THE STATE OF PAKISTAN’S ECONOMY

Third Quarterly Report for FY08

1.1 Economic Outlook

Pakistan’s economy is
Table 1.1: Selected Economic Indicators
showing increasing signs of
FY06 FY07 FY08
stress by April 2008. A
Growth rate (percent)
combination of adverse
LSM Jul-Mar 8.0 9.0 4.8
domestic and international
Exports (fob) Jul-Apr 17.2 2.9 10.2
developments is driving a
Imports (cif) Jul-Apr 40.4 8.9 28.3
broad deterioration in key
macroeconomic indicators (see Tax revenue (FBR) Jul-Apr 21.3 20.0 16.3

Table 1.1). Real GDP growth CPI (12 month MA) Jul-Apr 8.2 7.8 9.8
th
in FY08 is expected to drop Private sector credit Jul-10 May 19.9 12.5 14.9
below the 6 percent level for Money supply (M2) Jul-10th May 12.3 14.1 9.0
billion US dollars
the first time in five years,
annual inflation is poised to Total liquid reserves1 end-Apr 13.1 13.7 12.3
return to double digits, the Home remittances Jul-Apr 3.6 4.5 5.3
fiscal deficit is forecast to rise Net foreign investment Jul-Apr 4.0 5.9 3.6
substantially, and the annual percent of GDP2
current account deficit, as a Fiscal deficit Jul-Dec 1.8 1.9 3.6
percentage of GDP, is Trade deficit Jul-Apr 7.5 7.8 10.7
projected to be at an all-time Current a/c deficit Jul-Apr 3.1 4.6 7.0
high (see Table 1.2). The 1.
With SBP & commercial banks.
2.
weakness in the external Based on full-year GDP in the denominator. For FY08
estimated full-year GDP has been used.
account is also reflected in
weakening foreign exchange reserves (and a 7.3 percent YTD depreciation of the
rupee by the first week of May 2008).

However, despite the deterioration, it is also important to note that as a result of

structural reforms and liberalization measures over the last fifteen years, the
economy has fundamentally gained resilience. This suggests that a policy focus
on regaining macroeconomic stability through further reforms, and corrective
measures could quickly reinvigorate the growth momentum of the economy.

The most recent data clearly indicates that the slowdown in the economy during
FY08 is principally in the commodity producing sectors. For example, the
disappointing performance of important major crops contributed significantly to
slowdown in agricultural growth during FY08. This sector is globally vulnerable
to weather conditions, but in Pakistan farmers also suffer from policy risk in the
pricing of agri-produce, insufficient regulation on quality of inputs (pesticides,
 Third Quarterly Report for FY08 

seeds, etc.) and poor infrastructure (for water management, storage and processing
facilities as well as lack of farm-to-market roads, etc.). Similarly, facilitation of
institutional credit, as well as risk mitigation for farmers through active futures
market and crop insurance, can allow a substantial increase in value-addition.
Policy focus on the above areas can thus yield relatively quick returns in the form
of higher productivity and lower post-production losses. Moreover, given that
Pakistan is already a low-cost producer of many agri-commodities, and that
international commodity prices seem likely to remain strong for years to come,
agri-reforms offer broad-based gains in terms of income generation (and poverty
reduction), support for lowering inflation, and higher exports. Interestingly,
strategies to increase yield in agriculture also offer benefits for industry, raising
hopes of low price inputs, and creating room for downstream value-added
investment. This would also help diversify the country’s manufacturing and
export base, thus reducing output volatility.
Table 1.2: Projections of Major Economic Indicators
Productivity improvements
FY08
can also be important in Original
containing domestic inflation. FY07 P SBP projections
target
Inflation is already a serious Growth rates (percent)
policy concern for Pakistan, GDP 7.0 7.2 5.5 - 6.0
with CPI inflation at 17.2 Inflation 7.8 6.5 11.0 - 12.0
percent YoY for April 2008, Monetary assets (M2) 19.3 13.7* 17.0 - 19.0
the highest level in a month billion US dollars
since April, 1995. At least a Exports (fob-BoP data) 17.1 18.9 19.9
part of this is driven by Imports (fob- BoP data) 27.0 29.6 34.0
domestic supply-shocks that Exports (fob-customs
have compounded the impact data) 17.0 19.2 18.3
of strong aggregate demand, Imports (cif-customs
30.5 32.3 39.0
data)
and high international
Workers’ remittances 5.5 5.8 6.2 - 6.7
commodity prices. The latter,
in particular have continued to percent of GDP

rise, and the pass-through to Budgetary balance -4.3 -4.0** (-)6.5 – (-)7.0
the domestic consumers is Current account
increasing; administered prices -5.3 -5.0 (-)7.3 – (-)7.8
balance@
are increasing, wages are *Announced in MPS Jul-Dec FY08; **Budget estimates.
facing upward pressure, and
@: without official transfers P: provisional
imported inflation is on an
Note: Targets set by Government of Pakistan. SBP projections
uptrend. This clearly indicates have been estimated outcome on the basis of information
that restoring price stability in available by mid-May, 2008.
the short-run may prove
challenging. Even fiscal measures (tariff cuts and subsidies), aiming to at least

