FAISALABAD (September 17 2008): The Asian Development Bank has observed that the unprecedented increase in global oil and food prices and domestic policy uncertainties in a turbulent political year stressed the Pakistan economy in FY2008, resulting in a slowdown in growth, build-up in inflation, wide fiscal and current account deficits, a weaker currency, and a large drop in foreign reserves.
The 'Asian Development Outlook 2008 Update' (ADO Update) has forecast that the growth in FY2009 is expected to remain subdued at 4.5 percent, with a continued slowdown in commodity producing sectors. Domestic spending will have to rise less than output for the current account deficit to shrink.
Increased risk perception was seen in downgrading of credit ratings, rise in sovereign bond spreads, slide in capital inflows, and declining access to international capital. With continued high oil prices, an ongoing power deficit, and tightened demand management policies to correct macroeconomic imbalances, economic growth in FY2009 is put at only 4.5 percent, ADO Update 2008 said.
The ADO Update 2008 says that high inflation will persist as domestic fuel, food, and power subsidies are rationalised. Although imbalances are expected to shrink, they cannot be eliminated quickly. To move forward, a coherent and credible short- to medium-term economic stabilisation and reform program needs to be adopted and implemented, the ADO Update added.
According to ADO Update, FY2008, ended June 2008, was a tumultuous year, and GDP growth slowed to 5.8 percent in Pakistan. Agriculture in particular suffered as major crops such as cotton and wheat failed to reach targets because of weather conditions, insufficient water, pest attacks, higher costs of fertiliser, and a delayed government announcement of the support price for wheat (which led to a lower sown area).
Manufacturing growth, hit by a listless textile subsector, power shortages, and political disturbances in major industrial towns, fell by half to 5.4 percent, after averaging over 11 percent in the previous 4 fiscal years. Construction maintained relatively strong growth. Services remained the main economic driver, rising by 8.2 percent, backed by thriving wholesale and retail trade, a strong expansion in telecommunications, and robust financial activity.
Real private consumption was the largest contributor to growth from the demand side, underpinned by booming remittances and high food and fuel subsidies. Private investment in contrast stagnated, falling to 14.2 percent of GDP on account of political uncertainty, power shortages, and a downgrade in credit ratings.
National savings as a share of GDP declined even more, widening the savings/investment gap. Net exports once again subtracted from growth as import volumes expanded markedly, with demand bolstered by domestic subsidies on oil and some food commodities.
Some pass-through of the substantial rise in international food and oil prices from March 2008 (when the Government began raising administered prices), together with lower domestic food production, a depreciating currency, and strong consumption led to a surge in inflation in FY2008. It averaged 12.0 percent for FY2008, the first time in 11 years it had hit double digits.
Food inflation year-on-year reached 32 percent in June 2008 as prices of essential food commodities jumped, and inflation accounted for much of the 21.5 percent increase in overall inflation in June. It also fed into core inflation, which rose by 13.0 percent in June 2008, year on year.
The State Bank of Pakistan (SBP), in its Monetary Policy Statement for July-December 2008, estimated that about one-third of inflation came from direct and indirect impacts of higher commodity prices in FY2008. To help protect consumers from the impact of rising inflation, ADO Update observed, Pakistan Government provided large subsidies for oil products, electricity, imported wheat, and fertiliser.
Although actual subsidies in FY2008 were much higher than had been budgeted, many subsidies were not targeted and therefore had only a weak impact in protecting the poorest. The large gap between actual and budgeted subsidies and higher interest payments overrode the impact of lower than targeted development expenditure, and resulted in a significant deterioration in the fiscal deficit, which substantially widened to 7.4 percent of GDP, surpassing the targeted deficit of 4.0 percent.
The budgeted revenue target was achieved, helped by rising non-tax collections. However, revenue growth did not match that of nominal GDP, causing the revenue-to-GDP ratio to fall to 14.3 percent from 14.9 percent in FY2007, while the tax-to-GDP ratio was stagnant at 10.0 percent.
To finance the burgeoning fiscal deficit in FY2008 at a time of dwindling external capital inflows (which covered only 26 percent of the fiscal deficit), and given the reluctance of commercial banks to purchase Treasury Bills, the Government was compelled to borrow Rs 689 billion from SBP, equivalent to almost a third of total government expenditure.
Pakistan Government borrowing from SBP was the single largest contributor to the 15.4 percent growth in broad money supply, which was inconsistent with SBP's effort to contain monetary growth. That would have been higher still had it not been accompanied by a marked drop in net foreign assets of the banking system.
With regard to monetary measures in FY2008, SBP raised the discount rate three times by a cumulative 250 basis points (bps) and increased commercial banks' cash-reserve requirements. Real commercial lending rates stayed negative. Private sector credit grew by 16.5 percent, only slightly less than a year earlier. Nevertheless, high inflation persisted as a result of elevated commodity prices.
The ADO Update said that the fiscal slide, precipitated by the failure to pass on the hike in international oil prices, became intertwined with the corresponding rise in the oil import bill, which was driven higher by both price and quantity increases.
