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Old Monday, May 28, 2007
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FY2007: focus on current account
deficit, FDI and public debt


Current account deficit by the end of current FY is likely to swell to around $8.0 billion or around 5.4 per cent of GDP, primarily because of an increased trade deficit of around $13 billion. It would be the highest during the past seven years
By M. Sharif

Performance of current account deficit, FDI and public debt needs special attention because of their extraordinary importance for the national economy. They are vital in short and medium term perspective to achieve and sustain high economic growth, alleviate poverty, reduce inflation, have stable rupee-dollar parity and provide solid base for self-reliance of the economy. Performance of current account deficit and public debt, over the past three years in general and during outgoing fiscal year in particular calls for more vigilance. Against this, the performance of FDIs, during the current fiscal year has been beyond expectations.

Current account deficit
Pakistan has a history of living with trade and current account deficit of manageable magnitude. It also has a history of contracting foreign loans and being blessed with substantially large amount of remittances by the expatriates. Pakistan’s commitment to the US in its war against terrorism facilitated financial assistance by the US and multi-lateral donors that has been pouring in over past few years. The quantum of remittances has also increased to more than four times during the past five years to more than $4.0 billion a year. It is likely to be around $5.0 billion by the end of current fiscal year.

According to a study conducted by the Centre for Strategic and International Studies, reported in NYT, Pakistan has received roughly $10 billion from the US since 2002 under various heads: $5.6 billion in reimbursements, $1.8 billion for security assistance, $1.6 billion for budget support and $900 million for health, food aid, promotion of democracy and education. It averages to around $2.0 billion a year. Another analysis states, “Pakistan has received a massive liquidity injection of about $50 billion in remittances, aid, debt relief, earthquake assistance, FDI and privatisation proceeds during last five years.” Obviously, substantial part of the liquidity injection has been helping in tiding over current account problem which otherwise would have been quite troublesome. A closer look shows that main problem causing current account deficit is high trade deficit that consumes all sorts of liquidities coming from abroad.

Current account deficit has been on the increase during past three years. Prior to it, it was positive (3.8 per cent by the end of fiscal year 2002-03) and the government rightly felt proud of it publicly but the fact is that even then foreign trade was in deficit. But it was not that large to consume all foreign inflows. Current account deficit by the end of current FY is likely to swell to around $8.0 billion or around 5.4 per cent of GDP primarily because of swelling of trade deficit to around $13 billion. It would be the highest during the past seven years. The figures reveal that during first nine months of current FY, current account deficit increased to $6.0 billion against $4.3 billion during the corresponding period of last fiscal year. The increase is because of the trade deficit of $11.0 billion during first nine months of current FY against trade deficit target of $9.6 billion for the last fiscal year.

Import of some essential items to keep industry, agriculture and economy going is indispensable. It certainly raises import budget particularly when the economy is in the expansion mode as has been witnessed during the past four years. Industry related imports during the first nine months of the current fiscal year were registered to the tune of $11.0 billion, oil imports stood at $5.23 billion with an increase of 13.0 per cent over last year. Oil import bill is anticipated to be more than $7.0 billion by the end of current fiscal year. Like- wise import of other items related to economic growth at enormous import bill is understandable.

What is surprising is that telecommunication which is fetching perhaps highest FDI is costing a heavy import bill leaving aside high import bill of other consumer durables and non-durables. During first nine months, import bill related to telecom has hit $1.6 billion mark and by the end of the fiscal year it is expected to be more than $2.0 billion. Import bill of food items has also hit $2.3 billion mark during first ten months of the current fiscal year and is likely to be around $3.0 billion by the end of the year. One should not feel alarmed by these import figures but for the reason that our exports are not increasing at a pace they should have. This is the crux of the issue.

In order to reduce current account deficit, it is imperative to give boost to exports. Our exports are faced with a number of problems ranging from textile-centric with least value addition to comparatively high cost of production, inelasticity in exports and limited export markets. This obviously necessitates adopting new export regime to exploit country’s full export potential. The problem of current account deficit can be squarely addressed by bridging the trade gap. It is the only viable option that should be utilised at the earliest. But, because of certain subtle ground realities such as power crisis, high cost of production, low productivity and competitiveness in industrial and agriculture sector, it is unlikely if exports can make real big head way in near future notwithstanding the fact that the government has laid a very ambitious programme of doubling exports during the next five years. Exports have doubled to more than $17 billion during the past around seven years. That is why government’s dependence on foreign inflows is on the increase. The risk of depending on foreign inflows including commercial borrowing from international money market by floating various bonds will only add to foreign debt that is already swelling in absolute terms.

Foreign direct investment

Foreign investment has swelled to $5.97 during first ten months of the current fiscal year, a figure that has surpassed full year’s target of $5.0 billion. FDI in 2000-01 was $484.47 million and $3.87 billion in last fiscal year. Substantial increase in FDI during current fiscal year is really a positive news and augers well for the economy by any stretch of imagination particularly in the backdrop of ongoing judicial and political crisis in the country going on for around 10 weeks. They could have deterred investors. On the contrary, the investors and rating services have reposed confidence in the economy and government policies. The Standard & Poor’s Ratings Services on 18 May 2007 assigned B+ senior unsecured foreign currency debt rating to Pakistan’s proposed global bond issue of up to $1.0 billion. Confidence in the economy is likely to persist and it is expected that by the end of current fiscal year foreign inflows are likely to increase to more than $7.0 billion. While all this sounds well and is encouraging, the basic question is: What is exactly the nature of FDI? In which sectors of economy is it being spent? Is it going to help boost exports, create employment and create more avenues for further FDI?

According to an analysis acquisition of banks and their privatisation proceeds has contributed substantially towards accelerating FDI. In addition to this, launching of the Global Depository Receipts of OGDCL, MCB from UK and receipts of Euro bonds helped in giving boost to foreign portfolio investment in stocks. Equity securities and portfolio investment during first ten months were recorded $847.6 million inclusive of CDRs of the MCB worth $150 million and $120 million of OGDC. The second important point is that foreign investment is keeping pace: in April it was recorded at $418 million against $933 million in March. Tele-communication, real estate, hotels, insurance, power sector, oil and gas exploration are some of the sectors of economy that are attracting investment. Most of the foreign investment is coming from neighbouring Gulf States that have surplus liquidity because of increase in the price of oil in global market.

Privatisation of large number of public enterprises and banks and very little investment in new industrial units hardly creates job opportunities and technology transfers for Pakistan as has been experienced by China. That is why that unemployment in the country is on the increase despite increase in the level of FDI. The other matter of concern is that FDI through privatisation “target the domestic market such as telecommunication and real estate and thus have a low potential for improving the balance of payment.” For the latter, the government has to depend upon foreign inflows of all sorts as has been pointed out earlier. This underscores the importance of changing the track of FDI keeping in view the Chinese experience and the upcoming experience of the Indian economy.

FDI has many positive points to offer but it all depends how it is exploited by managers of national economy. In our context, in long-term perspective it is feared that inflows of investment focused on domestic market could be drain on our meager forex earning because outflows of profit repatriation is likely to increase gradually from its present level of around half a billion US dollar to much more than that.

Public debt
The government rightly takes the credit for having reduced public debt from more than 100 per cent of GDP around seven years earlier to around 50.0 per cent at present. But, the main purpose of taking a look at the economic indicator is increase in absolute terms, cost effectiveness of the debt in view of rising interest rates and its implications in the mid and long-term perspective and government’s efforts to address the problem.

According to debt policy statement issued by the finance ministry recently, total domestic debt stood at Rs2.422 trillion by the end of November 2006. It has increased from Rs2.312 trillion at the end of last fiscal year 2005. It is still on the increase because of increase in fiscal deficit during past two years. According to ADB this fiscal year it could be more than 4.5 per cent of GDP. The net increase of Rs1.532 billion represents a growth rate of 7.1 per cent that is slightly more than average growth rate of 6.6 per cent from fiscal year 2000. It is quite likely that domestic debt would end at slightly higher growth rate of 7.1 per cent by the end of current fiscal year. Foreign debt and liabilities of the country have settled close to $39 billion by March 2007, showing an increase of $1.623 billion over FY2006. The foreign debt started increasing gradually from FY2005 when the government started offering global bonds to raise foreign exchange in addition to annual borrowings of around two billion US dollars from foreign donors to meet current account needs. Since then the trend of borrowing from international financial market has continued. It will increase the debt burden if sufficient revenues are not generated from within the country.

