Shamshad Akhtar: Pakistan - economic outlook and prospects
Speech by Dr Shamshad Akhtar, Governor of the State Bank of Pakistan, at the Adam Smith Institute,
Thun, Switzerland, 27 June 2006.
* * *
Economic turnaround of Pakistan has been remarkable and impressive. This is more obvious if one
keeps in perspective
(i) the context of the pre-2000 scenario when un-sustainability of macroeconomic imbalances
and debt threatened medium term economic prospects;
(ii) the fact that achievements and gains have been realized in the midst of economic
complications caused by high oil prices, growing global and regional competition both for
investment and trade and the fiscal consequences of the earthquake that rocked
north-Pakistan in 2005; and
(iii) that Pakistan opted to graduate from IMF's structural adjustment program and has since
designed its own economic policies, steered their implementation and addressed effectively
emerging challenges.
Aside from reducing and restructuring its external debt in a short period, the Government's resolve to
unleash Pakistan's real economic potential has, within a period of 4-5 years, strengthened the
country's fundamentals and has improved its medium term economic outlook and prospects.
Sequentially, I propose to discuss:
(i) key features of this success story
(ii) structural reforms that have helped this turnaround
(iii) medium term economic prospects and challenges
Economic turnaround - its key features and structural shifts
FY05 was a record year for Pakistan. Its economic growth at 8.6% surpassed the average economic
growth of 8.2% recorded for emerging Asia. Backed by significant across the board growth in all
productive sectors, this growth has been primarily consumption led. Aggregate demand pressures
were at an all time high as the per capita income grew and public had easy access to low interest
credit for almost 4 years in a row. Four fold increase in remittances inflow since FY01 also contributed
to strong demand. Pakistan's growth has trickled down as the poverty head count ratio declined to
25.4% relative to 32.1% in 2001 and the unemployment rate also declined to 6.2%.
The macroeconomic imbalances remained at manageable levels despite fiscal pressures, and the
external current account registered a deficit relative to surpluses achieved in the preceding year. The
higher aggregate demand manifested itself in the build up of inflationary pressures and CPI rose to
9.3% in FY05 - more than double the average inflation rate recorded in the preceding 4 years.
Prudent economic management has helped change the dynamics of external debt since FY00.
Pakistan's external debt and liabilities fell by $ 1.3 billion - down from $37.9 billion in FY00 to $ 35.8
billion by end-FY05 as it prepaid expensive debt and a part of debt was written off. The combined
effect of this debt reduction and greater prudence in fresh borrowing coupled with GDP growth, helped
reduce the external debt and liabilities/GDP ratio to 32.5% by end-FY05 relative to 51.6% in FY00, and
external debt and liabilities as a %age of foreign exchange earnings declined to 134% relative to
almost 300% in FY00. Aside from the decline in external debt, the external debt burden also fell as a
consequence of the real cost of borrowing. With the pace of foreign exchange earnings gaining
momentum, the country's debt carrying capacity grew. At the centre of all these developments was the
pursuance of prudent monetary, fiscal and exchange rate policies.
Against this background, S&P has revised its outlook on Pakistan: B+/Positive/B to B+/Stable/B for
foreign currency, while keeping BB/Stable/B rating for local currency. Pakistan returned once again to
the international capital markets earlier this year and the sovereign bond issue was oversubscribed.
This reflected investor appetite for long term sovereign paper which was tightly priced relative to the
earlier two issues: a $500 million 5-year Eurobond in February 2004 which was priced @6.75%
implying 370 bps spread over US Treasuries and a Sukuk for $ 600 million issued in January 2005
carrying a yield of 220 bps over the six-month LlBOR. The benchmark set for Pakistan sovereign
paper is expected to help Pakistan's firms with stronger balance sheets to turn to the international
capital markets for raising their financing requirements. This has already been contemplated as the Oil
and Gas Development Corporation plans to float a Global Deposit Receipt soon.
Enabling policies
Fiscal responsibility: To promote fiscal stability and sustainability, the Government promulgated the
Fiscal Responsibility and Debt Limitation Act
2005 in June 2005 which encourages a steady reduction
in revenue deficit to nil by 30th June 2008 and maintaining it thereafter and reducing the total public
debt to sixty % of GDP by 2013 and below that limit thereafter.