The direct subsidy on diesel and kerosene oil--the Price Differential Claim paid to oil marketing companies as well as the implicit subsidy through a reduction in the Petroleum Development Levy--helped sustain the high oil demand.
The biweekly adjustment mechanism in domestic oil prices to respond to changes in international prices had been suspended in May 2006, and oil price adjustments only restarted in March this year, with five subsequent upward moves through 21 July.
So far, the adjustment to counter the impact of the rise in international prices had been incomplete, although the Government had committed itself to eliminating all subsidies on oil products by December this year.
Oil imports increased by 43 percent in FY2008, and reached $10.5 billion. This was the major cause of the worsening trade deficit, which soared by 57.4 percent to $15.3 billion, even though the annual export target of $19.2 billion was exceeded.
The main reasons for the good export performance were higher rice exports, which increased by 40 percent following sluggish production and export restrictions in the major rice producing countries and higher international prices; the trebling of cement exports resulting from strong demand by Middle East and African countries; and strong growth of exports of chemical products, especially plastic materials.
These categories' robust performance compensated for the continued stagnation of textile exports, which stemmed from strong international competition, domestic production losses due to power shortages, and disruption caused by the political and security situation.
The food import bill swelled by 46 percent and was another key contributor to the trade deficit, driven by $1.52 billion imports of edible oil and $571 million of wheat imports, as domestic consumption outstripped supply.
The overall trade deficit and deterioration in the services and income accounts resulted in a huge $14.0 billion current account deficit, or 8.4 percent of GDP. This deficit would have been even wider had it not been for healthy workers' remittances, which, helped by the oil boom in the Middle East, continued to grow by 17.4 percent to total $6.5 billion in FY2008.
The heavy fiscal and current account deficits struck at a time when capital inflows slowed over anxieties concerning the domestic political and security situation and the turmoil in international credit markets. Led by a significant drop in portfolio investment, foreign private investment fell by 38.4 percent (despite the resilience of foreign direct investment, which was unchanged from a year earlier).
This decline, along with a stall in the privatisation program, was indicative of investors' concern over the weakened fundamentals of the economy. The larger current account deficit thus resulted in a significant drawdown of foreign exchange reserves, as capital inflows slowed. Overall foreign exchange reserves fell by almost a third, from a high of $16.5 billion in October 2007 to $11.3 billion in June and to $9.4 billion as of 22 August 2008 to drop below 10,000 on 4 August, ADO Update said.
It points out that the negative market sentiment was reinforced in May when Standard and Poor's downgraded Pakistan's debt rating from B+ to B and its long-term local currency rating from BB to BB-. Moody's quickly followed suit. This market pessimism translated into a risk premium of 912 basis points on the spread of sovereign bonds by 19 August 2008, and consequently plans to access international capital markets through sovereign bond issuance and global depository receipts were deferred.
Undermined by the current account deficit, the slowdown in capital inflows, and the drop in reserves, the rupee-dollar exchange rate depreciated by 12 percent between 1 July 2007 and 30 June 2008. Subsequently, it depreciated further by about 11 percent through end-August, ADO Update said.
Furthermore, higher interest rates were insufficient to arrest the decline of the rupee and, since end-April this year, SBP adopted administrative measures, including suspending forward booking of imports, reducing advance payments against imports' letters of credit, and requiring foreign exchange companies both to obtain approval for transactions of over $50,000 and to surrender their "surplus" foreign currency to SBP.
The sharp depreciation in the nominal exchange rate overshadowed the upward movement in the relative price index, such that the real effective exchange rate depreciated by 2.3percent over the four quarters of FY2008. According to ADO Update, 'Economic Prospects for FY2009' remain sobering and require steadfast commitment by the Government to implement the various adjustment targets it has set for itself.
It will need to maintain fiscal discipline, persist in cutting down untargeted subsidies and in passing through price increases (while compensating the poor adequately), and reduce reliance on borrowing from SBP. The reform program should also aim for a significant reduction in the current account deficit. Unless export growth picks up, this will require a significant reduction in domestic demand.
In parallel, the Government also needs to generate greater external inflows in order to increase foreign reserves through privatisation, access to capital markets, and support from international development partners, besides pursuing and finalising the Saudi oil facility.
Finally, over the medium term, the Government needs to implement programs that promote upgrading and diversification of the economic base. Potential risks include further increases in political uncertainty and a deterioration in the security situation on the country's western border.
Economic projections for FY2009 are based on following assumptions: political tensions will lessen, leading to a more stable political environment, though uncertainty and security concerns will continue to affect economic decision making and investors' confidence; the stabilisation measures announced in the budget to rationalise subsidies and curb demand will be implemented and overall demand management policies will be tight; international oil prices will remain high (averaging $120 per barrel, as assumed in the baseline for this ADO Update); and the pass-through of price adjustments related to the ending of oil subsidies as well as continued power shortages will increase the cost of doing business and therefore exacerbate inflation, said ADO Update.
On these assumptions, it said, the growth in FY2009 is expected to remain subdued at 4.5 percent, with a continued slowdown in commodity producing sectors. Domestic spending will have to rise less than output for the current account deficit to shrink.
In these circumstances, export growth becomes crucial, as it will help make the current adjustment less painful. The faster the growth in exports the smaller the reduction in growth required to close the deficit.
