1 Economic Outlook

1.1 Overview
The prospects of returning to Table 1.1: Selected Economic Indicators
macroeconomic stability FY08 FY09 FY10
improved in the initial months Growth rate (percent)
of FY10, with most key LSM Jul-Oct 7.7 -5.0 0.7
indicators continuing the Exports (fob) Jul-Nov 6.5 12.0 -7.4
positive trends that began in Imports (cif) Jul-Nov 18.4 16.4 -23.0
the closing months of FY09. Tax revenue (FBR) Jul-Sep 11.6 27.7 0.6
CPI (12 month ma) Nov 7.6 19.1 14.6
Available data on agriculture 5.8 4.4 0.9
Private sector credit Jul-5th Dec
and the industrial sector, is in
Money supply (M2) Jul-5th Dec 4.8 0.6 4.2
line with the expectations of a
billion US dollars
modest recovery in economic
Total liquid reserves1 end-Nov 15.7 9.1 13.7
growth during FY10. While
Home remittances Jul-Nov 2.6 2.9 3.8
the performance of major crops
Net foreign investment Jul-Nov 2.1 1.4 1.1
during FY10 kharif (April-
percent of GDP2
October 2009) cropping season
Fiscal deficit Jul-Sep 1.5 1.1 1.5
was below expectations,
Trade deficit Jul-Nov 4.4 5.3 3.1
growth in large-scale
manufacturing has recovered Current a/c deficit Jul-Nov 2.9 4.4 0.8
1.
substantially after recording a With SBP & commercial banks.
2.
Based on full-year GDP in the denominator. For FY10,
20.6 percent YoY decline in estimated full-year GDP has been used.
March 2009 (see Table 1.1).
Similarly, a sharp reduction in inflation, contained government borrowings from
SBP, substantial contraction in external imbalances, the stability in the rupee-US$
parity, and easing monetary stance, are all likely to support economic stability.
However, the drop in overall volume of trade, poor tax growth, risk of lower than
expected aid receipts and, in particular, a rise in the fiscal deficit, highlight the
fragility of the improvement and pose continuing risk to the recovery.

With the country engaged in a war against militants and facing weak international
demand, policy options are relatively limited. In particular, the operations against
militants in some northern regions of the country have resulted in additional
expenditures, putting pressures on the federal budget. It is quite difficult to
contain such discretionary government spending. Not surprisingly, the fiscal
deficit for Q1-FY10 is reported at 1.5 percent of GDP as compared to 1.1 percent
in Q1-FY09. However, it can be argued that the accommodative fiscal stance has
The State of Pakistan’s Economy

probably helped trigger at least part of the modest recovery in aggregate demand,
thus supporting business and consumer confidence. Business confidence was
probably also helped by signs of a mild recovery in the global economy, which
has improved export prospects somewhat. Nonetheless, the rising fiscal
imbalance and greater quasi-fiscal activities have increased the risks to
macroeconomic stability. Below expectation growth in external funding for
budgetary support, and restricted access to borrowings from the central bank mean
that the financing needed by the government from commercial banks has
ballooned. To put this in perspective, a significant contribution to the 4.2 percent
year-to-date (YTD) increase in broad money supply during Jul-Nov FY10
(compared to only 0.6 percent YTD last year) has essentially stemmed from fiscal
and quasi-fiscal activities. By contrast, net private sector credit growth during the
same period was an anemic 0.9 percent YTD.

Weak private demand for credit and the risk-averse behavior of banks allowed the
government to finance its increased spending in FY10 without crowding out
private sector activities. There is now evidence that this room will not persist for
long. In this case, continued excessive fiscal needs can have adverse implications
for market liquidity, interest rates and credit to private sector, which in turn will
limit the central bank’s ability to further reduce the policy rate. The continued
fiscal stimulus could also complement an expected rise in imported inflation,
raising the risk of resurgence in domestic prices.

Although, headline CPI inflation dropped to 8.9 percent YoY in October 2009 (the
lowest level in the preceding 26 months), it bounced back to 10.5 percent in the
next month. Similarly, WPI inflation has seen a sharp jump in November 2009 to
12.5 percent, from only 3.8 percent YoY during the previous month. As a leading
indicator, this shows growing inflationary pressures in the economy. This view is
also reinforced by: a) an uptick in inflation measured by SPI in recent months, b)
continued high levels of core inflation, as well as, c) strong CPI inflation numbers
on a month-over-month basis for an extended period.

