The Vulnerability of Pakistan’s Economy ADB’s premonitory concerns

On September 26, the Asian Development Bank (ADB) released its updated Asian Development Outlook – 2017. The report contains warnings for Pakistan that the country’s economy is increasingly becoming vulnerable to external shocks and funding shortfalls. Xiaohong Yang, ADB’s country director for Pakistan, said given the coming challenges in the near future, the “Government of Pakistan must carefully manage external debt, the balance of payments and their financing requirements, while instituting macroeconomic and structural reforms to support economic stability and expansion as well as to make Pakistan more competitive and for fiscal sustainability.” The ADB also termed the Rs1.4 trillion budget deficit target ‘ambitious’, suggesting that it will be difficult to achieve in an uncertain political environment. Pakistan will also miss its 6% economic growth target that according to the ADB will remain at 5.5%. Following is the part of the report related to Pakistan:

Provisional estimates indicate that GDP growth in FY2017 accelerated to 5.3% from a year earlier, led by revived agriculture and manufacturing. Better weather and input use improved yields for major crops, boosting agriculture growth to 3.5%. Growth in manufacturing strengthened markedly to 5.3% on strong upturns in steel, sugar, electronics and automobiles, solid growth in pharmaceuticals and cement, but only slight expansion in the large textile and garment industry. Overall industrial growth slowed slightly to 5.0%, though, as construction growth eased to 9.0%. Strong wholesale and retail trade, finance and insurance, and general government services edged up growth in services to 6.0%.

On the expenditure side, private consumption, at 80% of GDP, increased by 8.6% to remain the largest contributor to growth. Increased consumption spending reflected rising middle class incomes, as average monthly household income in the three middle quintiles more than doubled in the past 10 years from PKR 9,788 in FY2006 to PKR23,145 in FY2016. Faster growth in fixed capital formation, at 8.3%, reflected a 20.7% increase in public investment in large infrastructure programmes. Private fixed investment, which varies from year to year and is markedly lower than elsewhere in Asia, grew by only 4.1%. Low private investment in recent years has many causes but the main one is a substantial infrastructure deficit, especially in electric power supply. This deficit is being addressed by several new infrastructure projects including the economic corridor project called the CPEC approved in April 2015, which links Pakistan with the People’s Republic of China. Many of these planned infrastructure projects are already under way, prioritizing power investments that are being financed by the government development expenditure, multilateral development banks and CPEC lending. Net exports substantially subtracted from growth as the volume of imports increased, especially of machinery, transport equipment and intermediate goods.

Stronger domestic demand and reviving global prices for oil and other commodities pushed inflation higher to average 4.2% in FY2017 from only 2.9% a year earlier – the lowest rate in the past decade. Food inflation increased to average 3.8% despite improved supply as global prices strengthened, while non-food inflation rose to 4.4%. Categories contributing to inflation were housing, education, perishable fruits, meat, medicine and fuel. Core inflation, leaving aside food and energy, rose by 1 percentage point to average 5.2% in FY2017. Year-on-year food inflation dropped sharply in June and July with a bountiful harvest to bring overall inflation down to 2.9% – the lowest in nearly 2 years.

To support growth, the State Bank of Pakistan, the central bank, maintained its policy rate at 5.75% in FY2017, allowing domestic credit to expand by 13.1%, slightly faster than a year earlier. The average rate on new lending was broadly stable at 7.25% through the fiscal year, and credit to the private sector grew by 67%, the strongest expansion in recent years, to PKR748 billion. The increase was notable in working capital and fixed investment, especially in food processing, construction, and consumer finance but in other sectors as well. Credit to public sector enterprises more than doubled to PKR355 billion, reflecting their weak financial position and the need for continued reform.

The deficit in the provisional general government budget, consolidating federal and provincial accounts, surged to PKR1.8 trillion, equaling 5.8% of GDP in FY2017, up from 4.6% a year earlier and much higher than the initial estimate of 4.2%. Revenues increased by only 0.2% of GDP over the previous year to reach 15.5% despite additional excise and customs taxes to cover emerging shortfalls in indirect taxes. Non-tax revenue recovered after declining over the past 2 years, reaching 3.0% of GDP but not the budget target because of disappointing receipts from the Coalition Support Fund, the sale of 3G/4G telephone licenses, central bank profit transfers and dividends from public sector enterprises.

Expenditure was, at 21.3% of GDP in FY2017, higher by 1.3% than in the previous year. Current expenditure grew by 0.4% of GDP, to 16.3%, with higher spending on defence and a fertilizer subsidy in a farm relief package. Electricity subsidies were higher than budgeted, but interest payments edged down. Development expenditures grew by 0.9% of GDP to 5.3%, mainly on increased infrastructure spending under the public sector development programme.

The government financed a sharply higher fiscal deficit largely through domestic bank loans. Borrowing from the central bank reached PKR907 billion in FY2017, against net retirement of PKR486 billion in FY2016, to significantly reduce reliance on commercial banks. External borrowing increased by half to finance about 30% of the deficit.

The current account deficit widened to $12.1 billion, equal to 4.0% of GDP in FY2017 from 1.7% a year earlier. Imports rose sharply, especially in the final months, to grow by 17.5%, with just over half of the increase being petroleum, machinery and transport equipment. A sharp rise in global prices was a major cause of a 26% higher petroleum bill, while imports of machinery and equipment increased by about 20%, following 40% expansion a year earlier – in part to supply the CPEC. Exports declined by 1.4%, slowing the 8.8% fall in FY2016 as all major export categories suffered lower earnings. While the trade deficit was the main factor widening the current account deficit, worker remittances, the major cushion to Pakistan’s traditionally large trade deficit, widened it further with a 3% decline.