Standard & Moody’s Ratings Services has made somewhat similar observation when it stated, “the long-term challenge for the government remains to rise significantly from the current level, and to demonstrate that the current pro-market, pro-growth set of policies will be sustained during successive administrations.” Governments inability to put economic fundamentals on correct track that is visible because of high current account deficit, domestic market focused FDI and resort to increase public borrowing to manage economy during the current fiscal year, gives a clear indication that a lot is more desired to be done to make economy self-reliant.

Conclusion:
Current fiscal year is likely to end with a few positive indicators and benefits accruing to privileged sections of the society. But, the three important economic indicators deliberated above show that government has preferred to adopted easy route of giving boost to growth through external resources rather than making corrections, the hard way. It could have serious implications for the economy in long and even medium term perspective. Will budget of forthcoming fiscal year take care of weaker indicators that have shown further downward trend during current fiscal year instead of improving? Budget for FY2008 will be closely watched by analysts for this very important reason.



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Is the direction of our economy showing alarming trends?
By ADIL MAHMOOD

ARTICLE (May 26 2007): Years 2003 to 2005 were good years for the Pakistani economy. Some say that it was the incoming post 9/11 funds, which gave the economy a boost while others truly believe that the economy was managed well and years of sustained efforts, post 1999, resulted in the average 7+% growth rates in the economy.

To be fair it was both. Unfortunately, we seem to have lost direction somewhere along the line, to have gone from the strong positives of two years ago to a situation which could be disastrous to say the least!

We are heading towards a serious problem in our economy! The first step to solving any problem is to recognise that there is a problem in the first place. Unfortunately, many in power refuse to recognise that there is any problem! For those I have no words but for the others I will attempt to give an overview of the ground reality.

From a relatively comfortable position of holding enough foreign exchange reserves to pay for 9 months imports we can now only pay for 5 months imports and the situation gets worse with each passing day as the export vs. import gap widens.

The rate at which exports are increasing has fallen to 3.36% fetching $13.9 bn, whereas imports continue to gallop ahead at an alarming rate of 8.92% and totalling $24.993 bn during the ten months. At this rate, a report says that our trade deficit should hit a staggering $14 bn this fiscal year.

It goes onto to say that "the more we borrow, the more money we would need in foreign exchange in future to service the debt. Selling the family silver to the foreigners is an option but no sane person would favour such a reckless attitude".

Textiles, whether we like it or not, is our economy's mainstay. With over 66% of export earnings coming from this single sector we cannot afford to ignore this vital sector. It will not be out of place to mention that many considered the Bangladeshi economy like those of the many failed states whereas today, because of textiles alone, that economy is growing, vibrant and progressing in leaps and bounds.

It is critical that in an effort to diversify the economy so as to reduce our reliance on a single sector, we should not do so at the cost of the single most important sector. Causal comments, reported and unreported, from the SBP Governor, the PM's advisor on Finance and others are disturbing indeed when one hears about such people suggesting that the textile industry should "die". Others have reported that the powers that be want to transform our economy into a marketing economy at the cost of the manufacturing industry.

The textile industry has recently been accused of being dependant on handouts and inefficient. One has to reasonably ask how the most efficient industry in Pakistan, that was the Government's blue eyed boy with a $6 bn investment in new textiles, increasing exports, and providing the largest industrial employment etc-etc has now become the untouchable, inefficient and dependant on the kashkol!

What is the reality? Our leading industrial association, APTMA has been facing the wrath of the Government, with the powers that be openly criticising them. So much so that a break away group is proposing to form their own Association of Spinning Mills (APTA), as they feel that APTMA is perceived as having become a rich man's club, whereas the problems of smaller mills and single units are not highlighted.

To add salt to wounds, the few benefits and handouts that have been given by the government have been only to the larger vertical units and downstream industry whereas the base industry, spinning, which is the worst hit is getting squeezed further day by day.

APTA has been after the issue of the government providing an honourable exit strategy to mills who want to wind up their businesses and go and do some other business, where they can get some respect. They say that selling imported juices and imported mobile phones should be better as that seems to be the future of our marketing economy.

The only hesitation for them to close down is that the present banking laws are criminal in nature and whereas, the world over debtors prisons were done away with 200 years ago, the same exist in our one-sided banking laws. Publicly listed limited company's directors can be hauled up to pay for the Company's losses and defaults.

There is no practical form of bankruptcy like the Chapter 11, 13 and 7 bankruptcy laws in the USA. They said that one of their colleagues had his factory stock wiped away in floods 30 years ago and spent the next 20 years fighting the banks after which he got Parkinson disease and died.

The desperation in the textile sector can be gauged by the APTMA spokesman's press statement in the May 17th newspapers, asking for an honourable exit strategy for mills who want to close and wind up their business and basically call it a day!

What has happened in the last two years for such a drastic downturn? We spoke to the first Chairman of the proposed APTA, Mr Adil Mahmood and asked him as to what had changed. He gave us the facts, which we found to be startling. He gave us a list of increases in costs of production within a period of less than two years, which has led to an increase in a spinning mills conversions costs by over 70 to 80% in less than two years!

Wages were increased by 33% on July 1, 2006, petroleum prices increased resulting in increases in transport costs from Rs 18,000 to over Rs 55,000 for an up-country truck resulting in a spiralling increase in costs of incoming raw material and stores and outgoing finished products. Packing materials like polybags, paper cones, lubricants all increased over 80% during this period.

Gas prices for captive power generation units increased from Rs 182 per mmbtu during December 2005 to Rs 264 during July 2006, an increase of 46% in 6 months and over 53% in last one and a half years!

This figure had us bewildered as Bangladesh's gas prices are reportedly around Rs 80 per mmbtu ie their industry gets electricity at one third the cost than what our industry gets it at! One of the main reasons for this disparity is that the industry finances cross subsidy to other sectors like fertiliser and domestic. This rate was recently decreased by 10%.

Adil continued that one of the problems with industrialists is that if they are making money, they want to expand. The textile industry were earning and had the assurance of the government in respect of continuity of policies, so they went ahead and invested over $5 billion in new machinery.

The rates of mark up were 3 to 4% so the risks were thought to be minimal. Lo and behold, within a short period of two years, we are now sitting at close to 15% mark up rates and even at this level, banks are not willing to lend to this now risky sector.

An increase of 400% in two years! Is this continuity of policies? The Government must realise that these increases in costs of production in such a short period of time is not possible for any industry, however efficient, to absorb.

We were further amazed when Adil showed us the details of what support our regional competitors were giving their industry. Bangladesh wages are Rs 1,500 per month, gas prices one third of ours, fuel substantially cheaper than ours, cash rebates of 5% and soon to be 10% on local purchases of raw materials, yarn and fabric.

Imported textile machinery purchases of Bangladesh have been double of Pakistan's despite no local cotton production. Looms purchases, spinning mills have all boomed in the last few years and continue to do so. This is apart from the preferential tariff treatment that their products get into EU. Foreigners feel safe in Bangladesh despite its strikes and roam around freely in hand rickshaws.

India's conversion costs are slightly higher than Pakistan's but more than compensates its industry through a special scheme called TUFFs to fund cheap rate interest to its industry and the most critical of all is its agricultural research and development base.

India's cotton crop has been increasing in quantity by over 20% year on year over the last few years. Such growth in agriculture is phenomenal and a win situation for the entire chain of their textiles. Resultantly India's raw material costs are much lower than Pakistan's. Again, in India, all buyers are willing to travel and stay.

Recently Gherzi, a consultancy firm hired by the Government, submitted its report on Pakistan's competitiveness in which it praised the efficiency of the spinning industry and detailed the subsidies provided by the various Regional Governments including China. The incentives provided by Pakistan to its industry is miniscule compared to that provided by India, China and Bangladesh.

Adil pleaded that costs of production increased beyond comprehension during the last two years, while regional competitors Governments were providing unfair subsidies to their industry, no buyers were willing to travel to our country particularly Karachi and raw material, cotton production, going from 14.5 million bales to 12.3 million was of very bad quality cotton.

He asked me if I had begun to understand why the textile millers were so upset and were highlighting the lack of a continuity of policies. He once again highlighted the fact that now millers were asking for an honourable exit as they had given up hope of the government facing up to reality in the region.

