Pakistan and ADB’s Asian Development Outlook 2017

On 6th April, the Asian Development Bank (ADB) issued its Asian Development Outlook 2017. The report predicts that the developing Asia will continue to perform well this year even as recovery in the major industrial economies remained weak. It further predicted that the region’s economy will expand by 5.7 percent in 2017 and 2018. “Growth is picking up in 30 of the 45 economies in developing Asia, supported by higher external demand and rebounding global commodity prices … Developing Asia is set to grow steadily, and it is well positioned to handle any risks that might stem from policy uncertainty abroad,” says the report.

The Asian Development Outlook 2017 suggests that growth accelerated in Pakistan in FY2016, benefitting from major economic reforms and improved security. Low oil prices helped slow inflation markedly and keep the current account deficit moderate despite weaker exports. ADB’s outlook on Pakistan is for higher growth, with inflation and current account deficit edging up on higher oil prices and substantial imports for a major investment project.

Economic prospects

GDP growth is expected to edge up to 5.2% in FY2017 and 5.5% in FY2018, underpinned by higher growth in the major industrial economies. This outlook is supported by better security, macroeconomic stability and improved economic fundamentals resulting from the continued implementation of government reform under 3-year International Monetary Fund programme completed in September 2016, as well as ongoing and planned infrastructure and other investments under China-Pakistan Economic Corridor (CPEC). These favourable developments are reflected in Standard & Poor’s and Fitch upgrading Pakistan’s credit rating to B in October 2016 and February 2017, respectively. Moreover, the Pakistan Stock Exchange (PSX) scored the highest price increase in Asia in 2016 Pakistan’s re-entry into the MSCI Emerging Market Index, scheduled for May 2017 after a 9-year hiatus, further underlines investor confidence in the economy. In this connection, a consortium of three Chinese stock exchanges invested $85 million in December 2016 to acquire 40% of strategic shares in the Pakistan Stock Exchange.

Higher growth in FY2018 reflects accelerated infrastructure investment through CPEC, which is steadily lifting consumer and investor confidence and thereby further catalyzing economic activity. The government can lend policy support by maintaining macroeconomic stability and addressing structural issues that continue to inhibit exports despite the easing of regulatory constraints on doing business. With national elections scheduled for 2018, the budget to be announced in June 2017 will likely prioritize measures to foster economic expansion. The forecast for growth in FY2017 envisages revived agriculture as recovery in cotton and sugarcane offset a forecast decline in the rice crop. The revival is underpinned by special credit facilities, subsidized fertilizer and improved global commodity prices. Favourable weather, including timely rains in January 2017, augurs a strong winter wheat crop. Prevailing low interest rates, improved electricity supply, and government budgetary incentives announced in June 2016 should boost large-scale manufacturing. The government announced in January 2017 a support package worth $17 billion for exports of textiles, clothing, and related raw materials. It is expected to revitalize the textile industry, which suffered from a weak cotton crop and frail global demand last year. Stronger growth in industry and agriculture will catalyze activity in the service sector.

Average consumer inflation is expected to accelerate to 4.0% in FY2017 on a rebound in oil prices, higher domestic demand and expanded government borrowing from the central bank. Headline inflation averaged 3.8% in the first 7 months of FY2017, up from 2.3% in the same period last year, with increases for food and other goods. Core inflation, which excludes food and energy, followed the trend and rose by 1.1 percentage points to 5.0%. The government passed the global oil price increases on to domestic consumers by raising domestic oil prices three times from December 2016 to February 2017, after having kept them low for several months. A continued recovery in oil prices will likely accelerate inflation, which is projected to reach 4.8% in FY2018. The central bank will need to be vigilant and readjust its accommodative monetary policy if inflationary pressures intensify.

The general government budget deficit is projected to shrink to the equivalent of 3.8% of GDP in FY2017. This assumes total revenue equalling 15.8% of GDP, based on Federal Board of Revenue tax collection at 10.8% of GDP, and continued expenditure rationalization. To achieve the lower deficit, additional measures may be needed in the remaining months of FY2017 to bridge a revenue shortfall in the first half of the year, though higher imports and the pass-through of higher oil prices to consumers may be sufficient to boost indirect tax revenue. A shortfall in non-tax revenue poses an additional challenge, but it should be mitigated somewhat by expected inflows under the Coalition Support Fund and, if accomplished, the budgeted sale of the 3G spectrum.