Sound fiscal management helped Pakistan reduce its overall fiscal deficit, from an average of 7% of
GDP in the 1990s to around 4% in recent years. Although the deficit levels are higher than what is
desirable this reflects the strains of (i) the recent loss to the budget of the Petroleum Development
Levy (PDL) as the oil price increase has not been passed to the domestic consumers, (ii) the low
tax/GDP ratio, even though tax collections in nominal terms have been higher, and are expected to
support a modest increase of 0.4% in the tax/GDP ratio for FY07, (iii) higher transfer to provincial
governments, (iv) unforeseen spending on earthquake, and (v) determination of the Government to
raise both infrastructure and social expenditures which for some time were not raised in real terms.
Despite these fiscal strains, key structural changes are notable. Aside from near elimination of the
revenue deficit, prudent fiscal management has helped reduce the share of interest payments in the
total outlay from 33% in FY02 to 17.6% in FY05 - a 15 percentage points decline in just four years.
This in turn helped achieve primary surplus. In wake of these developments the public debt burden
continued to decline to 62.5% of GDP from 84% in FY00. Over the medium term, greater fiscal
sustainability can only be achieved if there are more substantive tax reforms which extend the tax
base beyond the corporate and professional tax payers. It is with this intention that the Government
has now started to tax the financial services industry, though the agriculture sector and other services
remain outside the ambit of the tax regime.
Monetary policy now for some years has been largely supportive of the dual objective of promoting
economic growth and price stability. It achieves this goal by targeting monetary aggregates (broad
money supply growth as intermediate target and reserve money as operational target) in accordance
with real GDP growth and inflation targets. The fiscal responsibility legislation and central bank's
mandate to formulate, conduct and implement its monetary policy combined to somewhat help reduce
the fiscal subservience of monetary policy. With the rising inflationary pressure in FY05, the central
bank raised its discount rate by 1.5% to 9% in April 2005 and maintained its tight monetary stance by
conducting frequent Open Market Operations (OMO) to manage liquidity, while minimizing the volatility
in overnight rates. The policy stance has yielded results as headline CPI has reduced by 1.4% to 7.9%
in FY06, in line with the annual target of 8%.
Like other developing countries where transmission mechanisms are not immediately obvious or
efficient, it takes well over a year or more for high interest rates to curb the credit growth. Thus far
while credit growth has decelerated, it remains fairly robust as demand pressures from both public and
private sector remained high during the course of the year.
Consequently, it is no surprise that while food CPI decelerated as the Government eased constraints
by allowing imports of essential products (sugar, cement and selected pulses) and enhanced its
distribution mechanism, the core inflation (excluding volatile components of CPI i.e. food and energy)
is 7.1% for FY06. Although the rate of passthrough from the higher prices of energy and other
commodities to core consumer price inflation appears to have remained relatively low, the cumulative
increases in energy and commodity prices have been large enough to account for the recent
inflationary pressures in core CPI.
Anecdotal reports suggest that the labor market in Pakistan is tight. While labor productivity remains
low, the wage increases will generate additional pressures. Over the medium term, managing
inflationary expectations and perceptions and designing an appropriate monetary stance, which aligns
economic activity with the economy's productive capacity, will remain a challenge.
Financial sector reforms: Consistent with trends observed in growing Asia, structural changes in
financial markets have been remarkable and significant. First, a word on the financial sector's scope
and scale:
- Financial assets grew by 70% over the past five years and in CY05 reached Rs 5.1 trillion ($
85 billion), equivalent to 80% of GDP;
- The banking sector grew at a faster pace relative to non-bank sectors and accounts for 71%
of the financial industry assets;
- Market capitalization of the stock exchange grew steadily and recently peaked at 44% of
GDP relative to 10.3% in June FY00
Latest Financial Sector Assessment for Pakistan and the Banking Sector Review 20051, which will be
released by July 2006, together lend comfort that:
(i) Banking sector profitability (after tax), at over $1 billion, is at an all time high and the return
on assets (after tax) increased to 1.9 % in CY052 from 1.2 % in CY04; surpassing the
relevant international benchmark. The rapid growth in profits also resulted in considerably
higher return on equity (after tax), which improved to 25.8 %3 from 20.3% in CY04.