Adil said that he had taken on the task of forming the APTA in order to try and make the government realise the true magnitude of the problem that the mills were facing as many of their members believe that the people in APTMA, speaking to the government, are big groups which can sustain such downturns and in fact are happy, as many weaker single units would close to their delight.

While export of traditional products like footwear, surgical and leather goods and carpets have witnessed a negative growth, during the last couple of years, the focus on and the strategy for promoting exports of textile products also seems to have backfired.

It was known about 10 years before the end of MFA that China and India would be posing a real challenge to the large textile sector of Pakistan but the government and the textile sector failed to make an effective strategy for times to come.

Surprisingly, Bangladesh has also emerged as the main competitor of Pakistan, replacing it from its traditional markets of Europe and America. No serious attention has also been given to the policy framework. Judged by the huge imbalance in the external sector, the Pakistan rupee is overvalued.

Fiscal and monetary policies are still expansionary and attuned to high growth in imports. Factors like shortage of energy and its high cost are also impacting exports adversely.

Clearly, there is an urgent need to reserve the situation otherwise the mismanagement in the external sector would have serious repercussions, such as threat of default on external payments, massive depreciation of the rupee and high inflation. We could only hope that the government would take appropriate measures well in time to narrow the widening gap in the external sector of the country. Conclusively, the country is left with no alternative but to finance its import payments mainly by enhancing its export earnings.
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State of Pakistan's Economy: SBP's Third Quarterly Report for fiscal year 2007

ARTICLE (May 27 2007): The State Bank of Pakistan on Saturday released its Third Quarterly Report on the state of the economy. The following is the executive summary of the report.

1.1 OVERVIEW Recent statistics indicate that the economy is likely to show robust growth for the fourth successive year, with real GDP growth now expected to exceed the 7 percent annual target in FY07. Moreover, the growth is expected to be quite broad based.

The unexpectedly strong out turn by agriculture following the record wheat crop and upward revision in key kharif numbers means that agricultural growth is forecast to exceed the annual 4.5 percent growth target. The industrial growth is also expected to be stronger than that in the previous year, though it may not reach the FY07 target.

Similarly, the services sector is expected to continue with its growth momentum for yet another year; while growth in the wholesale & retail trade sub-sector is likely to slow somewhat, reflecting the deceleration in imports, the remaining services sub-sectors are expected to continue to record high growth.

The strength of aggregate demand reflected in the growth figures clearly belies claims that the monetary tightening has stifled growth in the economy. Quite to the contrary, it seems that monetary policy has struck an appropriate balance by protecting the growth momentum of the economy, while attempting only to remove excessive monetary stimulus from the economy.

Unfortunately, the impact of the latter in reducing inflationary pressures has been offset partially by the rise in food inflation, and supply-side pressures. Thus, even as non-food inflation weakened, overall CPI inflation declined only gradually, falling from 11.1 percent in April 2005 to 6.9 percent by April 2007 (see Table 1.1), however still above the 6.5 percent target for FY07.

================================================== ====================
Selected Economic Indicators
================================================== ====================
July-March or as mentioned
================================================== ====================
FY05 FY06 FY07
================================================== ====================
Growth rates (percent)
LSM 18.7 9.9 9.8*
Exports (fob) 14.3 18.0 3.5
Imports (cif) 37.6 43.2 8.1
Tax revenue (CBR) 13.5 22.1 21.9
CPI (12m MA) end-Apr 9.0 8.2 7.8
Private sector credit Jul-Apr 28.6 20.2 13.0
Money supply (M2) Jul-Apr 13.7 10.8 12.1
billion US Dollars
Total liquid reserves1 end-Apr 13.0 13.1 13.7
Home remittances 3.1 3.2 3.9
Foreign investment 1.4 3.3 5.6
percent of GDP2
Fiscal deficit Jul-Dec 1.2 1.8 1.9
Trade deficit 3.8 6.7 6.8
Current account deficit 1.0 3.3 4.1
================================================== ====================

-- September 2006 data point.

-- More recent data is not available.

1 With SBP & commercial banks.

2 Based on full-year GDP in the denominator.

It needs to be recognised that food inflation is typically less responsive to monetary tightening and therefore monetary policy should not respond aggressively to temporary shocks in food prices.

At the same time, it is also clear that a continuing focus on tight monetary policy will be critical so that the second-round impacts of the high food inflation do not add to underlying inflationary pressures in the economy.

SBP depends more on market dynamics and government's administrative measures to contain food inflation while retaining a tightening bias to ensure that inflationary expectations are contained.

The challenge to the modulation of monetary policy is increased by the recent acceleration in the growth of monetary aggregates. Through most of FY07, even when seeking a broad reduction in aggregate demand, the SBP remained mindful of the pressures on the textile sector, and on exports, which faced rising competitive pressures.

Thus, a substantial portion of the credit availed by these sectors in FY07 was provided on concessional terms by the central bank. This included a total of Rs 332.8 billion during July-April 28, FY07 as gross disbursement from refinancing facility (Rs 43.8 billion disbursed under the LTF-EOP1 (Long-term financing for export oriented projects.) scheme and another Rs 289.0 billion through the export refinance scheme).

It must be recognised that the subsidy implicit in the provision of concessional re-financing by SBP is only part of the cost of supporting the strategic sectors; additional (less visible) costs include the downstream implications on reserve money growth and consequent lagged impact on inflation, fiscal costs (as SBP profits erode, reducing the pass through to government), as well as reducing the incentives for banks to generate deposits by raising returns.

Indeed, the concessional credit provided by the central bank was an important factor in the strong growth in reserve money during July-April FY07. The impact of this was compounded by the substantial increase in government borrowings from the banking system, and rising net foreign assets of the banking system.

Partially, as a result, growth in broad money during the period rose to 12.1 percent by April 28, 2007, significantly higher than the 10.8 percent growth during the corresponding period of FY06.

Another important development in FY07 was the change in the credit growth profile. Firstly, even though the growth in private sector decelerated substantially during the first nine months of FY07, the bulk of the fall owed to a few specific sectors.

Specifically while there was a sharp deceleration in consumer credit, the business loans presented a mixed picture, with many businesses witnessing a strong increase in credit demand (including telecommunications, food processing industries, and apparel industries).

In other words, there appears to be a healthy shift in the credit demand centers in the economy. Secondly, a part of the deceleration in credit demand owed to supply-side constraints, as a few large banks scaled down their credit activities either due to internal restructuring (eg to improve risk management, and credit extension services, etc) or as a consequence of mergers & acquisitions.

In fact, a substantial part of the deceleration in credit off-take is contributed by just a few institutions. Thirdly, while investment credit demand witnessed a decline, this essentially reflected lower demand in industries that had already substantially increased capacities in recent years (eg textiles and cement), as well as delays in the initiation of major infrastructure projects (eg power projects).

The above discussion suggests that at least a part of the deceleration in the private sector credit growth seen in FY07 may not persist in FY08. In other words, the high reserve money growth in FY07, together with the rising demand for private sectors credit, raises the risk to a strong resurgence in excess aggregate demand, and consequently inflationary pressures in FY08.

This makes it even more important that fiscal policy be aligned with monetary policy in months ahead. The rise in the fiscal deficit in recent years has been essentially an unavoidable function of the post-earthquake reconstruction activities and of the heavy development investments required to build up infrastructure and invest in human capital to enhance the productive capacity of the economy.

At the same time the government has also tried to avoid the build-up in fiscal imbalances by committing to a 4.2 percent of GDP cap on the fiscal deficit target. However, despite significant success in increasing non-bank borrowings in FY07, particularly following the resumption of significant PIB issuance's and a recovery in (net) NSS receipts, there is a worrying dependence on borrowings from the central bank.

The risk to monetary stability posed by heavy budgetary borrowings is highlighted by the February-April FY07 fiscal financing activities, with the government raising Rs 195.7 billion from the scheduled banks, net of maturities, but retiring only Rs 58.4 billion of its central bank loans.

Another significant challenge to monetary stability stems, ironically, from the Pakistan's comfort in financing the country's growing current account deficit. While the growth in the current account deficit has decelerated sharply as FY07 progressed (mainly because of sharp compression in import growth), in absolute terms it has grown to US $6.0 billion by March 2007.

