional external budget support to cover increased social
safety net spending up to $500 million per year (0.3 percent of GDP) will be used to replace
non-central bank domestic borrowing assumed under the program. Provided that downside
risks do not materialize, the government will use any additional external budget financing
beyond the first $500 million per year to further increase spending, up to a fiscal deficit of
4.7 percent of GDP in 2008/09 and 3.8 percent of GDP in 2009/10. Any external financing
support exceeding these limits will be used to retire government debt with the SBP and
strengthen the SBP’s international reserves position.
27. Key economic and financial downside risks to the program include lower-thanexpected
private capital inflows, a reversal of the current trend of declining oil prices,
and a more severe-than-anticipated economic slowdown in trading partner countries.
If these risks materialize, the government stands ready to adjust its policies, in close
consultation with IMF staff, to ensure the achievement of a sustainable external position by
the end of the program period.
IV. PROGRAM MONITORING
28. The program will be subject to quarterly reviews and quarterly performance criteria
as set out in the technical memorandum of understanding (TMU). Completion of the first two
reviews scheduled for end-March 2009 and end-June 2009 will require observance of the
quantitative performance criteria for end-December 2008 and end-March 2009, respectively,
as specified in Table 1.
29. An updated safeguards assessment of the SBP will be conducted in the context of the
first review.
30. The government authorizes the IMF to publish the Letter of Intent, its attachments,
and the related staff report.


Sources.......Pakistan: Letter of Intent, Memorandum of Economic and Financial
Policies, and Technical Memorandum of Understanding (To IMF)

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