(ii) Falling NPLs to loans and net NPLs to net loans ratios improved to 8%4 and 2.1%5 in CY05
respectively.
(iii) With strong profits, declining NPLs and fresh capital injections, the solvency position of the
banking system strengthened further. Capital adequacy ratio (CAR) increased to 11.3 %6
from 10.5 % in CY04.
(iv) Despite losing some momentum in FY06, the overall performance of the corporate sector,
which is the major user of banks' funds, remained satisfactory.
While the banking system has grown significantly in strength, credit growth in a high inflation and a
rising interest rate environment could pose a potential risk if the debt burden on banks' borrowers
exceeds their capacities and potentially erodes their repayment capacity. So far, the exposure and
default rates on advances to the consumer, SME and agriculture sector has been manageable as the
risk management systems within banks have improved significantly. Greater disclosure requirements,
strengthened corporate governance structure and Credit Information Bureau, which now provides
access to the credit reports of all borrowers, irrespective of the loan amount, are all effective risk
mitigants.
Pakistan is now embarking on the next phase of financial sector reforms which would focus on:
(i) Further consolidation and restructuring of the banking sector;
(ii) Strengthened risk management;
(iii) Developing capacities to cater for unmet requirements of special segments of the economy
and diverse needs;
(iv) Diversification of the financial sector by further development of the securities and debt
markets, which while fairly vibrant, need to play a more significant role in meeting the
country's financing requirements; and
(v) Promoting financial product innovation.
Trade liberalization has been underway steadily. With lifting of quotas and abolishment of several
special and industry specific regulations, all goods are today freely importable and protection granted
in the past to the domestic industry has been lifted. Maximum tariff rate has been reduced from 120%
in 1985 to 25% since FY01 and tariff bands have been reduced from 42 to 4. Almost half of the
imports enjoy zero to 5% tariff and the simple average tariff is now only 8.5% on dutiable & exempt
imports taken together and the SRO regime has been reduced to a bare minimum.
The trade policy aims to promote exports, which despite reaching $16.5 billion in FY06 relative to
averages of $7-8 billion over early FY00, have to make more inroads to raise their share in world
markets. Pakistan is launching a stronger drive to revive its exports which can only grow on a
sustainable basis if there is (i) sufficient surplus to export, (ii) if there is product, sector and
geographical diversification combined with value addition through capacity building and enhancement,
(iii) textile industry which contributes close to 60% of export earnings positions, repositions itself to
withstand new competitive forces emerging in the post quota regime, and (iv) the cost of infrastructure,
which is still suffering from bottlenecks, is improved.
Medium term economic prospects and challenges
High growth rates can be sustained. Pakistan being at the crossroads of one of the ancient trade
routes of the world and being richly endowed with natural resources has enormous potential and has
shown increased resilience to withstand economic shocks both domestic and external. The economy
is set to grow at around 7% in FY07. In FY06, despite set backs to agriculture and the industrial
sector, the buoyancy in the services sector helped real GDP to grow by 6.6%. Structural changes
underlying the real sectors, albeit slow, are emerging.
In agriculture, it is worth mentioning that Pakistan attained self sufficiency in major crops a long time
back. Notwithstanding, disruptions in production are inevitable given the uncertain weather conditions
as well as low yields which require far reaching efforts in research and extension and appropriate use
of inputs that have benefited from the rise in agriculture credit and fertilizer input use. More exploitation
of water resources is critical to ensure timely supplies of water. In agriculture, significance of livestock,
poultry and dairy products is visible and encouraging. The former accounts for 46.8 % (FY05) of
agricultural value added and about 10.7 % of the GDP, while providing livelihood to one third of the
population, and the latter produces 28 billion liters of milk a year, whose value is more than that of the
combined value of wheat and cotton.