While this was comfortably financed by even larger surpluses in the financial and capital account (with substantial non-debt components), the country's success in attracting international capital has led to a large jump in the NFA of the banking system, adding to liquidity in the domestic markets.

Real GDP growth is now estimated to comfortably reach the annual growth target of 7.0 percent in FY07 (see Table 1.2), and could potentially exceed it, if LSM growth reaches double digits, livestock growth exceed targets and the services sector growth remains on target.

However, the continued strength in aggregate demand, together with the resilience in food inflation, has meant that despite sustained monetary tightening the downtrend in inflation has been very gradual, and variable. As a result, domestic inflation is now forecast to remain in a relatively higher range than forecast earlier, and well above its annual target for FY07.

================================================== ===============
Major Economic Indicators
================================================== ===============
FY07
Provisional Original SBP
FY06 targets projection
================================================== ===============
Growth rates (percent)
================================================== ===============
GDP 6.6 7.0 6.8 - 7.2
Inflation 7.9 6.5 7.5 - 7.8
Monetary assets (M2) 15.2 13.5 14.5 - 15.5
billion US Dollars
Exports (fob)1 16.6 19.8 17.6
Imports (fob)1 25.0 27.4 27.2
Exports (fob)2 16.5 18.6 17.2
Imports (cif)2 28.6 28.0 30.2
Workers' remittances 4.6 4.5 5.3- 5.5
percent of GDP
Budgetary balance -4.2 -4.2 -4.2
Current account balance -3.9 -4.3 -4.8
1 BoP data, 2 Customs data
================================================== ===============
It is important that appropriate monetary policy be sustained as price stability is important to sustain long-term growth and for poverty reduction. In particular, it must be recognised that inflation has particularly adverse consequences for low-income groups, which generally have no means to hedge themselves from sustained high inflation, in contrast to high income groups that can partially offset the impact through investment in real assets.

The challenge to monetary policy is compounded by the unexpectedly strong resurgence in broad money in recent months, with M2 growth forecast to exceed the original 13.5 percent target, to fall in the range of 14.5 - 15.5 percent.

A part of this is a consequence of the concessional re-finance to strategically important sectors of the economy, which significantly raised reserve money growth in FY07, and will consequently have knock-on impacts by raising monetary growth in subsequent periods.

The impact on reserve money growth of this development has been compounded by the heavy reliance on central bank borrowings by the government and the growth in NFA of the banking system.

The impact of the former may be limited, if the government appropriately ensures that the SBP borrowings are retired as external and domestic non-bank receipts improve. However, the resurgence in NFA of the banking system poses an additional challenge - the country needs sustain these flows, but it is simultaneously imperative to sterilise the monetary impact of these flows in order to contain inflationary pressures.

The need to sustain the external flows is implicit in the growth of the current account deficit during FY07, which is now forecast to rise to 4.8 percent of GDP, up from the initial forecast of 4.5 percent of GDP.

It is a source of comfort that the monthly growth in the current account deficit continues to decelerate, and that the current account deficit is likely to be comfortably financed in the short-run, particularly given strong international liquidity flows towards emerging markets.

However, it should also be kept in mind that international capital flows can be volatile, and are sensitive to a host of domestic and global factors (both economic as well as political). The long run health of the economy, however, requires a lower sustainable current account deficit, concurrent with a rise in the domestic savings rate and a gradual reduction in the fiscal deficit.

For the latter to be sustainable, there is need to build upon the welcome growth in the tax receipts in July-March FY07. A graduated increase in the tax-to-GDP ratio, as proposed by CBR, is essential if the government is to sustainably finance the development spending required to raise the long-term growth potential of the economy.

1.3 EXECUTIVE SUMMARY

AGRICULTURE A record wheat harvest, and upward revision in the production figures for key kharif FY07 crops has raised the prospects of a strong recovery by the agriculture sector in FY07. Resultantly, it is estimated that growth for major crops could reach as high as 5.8 percent in FY07, significantly higher than the target growth of 4.3 percent for the year.

In particular, the most significant contribution to the improvement in the agri-growth estimates was from the exceptional FY07 wheat harvest. The 23 million tons wheat harvest is not only well above the target of 22.5 million tons, it is the largest ever recorded in Pakistan.

On the expectations of higher irrigation water availability and continued policy support (Continuity of subsidy on DAP fertilisers.), production targets for kharif crops for FY08 have been fixed higher as compared with the realised harvests in FY07.

However, actual performance will depend critically on market prices and favourable weather conditions. On the former count, the FY07 increases in price of cotton and rice and persistently high sugarcane prices will be encouraging for the farmers in FY08.

The banking system provided its supportive role to agriculture sector by meeting the growing financial needs of the farming sector. Agriculture credit disbursement rose to Rs 111.2 billion during July-March FY07, up by 22 percent relative to the corresponding period of FY06.

This growth is well above the 16.4 percent annual target, though 1.5 percentage points lower than seen in July-March FY06. The pace of agri-credit disbursement suggests that Rs 160 billion annual target for FY07 would be met comfortably.

Large-Scale Manufacturing (LSM).

The detailed LSM data of 100 items for Q1-FY07 and limited information for Q2-Q3 of current fiscal year implied that LSM growth may be higher during July-March FY07 as compared with the corresponding period of FY06, but suggests that the 13.0 percent growth target of LSM sector for FY07 may not be achieved.

Major industries supporting the recovery in LSM included textiles, sugar, cement and basic metals. The automobile industry, however, registered a slowdown in growth during July-March FY07 relative to the corresponding period of FY06. However, industries such as fertiliser, paper & board and engineering saw a decline in production during this period mainly due to weakness in demand and temporary shut down for maintenance as well as expansion.

PRICES Strong increases in food inflation continued to underpin inflationary pressures in the economy, and offset much of the gains from the abatement of non-food inflation through a tight monetary policy.

Thus, principally due to rising food prices, CPI and SPI measures of inflation both recorded year-on-year increases in April 2007, after steep falls in the previous months (when food inflation had dropped sharply).

The influence of food inflation is also evident in the WPI; although the WPI inflation has seen a year-on-year drop this is simply because a surge in its food component was largely offset by a sharper decline in its non-food elements.

Inflationary pressures are particularly evident in headline CPI inflation which accelerated to 6.9 percent YoY in April 2007 compared with 6.2 percent YoY in April 2006, despite a significant ease in non-food inflation.

The deceleration in non-food inflation is mainly attributed to slowdown in the sub-groups of fuel & lighting, transport & communication and house rent.

As a result of the unexpected resilience of food inflation and likely pressures in near term due to increases in the prices of milk and edible oil etc, SBP forecast for FY07 has been revised upwards from 6.7 - 7.5 percent to 7.5 - 7.8 percent.

MONEY AND BANKING The key challenge for SBP monetary policy during FY07 has been to maintain a balance between sustaining strong economic growth and low and stable inflation. While the economic growth momentum remains intact, the headline CPI inflation has been stubbornly high at an average of 7.9 percent during July-April FY07.

This is mainly due to continuing pressures on food inflation, as the slowdown in food inflation, expected during H2-FY07, did not materialise. SBP recognises that food inflation is typically less responsive to monetary tightening and therefore the monetary policy should not respond aggressively to temporary shocks in food prices.

Thus, SBP depends more on market dynamics and government's administrative measures to contain food inflation while retaining a tightening bias to ensure that inflationary expectations are contained. A more challenging development has been the sharp increase in monetary aggregate (M2) growth.

In fact, the M2 growth which has been showing gradual slowdown relative to the corresponding period till February 2007 (The money supply has risen by 7.7 percent during the initial eight months of FY07 (ie, July-February FY07) which was lower than 8.6 percent growth witnessed during the corresponding period of FY06.), 3accelerated sharply afterwards to reach 12.1 percent during July-April FY07 compared to 10.8 percent rise during July-April FY06.

Unfortunately, the underlying causes of the recent M2 growth (ie, strong government borrowings and rise in net foreign assets) leave the central bank with a dilemma. Specifically, the government borrowing from the banking system for budgetary support and net foreign assets (NFA) has been the key reasons for this sharp rise in M2 growth in recent months; these together contribute 3.6 percentage points to the total rise of 4.0 percentage points in M2 during March-April FY07.