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The State of Pakistan’s Economy 

partially protect the broad populace from rising food and energy commodity
prices, are likely to prove unsustainable, given the already large fiscal deficit. Any
such measures need to be carefully targeted at only the very poor and vulnerable.

In this environment, it becomes all the more important that monetary policy be
calibrated to squelch demand-led inflationary pressures in the economy. Over the
last 6 months, expansionary fiscal policy has overshadowed and substantially
weakened the impact of sustained monetary tightening by SBP. This impact of the
heavy government borrowings has been particularly evident in FY08, with the
borrowings rising to a record Rs 551.0 billion by 10th May, 2008 (compared to
only Rs 45.7 billion in the corresponding period of FY07), almost doubling the
total outstanding stock of borrowings to Rs 940.6 billion. This trend cannot be
sustained without risking a substantial further acceleration in inflation.

In other words, the government has to urgently address the growth of the fiscal
deficit as well as to diversify its financing away from the central bank. While
information on fiscal developments is only available for H1-FY08, SBP
assessment indicates that the Jul-Mar FY08 fiscal deficit (as a ratio of GDP) is
likely to be greater than the FY07 annual figure. The new government has
indicated an intention to broaden the tax base and rein-in expenditure growth in
support of macroeconomic stability. It has also indicated an intention to diversify
the financing of the deficit and reduce dependence on the central bank borrowings.
For the economy to retain its high growth momentum, it is important that these
goals are achieved.

Over time, the removal of the excessive fiscal stimulus, the increase in
administered energy prices, the recent exchange rate adjustments and continued
tight monetary stance1 are also expected to help correct the substantial increase in
the country’s trade deficit. This correction is overdue. With food and petroleum
imports constituting more than half of the rise in imports, there is a limited scope
for import compression in the short-run. Moreover, it is likely that the country
will need to raise imports to strengthen its infrastructure, particularly of power
generation. Thus, policy focus needs to remain on addressing structural
impediments to export growth in medium to long term. Typically subsidies do not
incentivize efficiency, raise fiscal costs, and often lead to “gaming” to maximize
rent seeking rather than increased productivity. Therefore, policies must instead

                                                            
1
Effective from May 23, 2008, SBP increased its policy discount rate by 150bps and reserve
requirements by 100bps. At the same time, SBP imposed a cash margin requirement of 35 percent
on selected imports. Furthermore, effective from June 1, 2008, banks are required to pay a minimum
profit of 5 percent on PLS/Savings Accounts.

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 Third Quarterly Report for FY08 

focus on structural reforms to reduce cost of doing business, ensure efficient

provision of key inputs (water, power etc.), improvement of logistics chains, etc.

In addition significant gains in foreign exchange earnings may be achieved by

boosting services exports such as IT services, tourism etc. and focusing on
increasing remittances by benefitting from labor market opportunities in East
Asian economies and the Middle East. Productivity gains likely to be accrued
from skilled labor will have spillover effects in attracting FDI, enhancing workers’
remittances as well as increasing exports of goods and services.

As of end-April 2008, the trade deficit recorded in the balance of payments has
reached US$ 12.7 billion, contributing directly to the record current account
deficit. The stress on the economy as a result of this has been compounded by the
continuing problems in the international financial markets. While the country has
largely been unaffected by the direct impact of these disruptions, investors are
increasingly risk averse, with a reduction in liquidity flows to emerging
economies. This makes financing the deficits more challenging.

In absence of hefty foreign investment inflows (both direct and portfolio) as

evident in FY07, rising current account imbalance and weak performance of
exports resulted in a depletion of foreign exchange reserves. A natural outcome of
these developments is weakening of rupee against major currencies, which was
further augmented due to appreciation of the US dollar in recent week.

1.2 Executive Summary

1.2.1 Real Sector

Agriculture
Recent information points to an increased risk of a decline in aggregate value-
addition by important major crops in FY08 relative to the previous year. It was
hoped that a wheat harvest close to the annual target would offset much of the
drag from the disappointing aggregate performance of the FY08 kharif harvest.
But some reports suggest that wheat production in FY08 may also turn out to be
substantially below the target. If these concerns prove correct then a weak
performance by major crops would drag the annual growth substantially below the
annual target.