Indeed, it was concern over the combined impact of tight liquidity and risks of a
re-emergence of inflationary pressures that led to only a measured easing of
monetary policy. For example, while the central bank cut the policy rate by 50
basis points in November 2009, the reduction was lower than market expectations.
The market was looking at a 100 bps reduction, in the backdrop of a sharp fall in
headline inflation numbers and the considerable narrowing of current account
deficit (83.9 percent lower YoY) during Jul-Nov FY10.

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 First Quarterly Report for FY10

In any event, SBP caution seems justified, given the apparent reversal in inflation
trends in November 2009. Moreover, in-house forecasts indicate the risk that an
inflation uptrend could accelerate in H2-FY10 because of higher international
commodity prices and lower than anticipated external receipts. The lower current
account deficit during Jul-Nov FY10 is a result of strong growth in remittances,
and a fall in imports (which more than offset the decline in exports). However,
this improvement may not be sustained in the remaining months of FY10. Import
demand, in particular, is projected to rise in months ahead with an expected
revival in domestic manufacturing, and rising international commodity prices. At
the same time, there are indications that the growth of some key exports (basmati
rice, cement, etc.) may slow in the same period.

Similarly, the reasons for the strong improvement in remittances are still unclear,
raising questions on the sustainability of the trend. Some analysts have raised
concerns that this growth is mainly attributable to one-off transfers from
expatriates who lost jobs in the Middle East, USA and Europe in the wake of the
economic crisis. However, it is equally possible that a structural shift has taken
place after the actions against alleged illegal activities by some foreign exchange
companies. If so, recent SBP steps to facilitate remittances through official
channels, could reinforce the positive trend.

Despite this improvement in

Figure 1.1: Exchange Rate and FX Reserves
the current account projected ER Liquid reserves (rhs)
for FY10, Pakistan’s overall 88 18
external account remains
83 16
vulnerable. This is because
financing a significantly 78 14
billion US$
Rs/US$

lower current account deficit

73 12
remains very challenging on
account of low external 68 10
inflows. Net investment
63 8
flows into the country for
Jul-Oct FY10 are already 58 6
Apr-09
Apr-07

Apr-08
Oct-06

Oct-07

Oct-08

Oct-09
Jan-07

Jan-08

Jan-09
Jul-06

Jul-07

Jul-08

Jul-09

15.5 percent lower YoY, and

access to international debt
markets remains severely
constrained (particularly after
the debt restructuring requested by Dubai World). In this environment, funding
under the Stand-by Arrangement with IMF has been a key to shore up the
country’s foreign exchange reserves and moderate the depreciation of rupee (see
Figure 1.1). These are important gains for overall macroeconomic stability but

3
The State of Pakistan’s Economy

maintaining these gains and ensuring continuity of the nascent economic recovery
remains challenging for the remaining months of FY10.

1.2 Looking Forward

SBP estimates suggest that FY10 GDP growth is likely to be around the annual
target of 3.3 percent, a little higher than the 2.0 percent seen in FY09 (see Table
1.2). The major impetus for this growth is expected to come from the services
sector. Within the commodity producing sector, an improvement in industrial
output is expected to be partially offset by weaker agriculture.

Similarly, the current account Table 1.2: Projections of Major Macroeconomic Indicators
deficit is likely to improve FY10
further in FY10 relative to the Annual Plan SBP
FY09 Targets Projections
previous year, though some
expected revival in import growth rates in percent

demand from manufacturing GDP 2.0 3.3 2.5 - 3.5

and rising commodity prices Average CPI inflation 20.8 9.0 10.0 - 12.0
may possibly contain the Monetary assets (M2) 9.6 - 12.0 - 13.0
improvement going forward. billion US dollars
Workers’ remittances 7.8 7.0 7.8 - 8.8
However, while average CPI Exports (fob-BoP data) 19.2 19.9 18.5 - 19.0
inflation during FY10 is Imports (fob-BoP data) 31.7 28.7 30.5 - 31.0
projected to decelerate percent of GDP
significantly from FY09 Fiscal deficit 5.2 4.9 4.7 - 5.2
levels, it is likely to remain Current account deficit 5.3 5.3 3.7 - 4.7
higher than the annual target Note: Targets of fiscal and current account deficit to GDP ratios
are based on nominal GDP in the budget document for FY10,
of 9.0 percent for the year. while their projections are based on projected (higher) nominal
The adjustment in GDP for the year.
administered prices of key
fuels amid rising international oil prices and cut in electricity subsidies, are
important factors behind the expected strengthening of inflationary pressures.