The capital and financial account surplus increased sharply by just over 40% to $10 billion in FY2017, mainly reflecting increased borrowing by the government, the private sector, and commercial banks as debt-free foreign direct investment stagnated from a year earlier at $2.3 billion. With the current account deficit at $12.1 billion, the gap was financed by a $2 billion draw on official foreign reserves, which declined to $16.1 billion at the end of FY2017 but still provided 3.7 months of cover for imported goods and services. External debt and liabilities increased by an estimated $8.9 billion, with the government accounting for $4.8 billion of the rise, to bring Pakistan’s estimated external debt, excluding currency valuation adjustments, to $82.8 billion in June 2017, or 27.2% of GDP, up from 26.4% a year earlier.

The Pakistan rupee remained largely stable in FY2017, buoyed by central bank open market operations, but depreciated by 0.6%, from PKR104.8 to the US dollar in June to PKR105.4 in July. In recent years, the currency has been on a rising trend in real effective exchange terms, eroding Pakistani competitiveness with appreciation by 3.6% in FY2017 on a widening inflation differential.

Prospects

GDP growth is expected to accelerate to 5.5%. This Update assumes better growth prospects in advanced and developing economies alike, a continued revival in world trade volumes, and continued improvement in the security and business environment. The main impetus for industry and services growth will be expanded CPEC infrastructure investments, other energy investments, and government development expenditure. Agriculture should expand by trend rates.

There are downside risks. Growth has improved, but the government needs to address fiscal and external sector vulnerabilities that have reappeared with wider current account deficit, falling foreign exchange reserves, rising debt obligations and consequently greater external financing needs. Political uncertainty heightened following the Supreme Court decision in August to disqualify for office the Prime Minister elected in 2013. Calm has returned, and his party will continue to lead the government until new Parliamentary elections due by the third quarter of 2018. Still, possible loss of momentum for making policy decisions may hamper growth prospects.

Rising domestic demand fuelled by economic expansion is expected to stoke inflation in FY2018. However, the ADO 2017 projection for 4.8% inflation could stand with continued central bank policy vigilance, a muted increase in global oil prices, and some expected easing of global food prices.

The general government budget for FY2018 sets the target deficit at 4.1% of GDP, significantly narrower than the 5.8% of GDP deficit of a year earlier. An 18.0% increase in tax collection and larger non-tax revenues would boost total revenue to 17.2% of GDP. Further rationalization of current expenditure to the equivalent of 15.0% of GDP is envisioned to support a projected expansion in capital expenditures. Total expenditures are projected at 21.3% of GDP, reflecting an increase of 18.0% on significantly higher budgetary allocations for development. Development expenditures are forecast to reach 6.3% of GDP after public sector development programme allocations increased by half in FY2017, the year before an election. Notable areas for allocations are security, road transport, aid for less-developed areas and internally displaced people, health and education.

The federal budget for FY2018 assumes two-thirds of deficit financing will come from domestic bank and non-bank sources with no borrowing from the central bank. Achieving such a large reduction in the general government budget deficit and this ambitious financing target appears to be very difficult, but a continued large deficit would again require very substantial foreign financing. There was a significant increase in government borrowing from the central bank in FY2017 to retire debt from commercial banks and non-bank sources such as Pakistan Investment Bonds. This government borrowing from the central bank helped increase commercial bank liquidity and extension of credit to the private sector, but further large borrowing risks creating inflationary pressure. Accordingly, the central bank needs to vigilantly shape monetary policy to emerging circumstances in FY2018.

The current account deficit is expected to remain high in FY2018, projected at 4.2% of GDP, with rising imports, declining remittances and stagnant exports. A key challenge will be to finance Pakistan’s burgeoning trade deficit as remittance inflows, however substantial, continue to fall. The share of exports in GDP nearly halved from 13.0% in FY2006 to a dismal 7.1% in FY2017. Exports fell annually by 2.5% on average from FY2013 to FY2017 for lack of competitiveness or conditions for modernizing investment, leaving persistently low value addition to fetch low unit prices. Better prospects for global growth and trade are expected to further the recent improvement in export performance, however weak, in FY2017. Exports are likely to take off, though, only with adequate and reliable power supply and other supporting infrastructure and policy.

Imports are expected to continue to increase as growth spurs domestic demand that domestic production cannot meet. July 2017 imports were, though 8% less than the peak in June, 50.9% above a year earlier. Petroleum accounted for a quarter of the increase, while imports doubled for power-generation machinery and construction, much of it apparently related to the CPEC. The continued large trade and current account deficits in July 2017 exceeded capital and financial account net inflows to create a gap that again was covered by drawing on foreign exchange reserves, which fell by $1.5 billion to $14.6 billion at the end of that month. Worker remittances have shown some unexpected improvement, however, in the first 2 months of FY2018, increasing by 13.2% from the same period in FY2017. If this rebound can be sustained for the rest of FY2018, it may ameliorate the projected deficit. In any case, the authorities may need to consider rapid currency depreciation at some point to rein in import growth, or increase foreign borrowing to finance the external gap, to prevent an undue weakening of foreign exchange reserves.

Over the medium term, increasing government and CPEC-related repayment obligations highlight the need to carefully manage external debt, the balance of payments, and their financing requirements, while instituting macroeconomic and structural policies to support economic stability and make Pakistan more competitive.

Courtesy: Asian Development Bank