Given that commodity prices are likely to remain strong, it is imperative that
policies be framed to support farmers’ ability to raise productivity substantially in
the years ahead. Key areas requiring policy intervention remain the transmission
of price gains (establishment of futures markets), risk mitigation (crop insurance,

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The State of Pakistan’s Economy 

storage facilities), increasing investment in agri-sector infrastructure (water

management, electricity, farm-to-market roads, etc.) and in value-addition chains
(e.g. through processing).

The agriculture credit disbursement continued apace with its positive trends. The
total agri disbursements amounting to Rs 157.6 billion during Jul-Apr FY08 - an
increase of 34.9 percent YoY. The water shortage seen in rabi FY08 are likely to
continue in first phase of kharif FY09, while improved water availability is
anticipated from better monsoon rains during the second phase of kharif FY09
(June -September). Fertilizers off-take increased by 9.2 percent during July-
March FY08.

Large Scale Manufacturing

Initial prospects of achieving a reasonable growth in LSM sector during FY08
were clouded by aggravating energy crisis coupled with high international
commodity prices and political unrest through most of the year. As a result, the
LSM sector posted a dismal growth of 4.8 percent in the first nine months of FY08
compared with 9.0 percent in the same period of FY07.

It appears that energy shortages had a broad-based impact on manufacturing

activities. The impact was more pronounced on metal sub-sector which also faced
a steep increase in international steel prices. Activities in textiles and chemicals
(especially caustic soda) industries were also affected by frequent energy
disruptions as well as rising input cost.

Although a large number of industries (10 out of 15) delivered a weak

performance; for some industries this was largely an outcome of short-term
developments including poor FY08 cotton harvest (hurting textile and allied
industries), political unrest through most of period (especially the economic losses
in the aftermath of 27th December 2007), temporary closures of certain industrial
units for maintenance and/or up-gradation (e.g., polyester fiber, paper and
fertilizer), as well as power shortages (e.g., metal industries and manufacturers of
caustic soda, among others).

Services
Information for the first nine months of FY08 suggests that the services sector is
poised to achieve the annual targeted growth. The main contributors to this
performance are wholesale & retail trade, transport storage & communication as
well as public administration & defence sub-sectors. In addition, social &
personal services seem well placed to contribute positively towards upbeat annual
growth in services sector. However, growth in finance & insurance sub-sector

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 Third Quarterly Report for FY08 

appears to slow due to weaker profitability of the commercial banks, nonetheless

remain strong in FY08.

1.2.2 Prices
The impact of strong global inflationary pressures on domestic inflation has also
been compounded by the adjustments of administered prices of key fuels and
wheat. All price indices have moved up significantly so far in FY08 and are
significantly higher than the annual averages for the preceding five years.
Consumer Price Index (CPI) inflation accelerated to 17.2 percent YoY during
April, 2008 contributed by both food and non-food sub-groups. In particular, CPI
food inflation reached to 25.5 percent in April, 2008.

The desired impact of tight monetary stance of SBP has been neutralized by huge
government borrowings. Core inflation, measured by 20 percent trimmed mean,
accelerated to double digits (14.1 percent - record high level) in April 2008.
Persistence of inflationary pressures is also evident from non-food non-energy
(NFNE) based core inflation that increased to 10.8 percent in April 2008.

1.2.3 Money and Banking

The conduct of monetary policy has become increasingly challenging for SBP as
the fiscal year has progressed, and inflationary pressures are gaining further
strength.

The inflationary pressures have gained momentum, due to a number of factors,

including supply shocks and continuing strong demand. The former include a
sustained increase in global commodity prices (including unprecedented hikes in
food and energy prices). The demand pressures, on the other hand, were mostly
reflected in a sharp rise in the fiscal deficit that was largely monetized through a
record increase in government borrowings from the central bank.

The pass through of high global commodity prices to domestic inflation is

significant, and has increased in recent years as (a) the economy has become more
open in recent years, and (b) the government began to gradually pass-on the rise in
cost of key fuel (petrol and diesel), which was earlier frozen, to the domestic
consumers.

Since the current higher prices in international markets are forecast to persist well
above their historical averages in the foreseeable future, it is anticipated that the
resulting inflationary expectations will be more lasting. There is also evidence
that the erosion in purchasing power and squeeze in profit margins due to
sustained increase in food and commodity prices is contributing to second round

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The State of Pakistan’s Economy 

of inflationary pressures. Without continued monetary tightening, the inflationary

pressures may turn into a wage-price spiral.