Growth in credit to private sector slowed from 20.2 percent during July-April FY06 to 13.0 percent during July-April FY07, suggesting that the monetary policy has been reasonably successful in reducing excess demand in the economy. Nevertheless, the desegregated data shows that the slowdown in private sector credit during July-April FY07 was concentrated in few business sectors, eg, textiles, cement industries and commerce sector as well as in personal loans.

FISCAL DEVELOPMENTS Consolidated data on fiscal accounts will only be available by the end May but the government has indicated that it remains committed to achieving the fiscal deficit target of 4.2 percent of GDP. However, the relative slowdown in the CBR taxes January 2007 onwards (dipped from 26.7 percent in H1-FY07 to 12.3 percent in Q3-FY07) indicates that expenditure growth would need to be monitored closely.

The CBR significantly surpassed its tax collection target during July-March FY07 with actual collection of Rs 597 billion despite slowdown in growth of collections. Indirect tax collection stood at Rs 359.2 billion against the target of Rs 396.8 billion.

This shortfall is the result of sharp decline in the import growth that fell from 43.2 percent YoY in Q3-FY06 to 8.1 percent YoY in Q3-FY07, reducing the import-related taxes substantially. Another significant development is the sharp rise in domestic borrowing by the end of Q3-FY07, which mainly reflected the relatively lower availability of external financing compared to the corresponding period of FY06.

The aggregate government borrowings for deficit financing from domestic sources stood at Rs 190.5 billion during July-March FY07, which was nearly four-times the July-March FY06 borrowings. However, external borrowings are expected to increase during Q4-FY07 due to an expected sovereign debt issue, which would reduce the government domestic borrowings.

An encouraging development was that, unlike the previous year, the government was able to substantially increase its non-bank borrowings in July-March FY07, as well as sourcing a greater proportion of its banking system borrowings from scheduled banks. The government also raised its non-bank borrowings as a result of PIB auctions and improved NSS receipts.

BALANCE OF PAYMENT Pakistan's current account deficit continued to widen during July-March FY07, rising to a record US $6.0 billion, up sharply from the corresponding period of FY06.

Encouragingly, the data also shows a distinct improvement in the pace of the growth of the current account deficit that has fallen sharply, with Q3-FY07 even witnessing a marginal (and probably temporary) year-on-year decline, largely reflecting the sharp deceleration in the trade deficit during the course of FY07.

Moreover, Pakistan continued to record large surpluses in the capital and financial account that comfortably offset the current account deficits. As a result, the overall external account recorded a surplus of US $373 million during the first nine months of the current fiscal year.

Pakistan's exchange rate remained broadly stable moving within a narrow band of 60.2-60.9 Rs/US$ during July-March FY07. However, the real effective exchange rate (REER) appreciated by 2.06 percent during this period primarily due to the rise in the relative prices compared to its trading partners.

FOREIGN TRADE During July-March FY07, imports and exports could record only 8.1 percent and 3.5 percent growth respectively, in contrast to high double- digit growth in the same periods of the preceding four years.

Thus, while the trade deficit continued to widen, the pace of the increase was appreciably slower, falling to 14.6 percent during July-March FY07 as compared to an average growth of 88 percent during the corresponding period of the last four years.

Unfortunately, the gains from the (largely) anticipated deceleration in import growth have been offset by an unexpected weakness in export growth. The abrupt deceleration in export growth in FY07, after strong increases in the previous four successive years, is a source of some disquiet.

The sluggishness in exports growth originated from a combination of factors, which include one-off supply shocks, EU-specific preferences & safeguards, as well as some competitive pressures. Going forward, the rising trend of commodity prices in the international market, higher demand for furnace oil by the thermal power plants and anticipated increase in the import of power generating machinery may put upward pressure on the import bill.

On the export side, Pakistan's textile industry needs to be more competitive as it would face increased competition in international markets after the abolishing of China specific textile and clothing safeguards in 2008 by the EU and the US.

In this backdrop, there is need to focus on devising a comprehensive export promotion strategy to narrow down the trade gap. Major issues to be addressed in the export strategy are: a) lack of exports diversification, b) supply side constraints, c) low labour productivity, d) relatively low quality of products, e) delay in the adoption of international standards, f) lack of scale economies, and g) inefficiencies caused by infrastructural bottlenecks.
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Growth with equity

HAVING achieved an average economic growth rate of seven per cent over four successive years, the government is now targeting a 7.2 per cent GDP growth for fiscal year 2007-08. The track record raises hope that Pakistan has not only the potential but also the wherewithal to join the league of Asian countries with decades-long sustained growth — a trend that is becoming more global. But one cannot be sure that the growth strategy now being pursued, resulting in the worsening of major macroeconomic indicators, can really protect the economy from the long-term risks of a possible slowdown. As is evident from a significant gap this year between budgetary targets and the revised provisional estimates, particularly the receding growth of industrial production and exports, the future course of development seems to remain uncertain. Industrial growth is down to 6.8 per cent against the budget estimate of 11 per cent and large-scale manufacturing has recorded a growth of 8.8 per cent, falling significantly short of the 13 per cent target. Similarly, export earnings are now pitched at $17.2 billion this year against the original projection of $19.8 billion. Despite the rise in home remittances and foreign investment — which together account for about $11-12 billion — the record current account deficit is expected to rise to $7.1 billion, mainly because of a very high trade deficit of $9.9 billion.

The current account deficit can be financed in the short run from international capital inflows but, as rightly pointed by the State Bank of Pakistan, global capital “can be volatile and sensitive to a host of domestic and global factors (both economic [and] political)”. Before the economy suffers a setback, it is imperative to boost exports of merchandise beginning with the next budget, focusing on manufacturing and by taking steps to increase the dismally low rate of domestic savings. The savings rate has been eroded by persistent high inflation, currently estimated at 7.6 per cent as against the budgeted target of 6.5 per cent. With increasing interest rates and decreasing purchasing power, consumer financing by banks has dropped by a huge 42 per cent in nine months during the current fiscal year. The share of consumers, along with exports, in GDP growth is falling. But a positive development this year has been a robust growth in direct taxes, a trend that, if sustained, can ultimately help lessen the heavy burden of indirect taxes on poor consumers.

Going by the official pronouncements, next year’s budget holds out some promise for the common man. As indicated by the secretary-general of finance, the salaried class and the common people will get relief though increases in their pay and pensions. The long-delayed plans for low-income housing are to be initiated. The size of small loans, which have so far not gone towards the uplift of the poorest of the poor, will be increased. How much these provisions will benefit the common people will be known only after the budget has been announced. Unlike the past two to three years, the economic growth this year is more broad-based coming from all three sectors — industry, agriculture and services. It is a positive trend. But the worsening macroeconomic indicators and structural imbalances pose a daunting challenge to the policymakers. It is time to address issues relating to the fundamentals of the economy to manage sustainable growth with equity.
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An analytic objective assessment of the economy

Pakistan’s economy is likely to show commendable growth for the fourth successive year, with real GDP expected to exceed the annual plan target of 7 per cent. This robust growth is estimated to be quite broad based with commendable contributions from agriculture, manufacturing and services sectors

By Aftab Ahmad Khan

The recently released third quarterly report of the State Bank of Pakistan (SBP) presents an analytic objective assessment of the economy during July-March FY07 against the background of past trends. It also recommends appropriate policies and measures for putting the economy on a path of sustained high growth in a stable and equitable milieu.

According to the report, Pakistan’s economy is likely to show commendable growth for the fourth successive year, with real Gross Domestic Product (GDP) expected to exceed the annual plan target of 7 per cent. This robust growth is estimated to be quite broad based with commendable contributions from agriculture, manufacturing and services sectors.

In the agriculture sector, the growth of major crops could reach as high as 5.8 per cent in FY07, which is notably higher than the target growth of 4.3 per cent for this year. The output of wheat has witnessed an exceptional growth of 6 per cent in FY07 to reach 23 million tons, well above the target of 22.5 million tons, and the largest ever recorded in Pakistan. A rise in the area under cultivation of wheat, higher irrigation water availability, policy support as well as efficient use of inputs are the main reasons for this exceptional growth.

Aside from the record wheat crop, higher that estimated output of sugarcane and cotton harvests has also contributed to the above target performance of the agriculture sector.

Agri-credit disbursements registered a strong growth of 22.5 per cent in July-March FY07 as against the corresponding period of FY06 and above the annual target of 16.4 per cent.