In agriculture, cotton production is likely to fall short of target due to a reduction in the sown area and to a mealy bug virus attack. (Lower cotton production will hurt the textile industry.) It is too early to predict the winter wheat crop, which will depend on the availability of water and on the supply response of farmers to the expected adjustment in the procurement price to bring it close to international prices.
Robust growth in services is expected to continue, although the sector will be affected by the tax measures announced in the budget and by power shortages. On the demand side, private consumption in FY2009 will be hit by higher prices as food, oil, and power subsidies are rationalised.
Government expenditure will be suppressed by measures announced in the budget to contain current spending. Investment levels will be restrained by uncertainty, low capital inflows, and power shortages. The present power shortages are a result of chronic under-investment in new generation capacity, high operational inefficiencies due to the lack of expansion of the power transmission and distribution infrastructure, and delayed institutional reforms.
Although the Government is undertaking investment and reform in all these areas, the demand-supply gap will remain until new generation capacity comes on stream and the transmission and distribution infrastructure is upgraded. With the Government setting out to progressively rationalise the oil subsidy by passing on higher prices to consumers and by reducing the subsidy between the full-cost producer price and tariffs charged for electricity, average inflation is projected to reach 20.0 percent in FY2009, higher than the government target of 11.0 percent.
According to ADO Update, the planned adjustment of the domestic procurement wheat price will contribute to higher food inflation. SBP has increased the discount rate several times since June 2007, taking it from 9.5 percent to 13.0 percent, and yet inflation has climbed.
Moreover, the ensuing increase in the Karachi interbank offered rate has led to a rise in bank lending rates. SBP's interest rate tightening should increase the attractiveness of Treasury bills for commercial banks, and this would help reduce the Government's dependence on borrowing from SBP.
An efficient way to achieve this objective, as recognised by SBP in the Monetary Policy Statement for July-December 2008, would be to limit the amount that the Government can borrow from SBP and encourage long-term non-bank borrowings. Achieving that statement's target of a 14 percent increase in money supply in FY2009, which is lower than in FY2008, would require strict limits on budget access to SBP credit, observed the ADO Update.
To the extent that inflation in Pakistan is driven by high commodity prices, ADO Update stated that monetary tightening will have a limited impact on inflation and will most likely aggravate the economy's other structural problems.
Excessive dependence on higher interest rates to stabilise prices will make firms reluctant to use debt financing and therefore push them to rely more heavily on self-financing, which might lead to less efficient capital allocation. Moreover, unless interest rates are raised significantly, it will probably take a long time for monetary policy to have an impact on the economy and inflation.
Although the tightening of expenditure policies, such as fiscal discipline, helps keep inflation in check, it also acts as a deflationary force resulting in underused production capacity and higher unemployment. A more effective anti-inflation tool would be identifying and eliminating fiscal programs that induce an inflationary bias in the economy, combined with pushing through moderate increases in interest rates to limit excessive credit expansion.
Finally, to prevent a wage-price spiral, the authorities might consider implementing policies that link nominal wage increases to productivity increases and that limit increases in firms' mark-ups through, for example, tripartite (state, employer, worker) agreements.
The Government expects a significant reduction in the fiscal deficit as a result of the measures adopted in the FY2009 federal budget. These aim to reduce subsidies, curtail general government expenditure, and boost revenues. A rationalisation of the large public sector development program announced in the budget will help contain public spending.
However, the difficulties in achieving a planned increase in tax revenues of almost 25 percent, a 20 percent increase in public sector salaries and pensions, and the projected slowdown in growth imply that the fiscal deficit will likely exceed the government target of 4.7 percent of GDP. But the outcome should, though, be much better than in FY2008.
Despite the need to reduce the budget deficit, a crucial requirement is protecting the poor from the impact of high oil and food prices. In this regard, the social protection programs announced by the Government in the budget need to be implemented quickly. As part of this effort, the Government has launched the Rs 34 billion Benazir Income Support Program, under which qualified beneficiaries will receive Rs 1,000 a month.
Despite possible reduced oil consumption as a result of ending domestic subsidies, international oil prices are expected to remain relatively high. This will result in a continued heavy oil import bill. However, the projected slowdown in the economy, tight monetary policy, SBP's administrative steps to stabilise the exchange rate, and higher customs duties imposed in the budget on nonessential items will discourage non-oil imports particularly.
As a result, imports are projected to grow at the relatively slow pace of 9.5 percent (in nominal US dollars) in FY2009. The Government's trade policy has set an export target of $22.1 billion, 10 percent higher than FY2008's exports. Even if this target is met, with slower growth in industry and weak global demand conditions, projected import growth will still result in a large trade deficit.
Taking account of continued growth in remittances, the current account deficit is projected to be marginally smaller than in FY2008, at 8.0 percent of GDP. The financing of the large fiscal and current account deficits will remain major challenges. If Pakistan's request to, for example, Saudi Arabia to grant a deferred-payment facility for oil is granted, this will help reduce pressure to finance the current account deficit. The long-term solution to the external deficits, however, involves a substantial upgrading and diversification of the export base.