The government will try to achieve the quarterly SBA targets for the budget
deficit. However, given exceptional circumstances arising from the stepped-up
campaign against militants, these targets may not be achieved due to huge
expenditures on defense and the rehabilitation of internally displaced people. The
indirect cost of war entails weaker growth in tax collections, as industrial and
trade activities (which are the main contributors to fiscal revenue) remain dull due
to security uncertainties.

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 First Quarterly Report for FY10

Thus, a major challenge in the economy is to improve the tax-to-GDP ratio. The
0.6 percent YoY increase in tax collection during Jul-Nov FY10 is a source of
concern; if this continues, Pakistan’s tax-to-GDP ratio will decline from an
already low 9.8 percent seen in FY09. In view of the needs of the structural
second generation reforms in the economy, it is necessary to strengthen the
capability of FBR, increase documentation, reduce exemptions, equal treatment of
incomes from different sources, and accelerate the levy of a comprehensive VAT.
Another challenge in public finance is the increasing level of contingent liabilities
of the government. In particular, the energy sector circular debt issue has not been
resolved yet, and the government’s borrowings for commodity operations have not
seen the expected seasonal retirement in Q2-FY10. Since, a large part of these
loans has been availed by the TCP and PASSCO, this needs to be settled before it
creates another circular debt problem.1

It must be stressed that excessive government involvement in commodity

trade/finance, and the interference in market price setting, can be counter-
productive and should be avoided. Cases of market failure are best handled
through effective reforms and strengthening institutions like the Competition
Commission of Pakistan.

1
Wheat procurement in FY09 was over 9 million tons, substantially higher than the targeted 7
million tons that supplemented the existing stocks from imports in the preceding year. As a result,
ample wheat stocks are lying with the provincial governments and agencies, much of which is
without adequate storage facilities. This raises significant risks: a) given substantially lower
international wheat prices, there may be some inward smuggling of cheaper wheat into the domestic
market, b) there could be significant losses in case of rains, and, c) off-take from government wheat
stocks could be significantly lower than anticipated. All of these raise corresponding concerns on
banking sector liquidity.

5
The State of Pakistan’s Economy

1.3 Executive Summary

1.3.1 Real Sector

Agriculture
Initial estimates suggest that the performance of FY10 kharif crops has been
significantly weaker than in the corresponding period last year. This was due to
water shortages at sowing times and, more importantly, farmers’ disappointment
with prices received in the previous kharif season. The latter is particularly
evident in the decline in area under rice and sugarcane cultivation. Conversely,
the impact of favorable prices is reflected in the higher acreage under cotton
during kharif FY10; cotton prices are currently at an all time high.

On the other hand, the announced support price for wheat may help the rabi crop;
however, it is less likely that wheat could add significantly to growth given the
high base set by the record FY09 crop. Early signals of poor kharif output,
saturation in rabi and uncertain livestock due to decline in non-farm agri-credit,
raise the risk of an overall weak performance of agriculture during the current
fiscal year.

Large Scale Manufacturing

A modest improvement in aggregate demand was seen in Jul-Oct FY10 as
manufacturing index increased by 0.7 percent compared with a decline of 5.0
percent in Jul-Oct FY09. This could be attributed to gradual easing in monetary
policy and fiscal support as well as the impact of increase in farm incomes in
FY09.

However, plagued by a multitude of structural issues, the recovery remained weak

and patchy: a) although ginning numbers were strong, high lint and yarn exports
resulted in raw material shortages for high-value added industries, bringing overall
textile growth in the negative, b) automobile sales showed promising growth
following a decline in both vehicle and fuel prices; but despite this, refinery
production declined owing to the unsettled circular debt, c) domestic cement sales
are expected to be impressive as modest recovery was seen in construction
activities evident in high YoY growth in production of building material items
(e.g., billets) as well as import of steel in October 2009. Nonetheless, export
prospects are uncertain given capacity augmentations in importing countries as
well as slowdown in construction industry in Afghanistan and Gulf.