Targeted expenditures in FY2017 equal 19.6% of GDP. Expenditures in the first half were, at 8.3% of GDP, about the same as last year because the government was able to contain current expenditure by curtailing domestic interest payments and spending on other categories including subsidies. Consolidated federal and provincial development spending was also low in this period at 1.5% of GDP, less than a third of the FY2017 full year target of 4.7%. Any provincial overspending in the full year, especially infrastructure development that looks ahead to the election, may challenge a key budgetary assumption that the provinces will record a cash surplus of PKR 339 billion, equal to 1.0% of GDP. The current account deficit is projected to widen to equal 2.1% of GDP in FY2017. The deficit increased to $4.7 billion in the first 7 months of FY2017, almost double the $2.5 billion deficit in the same period of FY2016. Services and income account deficits worsened as receipts under the Coalition Support Fund were delayed. Meanwhile, the workers’ remittances that critically offset the large trade deficit fell for the first time in 10 years, by 1.9% to $10.9 billion, because of declining expenditures and income in oil-dependent Gulf economies.

The trade deficit widened in the first 7 months of FY2017 by 21.1% to $13 billion as imports accelerated by 9.2%, driven by an 18% increase in investment goods and a 12% rise in oil import payments as prices recovered. Investment goods accounted for 40% of the increase in imports, and oil nearly 30%. Exports continued to decline, but by only 1.3%, which was much smaller than the 11.7% plunge in the same period of FY2016 . A third consecutive year of falling exports reflects weak global demand and low international commodity prices but also domestic structural issues such as power outages, scant investment in modernization, and currency appreciation in real effective terms, all of which hamper competitiveness. The nominal exchange rate was stable at PKR 104.7 to the US dollar in the first 7 months of FY2017, but the Pakistan rupee continued to appreciate in real effective terms, undermining export competitiveness

The current account balance will likely deteriorate further in FY2018 to 2.5% of GDP with somewhat higher global oil prices and accelerating infrastructure investments connected with CPEC. Revived oil prices are likely to improve the prospects for remittances in the medium term as Gulf countries may relax their efforts to consolidate their finances. A significant increase in the current account deficit could pose a risk to official exchange reserves, which peaked at $18.9 billion in October 2016 and then slid by $1.3 billion by February 2017. The increased inflows in the financial account from multilateral and bilateral disbursements, along with non-debt inflows in the first 7 months of FY2017 are providing a cushion for the widening current account deficit. Portfolio investment jumped by more than fourfold to $670 million and foreign direct investment increased to $1.2 billion with investments into dairy, consumer electronics, electric power, and oil and gas sectors. However, amortization payments on long-term government debt also increased markedly. Expected disbursements from multilateral development partners in the remaining months of the fiscal year will be needed to reverse contraction in the official reserves as of February 2017.

Policy challenge – realizing potential from the CPEC

The economic corridor project, i.e., CPEC, which runs from the Xinjiang Uyghur Autonomous Region in the People’s Republic of China (PRC) to the Pakistani port of Gwadar on the Arabian Sea, is expected to bring substantial benefits to the economy. Announced in April 2015 as a $46 billion project, but subsequently increased to $55 billion, it provides for major investments in energy and transport infrastructure. CPEC will be financed largely by the PRC and is expected to be completed by 2030. The project will significantly address Pakistan’s infrastructure deficit caused by annual spending on infrastructure at only 2–3 percent of GDP in the past 4 decades. The government has identified “early harvest” infrastructure projects that will be completed in the next few years. Of these, $21 billion will be on energy projects. These will be financed by foreign direct investment from the PRC supported by borrowing from banks there. Independent electricity-generating firms will be offered guaranteed tariffs for their sales to distribution companies that will ensure at least 17% return on equity. About $10 billion in investments in transport infrastructure will be financed by a combination of concessional and commercial loans from the Government of the PRC. For Pakistan, CPEC is expected to be a major opportunity to boost growth and development. CPEC is expected to provide many benefits, especially eliminating the power shortages that have held down economic growth in recent years. It will improve connectivity to domestic and international markets and so benefit Pakistan’s lagging regions. The large investment in infrastructure should boost construction and related industries, spurring job creation and growth.

In the long run, goods from the PRC transiting from northern Pakistan to the seaport will bolster the transport sector, further stimulating private investment and activity. Moreover, the extensive upgrading of Pakistan’s infrastructure is expected to attract direct investment from abroad, including mature industries in the PRC that seek lower-cost locations.

At the same time, CPEC investments are likely to require significant increases in imports of equipment and services to implement the projects. In the medium-to-long term, these inflows will likely be followed by financial outflows as loans are repaid and profits repatriated to foreign investors. Higher foreign exchange earnings and exports will be needed to avoid pressure on the external account.

To reap the potential benefits of CPEC and shift the economy of Pakistan to a higher growth trajectory, the government must continue to address key constraints on growth. Domestic security has improved significantly in recent years, but consolidating these gains will take continued efforts. Regulation remains burdensome, requiring more reform to provide an enabling environment that facilitates business and fosters investment. Reform to boost exports by diversifying products and markets and by adopting more flexible exchange rate policies are needed to maintain external stability. Similarly, structural reform to the energy sector and state-owned enterprises are required to fully realize investments’ productive potential.