Increased income of farming sector in FY07 is reflected by the improvement in the Agri-credit recovery, which grew by 22.5 per cent YoY during July-March FY07 against 16.1 per cent increase during the previous year.

Growth in the large scale manufacturing industries during July-March FY07, according to the report is probably higher than in the corresponding period of last year, but the 13.0 growth target of large scale manufacturing (LSM) sector for FY07 may not be achieved.

The services sector, according to the report, will maintain its growth momentum in the current fiscal year despite a slowdown in the growth of wholesale and retail sub-sector due to deceleration in imports.

On the monetary front, there was sharp expansion in M2 during July-April FY07 of 12.1 per cent as compared with 10.8 per cent growth witnessed during the corresponding period of FY06. According to the report, the FY07 M2 growth target of 13.5 would be exceeded. Large M2 growth is mainly attributable to strong government borrowings and rise in net foreign assets.

The report quite appropriately recommends that the government needs to retire borrowings from the banking system, particularly from the central bank and that the fiscal deficit may be contained in years ahead to reduce the risk of crowding out of the private investment.

The SBP has focused on effective liquidity management to prevent M2 expansion stimulating the multiplier process by putting downward pressures on interest rates in coming months. The SBP rightly is of the view that given the supply side pressures, a further increase in aggregate demand can only exacerbate inflationary pressures in the economy. The SBP has been monitoring closely liquidity in the inter-bank market and has been intervening as and when required.

The net foreign assets (NFA) of the banking system registered a massive rise of Rs82.2 billion during July-April FY07. The main factors responsible for this large increase in NFA includes influx of foreign exchange through GDRs, a relatively high foreign investment (both FDI and portfolio), private loans and increase in loan disbursements from the Asian Development Bank.

Growth in the net domestic assets NDA of the banking system during July-April FY07 at 12.1 per cent was more or less unchanged as compared with the previous year. There was, however, a slowdown in credit to the non-government sector (from 19.4 per cent in July-April FY06 to 12.7 per cent in July-April FY07) which was offset by acceleration in credit to the government sector (from 2.7 per cent in July-April FY06 to 14.3 per cent in July-April FY07).

Despite slowdown in credit growth to the private sector, the fixed investments have registered a higher growth during July-April F07 as compared with the same period in FY06.

Consumer loans dropped by 11.9 per cent in July-March FY07 as compared with a decline of 31.6 per cent in July-March FY06. The slowdown during July-March FY07 was primarily due to the increase in interest rates as well as more restrained lending by the banks.

The deposit base of the banking industry during July-April FY07 witnessed a growth of 11.7 per cent, little higher than the 10.5 per cent registered during July-April FY06. The increase in this behalf during July-April FY07 is primarily attributable to more aggressive marketing of deposit products by banks, increase in weighted average deposit rates and expansion in the network and usage of automated tellers machines (ATMs).

On the fiscal front, the report is confident that the deficit target of 4.2 per cent of GDP for FY07 would be achieved.

The Central Board of Revenue (CBR) surpassed its tax collection target of Rs579.8 billion during July-March FY07 with actual collection of Rs597.0 billion (21.9 per cent YoY growth).

Direct tax collection stood at Rs237.8 billion during July-March 07 against the target of Rs183 billion showing a massive growth of 55.7 per cent YoY. Almost half of direct tax collection was under the head of “voluntary payments” which nearly doubled during July-March FY07 as compared to the same period in the previous year.

Indirect taxes receipts during July-March FY07 amounted to Rs359.2 billion as against the target of Rs398.6 billion. This shortfall is due to a sharp deceleration in the import growth which dropped from 43.2 per cent YoY during July-March FY06 to 8.1 per cent during July-March FY07.

Inflation as measured by the consumer price index (CPI) YoY stood at 6.9 per cent for April 2007 as compared with 6.2 per cent for April FY06. The CPI inflation during the first ten months of FY07 is primarily attributable to food inflation. The contribution of food group in overall inflation was 56.1 per cent.

Inflation as measured by wholesale price index (WPI) registered an increase of 6.0 per cent in April 2007 compared to 8.1 per cent during the same month last year. WPI inflation during July-April FY07 is attributable to rise in wholesale prices of onions, fruits, poultry items, cotton, seeds, wires and cables etc. which showed increases of varying magnitudes.

The sensitive price Index (SPI) also remained uncomfortably high during the first ten months of FY07 on account of rising prices of food items. Inflation as measured by SPI was 7.7 per cent in April 2007 as compared with 6.4 per cent in the same period last year.

So far as performance of the economy’s external sector is concerned, Pakistan’s current account deficit continued to widen during July-March FY07, rising to a record of US$6.0 billion as compared with $4.2 billion during the corresponding period of the previous year. However, Pakistan continued to record large surpluses in the capital and financial account which comfortably financed the current deficit and generated an external account surplus of US$373 million during the first nine months of FY07.

The current account deficit (CAD) as a ratio of GDP during July-March FY07 was 4.1 per cent as compared with the corresponding FY06 level of 3.3 per cent.

The main factors responsible for the widening of the CAD during July-March FY07 include a widening of trade deficit by 1.3 billion and a US$730 million increase in income deficit. There was, however, an increase of US$425 million in current transfers which helped in curtailing the deficit to an extent.

Pakistan’s trade deficit increased to US$7.6 billion during July-March FY07 as compared with $6.24 billion during the corresponding period in FY06 despite a significant decline in import growth. Import growth slowed down to 10.0 per cent during July-March FY07 as compared with the growth of 34.5 per cent in the same period in FY06. This was mainly due to deceleration in petroleum imports on account of declining international oil prices and lower machinery imports. Exports grew by only 4 per cent during July-March FY07 as against a commendable growth of 12.4 per cent during July-March 2006.

Workers’ remittances of US$3.9 billion during July-March FY07 showed a remarkable rise of 21.9 per cent YoY. SBP projection shows that the rising trend in remittances will continue and the total for FY07 may approximate $5.5 billion.

The net foreign investment recorded a substantial increase of US$2.2 billion in July-March FY07 to reach US$5.5 billion. This impressive increase was mainly attributable to rise in foreign direct investment (FDI). Foreign portfolio investment also showed a significant increase of 55.5 per cent YoY during July-March FY07 to reach US$1.7 billion.

Pakistan’s total foreign exchange reserves increased by $616 million to reach US$13.74 billion at end-April 2007, compared to a level of 13.12 billion at end-June-2006.

Pakistan’s exchange rate has broadly remained stable during the last few years and moved within a narrow band of 60.2 to 60.9 rupees per US$ during July-March FY07.

The report has quite rightly emphasised that despite the impressive growth record of recent years, sustained efforts and vigilance are essential to adequately address the challenges of macro-economic environments. Inflationary pressures have to lowered, savings and investment rates have to be raised and a gradual reduction in the fiscal deficit should be achieved by a graduated increase in tax-to-GDP ratio.

TABLE-1: SELECTED ECONOMIC INDICATORS

Jul-Mar or as mentioned

FY05 FY06 FY07

Growth rate (per cent)

Large scale manufacturing 18.7 9.9 9.8*

Exports (fob) 14.3 18.0 3.5

Imports (fob) 37.6 43.2 8.1

Tax revenue (CBR) 13.5 22.1 21.9

CPI (12 month MA) End-Apr 9.0 8.2 7.8

Private sector credit Jul-Apr 28.6 20.2 13.0

Money supply (M2) Jul-Apr 13.7 10.8 12.1

Billion US Dollars

Total liquid reserves 1 End-Apr 13.0 13.1 13.7

Home remittances 3.1 3.2 3.9

Foreign investment 1.4 3.3 5.6

Per cent of GDP 2

Fiscal deficit Jul-Dec 1.2 1.8 1.9

Trade deficit 3.8 6.7 6.8

Current a/c deficit 1.0 3.3 4.1

* Sept 2006 data point. More recent data is not available.