With such unbalanced patterns of domestic recovery, expected upturn in global

prices that will push up domestic energy costs, and lower sugarcane harvest

6
 First Quarterly Report for FY10

coupled with fears of late crushing (which could impede growth in sugar industry),
the outlook for industry in FY10 remains uncertain.

1.3.2 Prices
Domestic inflationary pressures eased significantly during the first five months of
FY10 compared with the corresponding period of FY09. Inflation measured by
consumer price index (CPI) and the sensitive price indicator (SPI) declined, with
CPI inflation YoY dropping to 10.5 percent YoY in November 2009, after
reaching single digits (8.9 percent) during October 2009, for the first time in the
preceding 21 months. While an uptick in November is largely attributed to higher
food prices on account of Eid-ul-Adha, the recent disinflationary process is a
result of: a) improvement in supply of most of the key staples (except sugar), b)
constraints on the government’s monetization of the fiscal deficit, c) lagged
impact of tight monetary stance, and d) a decline in imported inflation.

However, variability in monthly inflation rates in WPI inflation (YoY) raises

concern over the sustainability of the downtrend, particularly in the second half of
the fiscal year. The risk of resurgence in inflationary pressures is also evident
from strong core inflation. Both indicators, the non-food non-energy (NFNE) and
20 percent trimmed mean, though declining since H2-FY09, remained high. One
of the main reasons for the persistence in both measures of core inflation, is the
double digit increase in house rent index (HRI) despite an easing since June 2009.
HRI has around 46 percent weight in NFNE and 29 percent weight in trimmed
mean, hence, the pace of decline in core inflation is slow relative to headline
inflation.

Moreover, the rising trend in international commodity prices, particularly crude

oil, metals and some food items (e.g., rice and sugar) is likely to fuel inflationary
pressures in the economy. The risk of higher inflation in food commodities also
stems from weak monsoons in India, which would likely have negative spillovers
on domestic prices.

1.3.3 Money and Banking

SBP continued to gradually ease monetary policy in FY10, reducing the policy
rate by 150 bps in two rounds.2 On cumulative basis, this means a reduction of
250 bps in the policy discount rate since the beginning of current easing cycle in
April 2009. These policy measures were supported by substantial moderation in
demand pressures. For instance, a very sharp drop in headline inflation, i.e., from

2
A policy rate cut of 100 basis points in August 2009 was followed by another 50 basis point
reduction in November 2009.

7
The State of Pakistan’s Economy

24.7 percent in November 2008 to 10.5 percent in November 2009; persistent

YoY fall in import growth (particularly the negative growth in import volumes
during Jul-Nov FY10) and the low growth in private sector credit expansion.
The scale and speed of the decline in inflation suggest that the tight monetary
policy and sharply constrained monetization of the fiscal deficit have eased excess
demand pressures that had plagued the economy in the previous three years. This
disinflationary impact received further support from lower imported inflation3 and
improved domestic production of key staples.

However, the expansionary fiscal stance in Q1-FY10 (the deficit increased by Rs

223.7 billion compared with a rise of Rs 137.7 billion in the same quarter last
year) has had some repercussions. For example:

1. A part of the growing deficit was financed through an IMF bridge finance loan,
the inflationary impact of which is similar to that of deficit monetization.
2. The large jump in deficit, and lower recourse to SBP finance, meant that
despite higher non-bank financing, government borrowings from commercial
banks increased substantially. Net budgetary borrowing from scheduled banks
was Rs 166.0 billion during Jul-5th Dec FY10 compared with a net retirement
of Rs 67.0 billion in the corresponding period last year.
3. Strong government demand for financing, and low deposit growth is now
constraining banks’ ability and willingness to take additional exposure; this
means an element of crowding out of private investment.

These problems are compounded by a significant increase in quasi-fiscal activities,

such as financing of the circular debt, and borrowings by various public sector
enterprises (PSEs), and government borrowing for commodity operation.