At the same time, the already high fiscal deficit is not only limiting the scope for
containing the pass through of global inflation through subsidies and tariff
reduction, challenges for monetary policy have been compounded as the
government is relying more on borrowings from the central bank – which is the
most inflationary source of financing. Moreover, the liquidity injections from
unpredictable government borrowings have weakened the transmission of policy
interest rates to retail rates. In order to meet the above challenges, SBP is
maintaining a tight monetary policy stance. However, this stance needs to be
supported by fiscal prudence.

The overall credit demand is also strong despite a significant slowdown in credit
growth to consumers, energy shortages and operational bottlenecks in major
industries. This was mainly attributed to (1) rise in working capital requirements
due to higher input costs; (2) the need for bridge financing to settle price
differential claims of OMCs and IPPs; as well as (3) the higher fixed investment
(visible in a few sectors, e.g. textile, refineries and power) in the month of March
2008.

1.2.4 Fiscal Developments

Although official statistics on public finance for July-Mar FY08 are not yet
available, SBP forecast suggests that the budget deficit for Jul-Mar FY08 (as a
percentage of the estimated FY08 GDP) is likely to be significantly higher than
the full-year FY07 figure.

The growth in government revenues in Q3-FY08 is expected to recover from the

low of 1.8 percent seen during H1-FY08 as: (1) FBR tax receipts, which
contribute the bulk of government revenues, have increased by 31.3 percent in Q3-
FY08 compared to 6.0 percent during H1-FY08, and (2) non-tax revenues have
been bolstered with the disbursement of budgetary support grants of US$ 281.7
million and US$ 300 million from USA and Saudi Arabia respectively.

Government domestic borrowing during July-Mar FY08 grew strongly, reflecting

a strong year-on-year increase in the deficit, and little change in external financing
from FY07. Thus, with net retirements of borrowings from commercial banks and
only Rs 1.7 billion in privatization proceeds (against Rs 75 billion budgeted for
FY08), the government borrowings from the central bank continued to rise
sharply. Indeed, incremental government borrowings from SBP as of May 10,
2008 have reached Rs 551.0 billion, pushing the outstanding stock of treasury bills

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 Third Quarterly Report for FY08 

with SBP to Rs 940.6 billion. This development has significantly augmented

inflationary pressures in the economy, and raised risks to macroeconomic stability.

After a sharp rise of 6.4 percent in second quarter, the growth in the domestic debt
moderated to 5.5 percent in Q3-FY08. Although, government availed substantial
financing from SBP in this quarter, growth in floating debt decelerated due to
significant retirements by the commercial banks, resulting in a moderation in debt
growth during Q3-FY08.

1.2.5 External Sector

Balance of Payments
The deterioration in Pakistan’s overall balance of payment accelerated during Jul-
Apr FY08. On the one hand, the current account deficit continued to expand while
on the other, financial and capital account surplus shrank. Consequently, the
country’s foreign exchange reserves fell to US$ 11.5 billion and the rupee
depreciated by 13.4 percent against US dollar by 22nd May, 2008.

A large part of the deterioration in current account deficit emanated Nov 2007
onwards on account of substantial increase in import bill. The rise in import bill,
in turn, was driven by both high prices and demand factors, with former having
the greater role. The rise in import bill was accompanied with rising freight
charges which together overshadowed improvement in export growth and
impressive increase in current transfers in the period under review.

The financial & capital account surplus declined during Jul-Apr FY08, mainly due
to substantial fall in foreign portfolio investment2, which resulted due to: (a)
outflow from stock market, and (b) due to delay in floatation of Global Depository
Receipts (GDRs) and (c) delay in issuance of euro bonds.

Trade Account
Pakistan’s merchandise trade deficit widened to a record high of US$ 16.8 billion
during Jul-Apr FY08, which is 37.8 percent higher than the annual trade deficit
target. The deficit was fueled by a very strong surge in imports as well as below -
target export growth. While the 10.2 percent YoY export growth during the Jul-
Apr FY08 was an improvement over the previous year, it was nonetheless
significantly lower than the 12.4 percent growth targeted for the period.3 The
surge in imports was caused by both higher aggregate demand and rising

                                                            
2
The foreign portfolio investment declined to US$ 118 million during Jul-Apr FY08 from US$ 1758
million in the same period of last year.
3
The FY08 annual growth target for exports for was set at 13.1 percent in the trade policy.   

8  
The State of Pakistan’s Economy 

international commodity prices. Growth in exports on the other hand was led by
non textiles, while textile exports registered a fall in the period under review.
 

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