1. With SBP & commercial banks.

2. Based on full-year GDP in the denominator.

Source: State Bank of Pakistan

TABLE-2: MAJOR ECONOMIC INDICATORS

FY2007

Provisional Original SBP

FY06 Targets projection

Growth rates (%)

GDP 6.6 7.0 6.6-7.2

Inflation 7.9 6.5 7.5-7.8

Monetary assets (M2) 15.2 13.5 14.3-15.5

Billion US Dollars

Exports (fob)1 16.6 19.8 17.6

Imports (fob)1 25.0 27.4 27.2

Exports (fob)2 16.5 18.6 17.2

Imports (cif)2 28.6 28.0 30.2

Workers' remittances 4.6 4.5 5.3-5.5

Per cent of GDP

Budgetary balance - 4.2 - 4.2 - 4.2

Current account balance - 3.9 - 4.3 - 4.8

1 BoP data 2 Customs data

Source: State Bank of Pakistan
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SBP Report on the state of the economy



EDITORIAL (June 08 2007): The State Bank of Pakistan's Third Quarterly Report for FY07 has been issued. As it should have been, besides stating plain facts about the economy, it focuses on the strong and weak areas of the national scene close to the end of the financial year and hence becomes important as the basis for the forthcoming budget to be framed in the light of the macro-economic objectives of the FY07 scheme and the objectives it would aim to achieve in FY08, as the country moves forward from the successes and failures of the outgoing year.

The year FY08 being the election year, the co-runner FY07 has also taken the toll what with the steps to create an economic ambience that favours the Government electioneering campaign.

But the most important question that needs to be answered is: how to justify the widening gap between the kitty and the burgeoning expenditure which would be incurred to appease the electorate who do not understand what the gap between the two means to them in terms of their purchasing power that stands eroded enormously?

Going by the picture presented in the SBP Report, the real GDP growth is expected to exceed even the projected 7.0 percent for the year, besides being broad based. FY07 would thus become the fourth year in succession to have seen high economic growth that should be quite satisfying as an election slogan. But a painful trade-off had to be accepted: the process of accelerating growth totally marred the prospect of achieving the coveted objective of decelerating inflation to 6.5 percent by the end of the year. At least this is what the SBP Report confirms beyond questioning.

According to the SBP, its tight monetary policy helped maintain a rather complex balance between decelerating inflation and maintaining growth momentum by "removing excessive monetary stimulus from the economy," leaving aside the food inflation which increased incessantly in the later part of the year. Notwithstanding the growth momentum at the cost of so much monetary pains, the supply-side pressures persisted only to be reflected in the rise in the prices of a number of edibles.

The Report says: "Unfortunately the impact in reducing inflationary pressures has been offset partially by the rise in food inflation and supply side pressures." The Bank did not substantiate the actual impact of food inflation on the CPI in terms of its weight in the Index. Revising SBP's earlier forecast on inflation, the Report observes:

"As a result of the unexpected resilience of food inflation and likely pressures in near term due to increases in the prices of milk and edible oil etc, SBP forecast for FY07 has been revised upwards from 6.7-7.5 percent to 7.5-7.8 percent."

Supply side pressures could be explained by rising consumption of petrol and petroleum products in the wake of increasing numbers of vehicles on the roads, despite the fact that a large number of them shifted to using domestically produced natural gas.

The record receipt of dollars from expatriates converted into rupee which is weakening unit by unit must have added to the rise in prices of many food items and electric and non-electric durables as high inflow of remittances has historically turned our increasing population ever more consumption oriented.

The Report, therefore, does not foresee any immediate relief to the people, particularly the poor, from their number one enemy, inflation, in the near future. We, however, cannot help reminding the central bank, which now enjoys quite a measure of autonomy, that with grit and determination it can always fight the war against inflation, together with the government, and become a trust worthy friend of the people.

The State Bank pursued a tight monetary policy for the very purpose of fighting inflation. One could ask a very pertinent question here: did the tight monetary stance of the central bank really work or did not because enough support was not available from the other end? Perhaps not, would be the right answer!

The other end connotes two important players, the Finance Division and the CBR. At the Finance Division end, the Public Sector Development Expenditure continued inflating, with excuses like justification of growth momentum, which cannot be attained under the obtaining power crisis, awfully neglected infrastructure and lack of social sector facilities. If these odds were removed, it could lead to creation of additional employment and hence moderation of existing poverty levels.

At the CBR end, loopholes in the country's taxation system took their toll and what could have been available for financing part of the increasing PSDP went into fuelling inflation. The question arises: When shall we tax the windfall money earned by the real estate and stock market sectors which also entail a damaging effect on the ruling land prices?

When shall we tax the big landlord who owns the lion's share of the country's land wealth and also enjoys the vetoing power in the legislature? Look at their large numbers in the Parliament with the increasing number of industrialists and businessmen turning landlords?

When shall we rationalise imposition of sales tax to bring larger numbers of individual traders and the services sector in the tax net? Who will bell the cat to tax the huge gains earned in stock trading where share capitalisation is setting new records? Their untaxed earnings are only adding to the inflationary pressures in the economy, worsening the already wretched living conditions of the poor of the country.

In our view, the apparently tight monetary policy in one way or the other yielded to the accommodative stance emanating from the government side. The result was that by May 12, the growth in broad money clearly surpassed the growth recorded last year by nearly 2 percent points or Rs 120 billion. Growth in reserve money or RM which proliferates (or contains) money balances was like-wise burgeoning.

The growth in RM recorded during FY07 up to May 12 worked out to over 20.12 percent compared with 14.65 percent recorded in the corresponding period of FY06. Concessional credit provided by the central bank to a number of export oriented sectors and target beating government budgetary borrowings from the banking system (Rs 212 billion as on May 12 compared with the target of Rs 120 billion) can be regarded as the contributing factors to the growth in both RM and M2.

Thanks to lower than targeted growth in credit to the private sector, which helped moderate the otherwise strong inflationary pressures, by May 19, private sector credit was at its highest of Rs 264 billion up 12.5 percent over 30th June 2006 compared with the target of Rs 390 billion.

THE STATE BANK NEEDS TO EXPLAIN: Was it really the tight monetary policy or some other factors that contributed to this even lower than projected growth of credit in the private sector? Even here, the growth, according to the Report, was concentrated in a few business sectors. What non-bank sources financed the rest of the sectors if growth in GDP was expected to surpass the projected 7 percent?

We presume that the real test of SBP's tight monetary policy, which is to continue in FY08 as Governor Akhtar recently indicated, would be in FY08 when, according to the SBP Report, "high reserve money growth in FY07, together with the rising demand for private sector credit, raises the risk of a strong resurgence in excess aggregate demand, and consequently inflationary pressures in FY08".

We reiterate that for the present the SBP has recognised, in guarded phrases though, that the tight monetary did not work to the extent desired on two counts. Commenting on developments in money and banking, the Report admits fairly honestly that the "key challenge for SBP monetary policy during FY07 has been to maintain a balance between sustaining strong economic growth and low and stable inflation" the latter by and large being predicated on the size of money balances in the economy.

At another place the confession reads: "The challenge to the modulation of monetary policy is increased by the recent acceleration in the growth of monetary aggregates" which was due to excessive budgetary borrowings. The Report stresses that with likely "strong resurgence in excess aggregate demand, and consequently inflationary pressures in FY08" it appeared imperative that the "fiscal policy be aligned with monetary policy in months ahead". We add not only in the months ahead but throughout FY08.

After all, why a Monetary and Fiscal Policies Coordination Board was created by amending the SBP Act if it was doomed to failures in achieving the desired coordination between the two policies? It indeed infringes the autonomy of the central bank, besides creating the impression that the two policies had in fact been moving in opposite directions, which reflected the inability of policy makers to co-ordinate prudently as opposed to imprudently.

The Report has described the government's borrowings as a rather "worrying dependence" especially when fiscal deficit has been capped to stay at 4.2 percent of GDP by the end of current fiscal year. We had already explained why the burgeoning deficit became a worrisome dependence, but calculating the cap ratio to the GDP at the end of the year runs the additional risk of playing with the figures by the interested quarters.

This takes us to developments in another important area, namely, the trade and current account status. To recall, throughout the year we have talked of widening trade gap despite compression in imports clearly indicating less than satisfactory growth of exports. The country is about to achieve a 7 percent growth rate.

Where has gone the export potential created by the phenomenal growth: across the borders and at whose cost has it been thrown away by the export guardians in the Ministry of Commerce and its allied institutions? Yes, the current account deficit "has decelerated sharply as FY07 progressed".

The SBP Report, however, goes on to add: "While this (current account deficit) was comfortably financed by even larger surpluses in the financial and capital account (with substantial non-debt components), the country's success in attracting international capital has led to a large jump in the NFA of the banking system adding to liquidity in the domestic market."

