From anticipated default to vulnerable economic recovery
By M. Sharif
During the year under review, the economy has moved away from a precarious state of sovereign default on account of depletion of hefty forex reserves of more than $16.5 billion in October 07 to $6.0 billion by November 08, because of steep increase in prices of oil and other commodities in the international market during 2008 that negatively affected the domestic market. An added factor was indiscrete fiscal expansion that increased to Rs688 billion during the period of interim government. It increased the fiscal deficit for FY 2007-08 to Rs777.2 billion; 7.4 per cent of GDP that pushed the inflation to 25.3 per cent by August 2008. These developments brought the economic conditions to a critical stage and sovereign default took place on repayment of foreign debt and sovereign bonds due for payment at maturity by early 2009 seemed imminent.
The situation was preempted by the government when it entered into a SBA with the IMF (International Monetary Fund) by end of November 08. It provided initially a package of $7.6 billion with the main focus on achieving macroeconomic stability through stringent conditionalities, which further tightened the monetary policy that raised the discount rate from 1,300 bps to 1,500 bps in November 08. This was for declining fiscal deficit, increasing tax-to-GDP ratio, improving governance and accepting low growth as a fait accompli for about 2-3 years that would provide a strong base for sustainable high economic growth afterwards. In August 2009, the package was enhanced to $11.3 billion. The IMF allowed the government to spend part of the credit to meet its fiscal expenditure because the promised financial assistance of around $2.2 billion from the FoP (Friends of Pakistan) did not materialise by mid-2009 to bridge the fiscal gap.
The IMF recipe set quite ambitious macroeconomic targets of reducing the fiscal deficit from 7.4 per cent (for FY 2007-08) to 4.5 per cent, inflation to 6.6 per cent, beefing up forex reserves to around $14.0 billion and raising tax revenue to Rs1.25 trillion by the end of FY 2008-09. These targets were to be achieved within seven months, mostly spread over H2 of last fiscal year and first-half of 2009. They looked unachievable in the wake of high discount rate that practically crowded out private credit because of high discount rate, deterioration of security and political environment and persistent power crisis in the country.
The results however were mixed. Fiscal deficit targeted at 4.5 per cent by end of last fiscal year was registered at 5.2 per cent. Although it did not meet the target but its reduction from 7.4 per cent was substantial. This was not achieved by either boosting the tax revenue or by curtailing non-development expenditure. On the contrary, it was done by reducing the PSDP (Public sector development programme) expenditure by around 40.0 per cent that slowed down the economic growth to 2.0 per cent by end of last financial year. Fiscal deficit was targeted at 4.9 per cent by the end of current fiscal year but it ended up at 1.5 per cent (against a target of 1.2 per cent) when the first quarter of current fiscal year ended. This clearly indicates that it might overshoot the target by end of current fiscal year.
The IMF during the economic review in November 09 ignored fiscal slippage of 0.3 per cent because it was unavoidable in the backdrop of high cost of combating militancy and insurgency, rehabilitating IDPs (Internally displaced persons) and meeting the cost of construction in militancy hit areas. The government has once again decided to reduce fiscal deficit during current fiscal year by reducing PSDP to Rs300 billion. The outlook for fiscal deficit remains uncertain because of unavoidable public expenditure on ongoing military operation, slow economic growth and collection of tax revenue which is less than the target. FBR (Federal Board of Revenue) suffered a revenue shortfall of Rs22.6 billion during the first five months of current fiscal year. The shortfall would have been on higher side if the refund of sales tax that amounts to Rs2-3 billion a month was not held back. The indications are that it is unlikely if the FBR would succeed to meet the tax revenue target of Rs1.347 billion when the fiscal year concludes.
It was expected that a tight monetary policy would quickly reduce inflation; however this did not materialise due to weak supply side of economy and manipulation of market for higher profit making. Inflation remained stubborn during the first two months of 2009 but reduced gradually subsequently. The SBP (State Bank of Pakistan) remained constrained to reduce the discount rate because the IMF had linked it with reduction in inflation. It could reduce discount rate in April and July only by 100 bps, each time. In November 09, the discount rate was further reduced by 50 bps that declined it by 250 bps throughout 2009. The SBP during the year that has just passed by remained conscious about taking any hasty decision that would decline the discount rate by a substantial amount, despite constant demand by the business community to reduce it to a single digit so as to increase the scope of investment for higher economic growth on account of fear of refueling inflation. Inflation increased to 10.5 per cent during November 09 after a dip to 8.87 per cent in October 09. It is likely to stay around this figure in December 09, though it may rise in third quarter of current fiscal year owing to withdrawal of 15.0 per cent subsidy on electricity and some of the cost push inflationary measures that the government might take to remove fiscal imbalances in the economy.
Forex reserves have increased to over $15.0 billion with the receipt of fourth IMF tranche of $1.2 billion by end of December 09. Remittances sent by expatriates that increased by approximately 30.0 per cent during first five months of current fiscal year, have boosted FOREX reserves notwithstanding the fact that FOREX reserves during 2009 have mostly been built on foreign borrowed money that increased to more than $9.0 billion in 2009. It brought stability in the exchange rate despite the fact that rupee has been gradually losing its value vis-à-vis USD and other international currencies. It is to be appreciated that depreciation of currency by just one rupee against USD increases foreign loan in rupee value by Rs46 billion at a parity of 1:60. Within two years the parity has increased to 1:84. According to an estimate, it has increased foreign debt in national currency by Rs900 billion. It is a publicly acknowledged fact that in 2009 the public debt and debt servicing has increased substantially, that could create a debt trap for a vulnerable economy like ours in the long run.
According to the SBP report the current account deficit remained well under control. During the first five months of current fiscal year it was recorded 82.0 per cent, less than the volume that was in the corresponding period of last fiscal year. This is mainly because of decrease in imports and low prices of oil and other essential commodities.
In the same time period mentioned earlier, the total imports were recorded at $13.08 billion. It is 23.0 per cent less than $17 billion import bill during the corresponding period of last fiscal year. Oil imports were reduced by 31.0 per cent to $3.78 billion in July- Nov 09,compared to oil imports of $5.47 billion during the same period of last financial year. The outlook for low current account remains positive, subject to the condition that oil prices and prices of other commodities remain on a lower side in the international market
The year 2009 has been eventful in taking the economy out of the woods to a larger extent .According to the IMF, “Pakistan has made significant efforts to stay on the course of stabilisation and structural reforms against the backdrop of weak external demand and difficult security and political environment. Inflation has declined, external position has strengthened and tangible progress has been made in other sectors also.” LSM and credit take-off by the private sector is picking up. But, regardless of these gains, the economy remains vulnerable for being highly dependent on external inflows that are likely to dry out and an increase in commodity prices in the international market is expected to take place, which would stoke inflation and distort external stability.
The other contributory factors towards vulnerability of the economy, according to DMD, IMF are, “low tax collection and large energy subsidies and weak private sector credit. A credible fiscal consolidation supported by flexible interest rate and exchange rate policies, further structural reforms and improved governance will be essential to reduce these vulnerabilities.” The government is talking loud in addressing these weaknesses. Subsidies on electricity would be done away with by end of current fiscal year. Yet, there is still much to be done and will depend on the government’s ability to implement concrete measures in significant areas that directly tackle these faults in the economy.