Although the manufacturing sector grew at 18% and 15% respectively in the preceding two years,
decline in its growth rate is notable. The performance of this sector is impacted by some of the
structural issues typical of Pakistan's manufacturing sector. Manufacturing sector is now beginning to
slowly diversify and modernize itself. Presently, almost three-fourths of the production stems from the
large-scale manufacturing sector. The key contributor is the textile and apparel group, though
chemicals, petroleum, engineering, tyres and tubes, fertilizers, cement, and automobile and durable
white goods are adding capacities and are likely to boost industrial production. SME Policy and
enhanced flow of credit for this segment would eventually enhance the linkages of this sector.
Macroeconomic sustainability: After a consistent reduction in macroeconomic imbalances over
FY00-04, the fiscal and external current account deficits have been above targeted levels for FY06
and are likely to be in that range in FY07. Most notable is the concern regarding trade deficit that is to
range around $8.2 billion in FY06.7 Almost 45% of the increase in trade deficit for FY06 stemmed from
the rise in import bill for crude oil and petroleum products.
Demand pressures are likely to grow further as the Government accelerates social and infrastructure
programs, and segments of population and businesses benefit from the FY07 fiscal package.
Infrastructure sector programs, while ambitious, are absolutely needed as businesses are set to grow,
capacities are being enhanced, new industries and sectors are being opened up and development of
industrial parks and additional EPZs are in the offing.
After a span of price stability, Pakistan continues to face inflationary pressures that emerged in late
2004 in response to an accommodative monetary policy. Thus far effective monetary management
and administrative measures to ease product supplies have controlled inflation which is now well
within single digits. With demand pressures expected to grow, SBP will continue to pursue monetary
tightening but there will be need to strike an appropriate balance between promoting economic growth
and price stability. Over the medium term, Pakistan is well positioned to deal with these emerging
trends effectively.
While the consumption demand would remain high, there are strong indications that
investment has picked up - though perhaps not fully captured by national accounts statistics. Rising
investment demand is confirmed by: First, the rise in gross fixed capital formation over the last two
years by 29.6% in nominal terms and by about 9.8% in real terms. This has raised investment levels to
Rs 1.42 trillion, equivalent to 20% of GDP and is likely to result in a reversal of the declining trend
observed in the preceding years. Private investment accounts for two thirds of the gross fixed capital
formation. Second, the rise in imports, which, excluding crude and POL products, grew by 35%.
Third, the rise in private sector credit which, while decelerating, still grew by 19% in FY06 despite
rising interest rates. Fourth, foreign direct investment flows, excluding privatization proceeds, also
contributed to the rise in investment. Finally, high corporate profits have largely been reinvested in
industry and there is a high degree of self financing taking place.
Furthermore, the Government is confident that all spade work undertaken in the last few years will now
pay off as approved or lined up industrial and infrastructure investments take off. The Medium Term
Development Framework (MTDF) anticipates a rise in the investment/GDP ratio of 20.7% by 2010.
Early indications are that both domestic and foreign investors are upbeat about the future prospects,
and there are already investment commitments lined up from Gulf states. During its economic
transition, Pakistan will have to develop capacities to tolerate and finance the required level of trade
deficit as fresh investments will bring in additional import demand. Over this period, leveraging
non-debt foreign flows will be critical to finance and sustain the external current account deficit.
Growth prospects for Pakistan are fairly promising. Sustainability of investment trends would, among
others, depend on Pakistan's success in improving the business climate by removing investment
constraints, continuity in financial reforms coupled with strong vigilance of credit growth, and success
in curbing inflationary pressures and tendencies within manageable levels. The World Bank report
'Doing Business in 2006' has placed Pakistan amongst the leading economic reformers of the world
and the top one in South Asia. For foreign businesses, investing in Pakistan not only facilitates
production but also provides opportunities to export to the Middle East, and Central and South Asian
markets. To attract investment, Pakistan has fully liberalized its incentives framework. All economic
sectors are open to foreign investment, foreign investors are allowed to hold 100% foreign equity in all
economic sectors, barring very few exceptions, and there is equal treatment given to local and foreign
investors with flexibility to easily remit Royalty, Technical & Franchise Fee, Capital, Profits, Dividends
etc. No Government sanction is required for setting up any industry, in terms of field of activity,
location, and size. Tourism, housing and construction sector, computer software and information
technology (IT) have been declared as industries and provided a set of tax incentives.