May be, this jump became available to the private sector to meet its credit requirements without resorting to bank credit, but certainly created excess demand for availabilities.

International capital that flowed in the country consisted of US financial assistance, proceeds of privatisation, borrowed money from international financial market using floatation of sovereign bonds and initiating GDR listings. These resources are welcome for any emerging economy like ours but their vulnerability to political mishaps cannot be ruled out which makes them unreliable as a long term financing source.

Ground realities of the economy are, however, hard for the common man to digest despite the hopes hinged on record increase in Foreign Direct Investment, unparalleled increase in the market capitalisation of shares attracting dollars and rupees alike, relatively stable dollar-rupee parity losing only about a rupee against the dollar, high GDP growth, comfortable foreign flows, especially expatriate remittances, and inflating foreign exchange reserves ready to cross the $14 billion mark.

High inflation remains the major discomforting factor and appears to be the result of unfettered profiteering and hoarding by market manipulators, on which the government has moved rather sluggishly to take any effective steps. The market can indeed go its way but the governments are bound to take prudent measures to correct the situation.

To conclude, the SBP Report sees that real GDP growth would comfortably reach the target of 7.0 percent in FY07 or may even exceed it. However, domestic inflation is forecast to remain in a relatively higher range than expected earlier.

The report emphasises the importance of appropriate monetary policy to achieve price stability as sustained high inflation has particularly adverse consequences for low-income groups who have no means to hedge themselves against this evil. The report underscores that concessional re-finance to strategically important sectors of the economy will have knock-on impacts by raising monetary growth in subsequent periods through increase in reserve money occasioned by such credit.

The impact on reserve money growth has also been compounded by the heavy reliance on central bank for borrowings by the government and the growth in NFA of the banking system. Referring to higher than projected current account deficit, the Report finds a source of comfort in that the monthly growth in the current account deficit continues to decelerate, and that given strong international liquidity flows towards emerging markets including Pakistan, the current account deficit is likely to be comfortably financed in the short-run.

However, the Report warns that international capital flows could be volatile, hence problematic. The long run health of the economy, therefore, requires a lower sustainable current account deficit, concurrent with a rise in the domestic savings rate and a gradual reduction in the fiscal deficit through increase in the tax-to-GDP ratio.

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Economy: revisiting the basics



Sunday, JUNE 10, 2007


WHILE the tempo of economic growth has been sustained this year, it is losing much of its lustre because of a double-digit food inflation, high unemployment and heavy indirect taxes that affect the common people. According to the Economic Survey 2006-2007 released on Friday, the Consumer Price Index at 7.9 per cent exceeded the estimated GDP (national income) growth rate of seven per cent. Food prices surged despite an impressive 7.5 per cent rise in output of major crops, a robust agricultural growth of five per cent and record foodstuff imports worth $2.3 billion during the first nine months. The price spiral can be attributed to fiscal expansion, heavy government borrowings, rising foreign capital and financial inflows and market abuse. On the eve of the budget, prices of such sensitive items as wheat flour, milk, rice, vegetable ghee, etc rose significantly. Convinced that “food inflation is less responsive to monetary policy”, the State Bank “depends on market dynamics and administrative measures” by the government to take care of the problem. In the event of market failure, the government has intervened on a case-by-case basis, though belatedly, but has so far failed to update the competitive law or set up the proposed competition commission. The decision to allow export of wheat without building up strategic reserves and the supply chain further fuelled inflation. The worst sufferers are the low-income groups, the poor and the vulnerable who have no means to hedge themselves against the effects of inflation. Combined with high interest rates, inflation is also eroding the savings of the middle-income groups, as is evident from a sharp fall of 42 per cent in consumer loans in the 10 months ending April 2007 compared to the same period last year. Now it is investment at a high level of 23 per cent of the GDP (rather than consumption) that is the leading factor contributing to GDP growth. The rise in the per capita income to $925 billion this year has come more from $4-5 billion remittances per annum than from the GDP growth.

While the government claims that it has brought down the unemployment rate to 6.2 per cent, it is actually higher than at the time General Musharraf took over in 1999. According to the Asian Development Bank, joblessness in the last two years was higher than the unemployment rates during 1990-1998. Over the last six years, the share in GDP of agriculture that employs more than 43.4 per cent of the workforce has declined by 3.2 percentage points. This belies the official claim that it has designated agriculture “as the engine of economic growth and poverty reduction”. The capital-intensive large-scale manufacturing (LSM) driven by sophisticated technology grew by 8.8 per cent against 10.7 per cent last year while the overall manufacturing growth was lower at 8.4 per cent. It shows that the growth in labour-intensive small and medium industries continues to lag behind LSM. Employment generated from high growth is not evenly distributed, province-wise or household-wise. The government’s development spending on physical and social infrastructure offers mainly temporary jobs. In these conditions, the trickle-down theory has lost much of its validity. As lifetime employment managed by changing jobs is the preferred choice of a flexible labour policy, the quality of human skills in all fields of economic activity needs to be improved on a war footing so that abundant and idle manpower can be utilised to realise a transforming economy’s full potential. Economic growth has to be socially sustainable. That the gender gap in labour participation ratio is 50 per cent against the average of 35 per cent in South Asia shows how much Pakistan lags behind in developing human resources.

Apart from price stability and a high rate of employment, low tax rates are also an inseparable part of any economic success story. With the present narrow base, taxes remain high and concentrated in the manufacturing sector which contributes well over 60 per cent of the total tax revenue and the bulk of the export earnings. The services and agricultural sectors which account for nearly 80 per cent of the GDP are lightly taxed as in the case of large land holdings, the share market and real estate business. The exemptions on capital gains tax and concessions to various sectors and investors are fast approaching the Rs200 billion mark. Besides, the bulk of the tax revenue comes from indirect taxes that puts a disproportionate burden on the low-income groups. However, one positive development this year has been a healthy growth in direct taxes which more than made up for the weak growth in customs duty and sales tax, resulting in the tax revenues rising by 21.9 per cent to Rs597 billion during July-March 2007.

A gradual increase in tax-to-GDP ratio, achievable by widening the tax net, is required to sustain an accelerated pace of governmental development spending. A record of Rs520 billion public sector development programme will help realise a 7.2 per cent GDP growth targeted for the next year. In the first three quarters of this year, the government’s domestic borrowings of Rs190.5 billion are four times the debt recorded in the same period last year. According to the Economic Survey, the revenue balance (revenue minus current expenditure) has suffered a deficit of 0.3 per cent as against the stipulated surplus of six per cent of the GDP. The primary balance (total revenue minus non-interest total expenditure) turned negative since last year after remaining in surplus for the previous seven years. The sovereign debt of $750 million, raised on the eve of the budget, is expected to be used to retire a part of the domestic debt and to stick to the budget deficit target of 4.2 per cent of the GDP. While the foreign debt-to-GDP ratio has declined sharply over the years because of a high growth over the last four years and rebasing of the national accounts, it has risen faster by $1.6 billion to $38.86 billion this year. The increased debt is a source of concern when GDP growth is driven by domestic demand and the growth in exports of merchandise has plummeted to 3.4 per cent.

While the external sector, with its huge capital and financial flows, indicates buoyancy, it is actually not robust, carrying as it does long-term risks to the economy. Of nearly 50 per cent of the six billion dollars estimated in foreign investment, $1.8 billion was portfolio investment or hot money and over one billion dollars came from the sale of two enterprises Paktel and Lakson Tobacco. After the Supreme Court judgment in the Pakistan Steel Mills case, the pace of privatisation has slowed down sharply. In the nine months to March, privatisation proceeds have decreased to $133 million as compared to $919 million in the same period last year. Imports estimated at $30 billion for this year continue to outpace exports, resulting in a record trade deficit projected at $13 billion and a current account deficit at seven billion dollars.

According to an independent economist, many worsening macro-economic factors linked to the GDP growth “are incongruent to their behavioural relationship with the GDP.” Apart from robust agricultural production which has made a seven per cent growth possible, the growth in key sectors is receding, whether large-scale manufacturing, exports or services. Even last year’s buoyant growth of 7.5 per cent in livestock, which contributes nearly 50 per cent of the agricultural output, is down to 4.3 per cent. With mounting macro-economic imbalances, it is time to revisit the basics.


http://www.dawn.com/2007/06/10/ed.htm#1
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