In terms of monetary aggregates, the YoY growth in M2 after witnessing the

lowest level of 8.0 percent in April 2009 during the last eight years, reached 13.4
percent by December 05, 2009. This improvement came entirely from YoY rise in
net foreign assets (NFA) of the banking system, as net domestic assets (NDA) of
the banking system decelerated markedly by end-November 2009. Deposit
mobilization by banks shows some recovery; on a cumulative basis, deposits
recorded a growth of 0.1 percent during Jul-Nov FY10 in sharp contrast to
previous year, when deposits contracted by 3.8 percent.

3
This was because of a relatively stable rupee and low international commodity prices in FY10.

8
 First Quarterly Report for FY10

1.3.4 Fiscal Developments

The Q1-FY10 fiscal deficit came in at 1.5 percent of projected annual GDP,
raising concerns over the government’s ability to meet the annual target of 4.9
percent of GDP. A significant part of the slippage owed to an unexpected rise in
spending (e.g., increase in government wages, anti-militancy operations, etc.) and
delays in some revenue receipts. If these factors are excluded, the quarterly fiscal
deficit should be below 1.2 percent target for the first quarter of FY10.

One concern, however, is the heavier contribution of non-tax revenues within

overall revenues during Q1-FY10. This is because jumps in non-tax revenues are
unpredictable, and are often not sustainable. For example, non-tax revenues
would have fallen by Rs 47.8 billion, had there not been a Rs 70 billion transfer
from SBP profits to the government in Q1-FY10.

Despite sharp increase in fiscal deficit, financing from domestic sources has
grown only moderately, because of the significant rise in net external financing.
Also, quite encouragingly, the government has reduced its reliance on inflationary
borrowing from the central bank.

The government faces very difficult choices, with considerable pressure to

increase social sector spending and build infrastructure, even as the cost of the
anti-militancy campaign continues to mount. At the same time, the weak
economy constrains its ability to raise revenues from an unchanged tax base. This
suggests the need to urgently work towards broadening the tax base to provide
needed essential services and public goods.

A major success in fiscal policy, however, is the recent agreement between the
federal and provincial governments on the 7th National Finance Commission
(NFC) Award (see Special Section 2 for details).

1.3.5 External Sector

Balance of Payments
Pakistan’s external accounts improved significantly during Q1-FY10 compared to
the same period last year. This improvement owed to both, a marked contraction
in the current account deficit and an increase in the financial account surplus.

The major impetus came from a contraction in the trade account deficit, but the
services and income account deficits also contracted significantly, reflecting lower
economic activity. Current transfers were particularly robust recording 43.9

9
The State of Pakistan’s Economy

percent rise on account of increase in both, workers’ remittances as well as other

transfers.

The financing side also recorded marked improvement with the financial account
surplus rising by 34.9 percent during Jul-Nov FY10. This improvement was
primarily driven by increased inflows from the IFIs. Although net foreign
investment contracted by 22.4 percent, net portfolio investment returned to
positive territory, contributing US$ 301 million during Jul-Nov, against a decline
of US$ 182 million in the corresponding period last year. Foreign direct
investment, on the other hand, did not show any signs of recovery and declined by
52.3 percent during the period under review.

As a result of the improvement in the overall external account, Pakistan was able
to rebuild its foreign exchange reserves, which reached US$ 14.5 billion by end
Nov 2009. The foreign exchange market also exhibited relative stability, and
exchange rate depreciated by only 2.6 percent during Jul-Nov 2009 compared to
13.3 percent in the corresponding period last year.

Trade Account
Pakistan’s trade deficit declined significantly by 37.6 percent YoY during Jul-Nov
FY10, in contrast to a 20.8 percent rise in the same period last year. The decline in
the trade deficit was entirely due to 23.0 percent YoY fall in the import bill as
exports continued to decline, recording 7.4 percent YoY fall.

The contraction in imports was a result of restrained demand, better domestic

production of some commodities (wheat and cotton), as well as fall in
international commodity prices. Of these, however, the impact of the fall in the
international commodity prices was strongest.

Like imports, the fall in exports was also broad-based. Growth in all the main
categories, including food, textile, petroleum as well as other manufacturers
groups, either extended their decline from the previous year or turned negative.

10