PAKISTAN'S FISCAL DEFICIT PUTTING ECONOMIC STABILITY AT

UNCLAS SECTION 01 OF 02 ISLAMABAD 001035

SIPDIS

SENSITIVE

SIPDIS

E.O. 12958: N/A
TAGS: ENRG ECON PREL PGOV PK
SUBJECT: PAKISTAN'S FISCAL DEFICIT PUTTING ECONOMIC STABILITY AT
RISK

Summary
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1. (SBU) Summary: The IMF expects the fiscal deficit for the
current fiscal year to be as high as 6.5 percent of GDP, far
exceeding the 4 percent target. A nearly $1 billion shortfall in
tax collection, larger than budgeted expenditures, below target
privatization receipts, and the projectization of the $200 million
in U.S. budget support are responsible for the above target budget
deficit. Deficit financing options are limited, and the GOP has
resorted to excessive borrowing from the Central Bank to finance the
growing budget gap. This is fuelling inflationary pressures with
July-January inflation at 8.6 percent, compared to the 6.5 percent
target. As a result, the incoming government will need to make
difficult choices to preserve macroeconomic stability. End summary.

GOP will miss fiscal deficit target
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2. (SBU) The GOP will miss its 4 percent fiscal deficit target by a
large margin. According to the IMF, the fiscal deficit will be 6.5
percent of GDP for the current fiscal year, compared to the current
fiscal year target of 4 percent of GDP. The shortfall is estimated
at $10.4 billion (Rs.650 billion),or $4.0 billion (Rs.250 billion)
above the $6.4 billion (Rs. 400 billion) budget deficit target. A
revenue shortfall combined with excess expenditures is contributing
to the larger than targeted fiscal deficit.


3. (SBU) According to the IMF, there will be a $960 million (Rs.60
billion) shortfall in tax revenues, which have grown by 10 percent
through July-January FY08 against the targeted 22 percent growth
rate. General sales tax was the only category which recorded a
significant growth of 15.78 percent. The income tax dipped by 4.55
percent, while customs duties increased at the marginal rate of 1.48
percent. Zero rating of the textile sector has led to tax leakages.
In addition, the financial sector did not perform as well as it did
last year, resulting in lower income tax collection.

Privatization program stalled
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4. (SBU) Privatization proceeds budgeted at $1.2 billion (Rs.75)
billion are also likely to fall short, as no major privatizations
are scheduled for FY08. The privatization proceeds stood at only
$133.2 million in July-January FY08. Following the Supreme Court
ruling (under former Chief Justice Chaudhry) to reverse the Steel
Mill privatization, the entire program came to a halt. The GOP
floated global depository receipts (GDRs) for a number of public
sector companies (e.g. Pakistan Telecommunication Company before
privatization, Oil and Gas Development Authority) in the
international equity markets as a substitute for direct ownership
transfer. In FY07 Pakistan earned $1.37 billion from capital market
transactions, including global depository receipts of Oil and Gas
Development Company Ltd. and United Bank Ltd. and other public
offerings of public sector enterprises. These transactions were a
significant source of foreign exchange. The domestic political
instability and rise in country risk have made GDRs less attractive
to both domestic and foreign investors. As a result, the GOP opted
to wait and has not floated any GDRs during the last six months.

But non-tax revenues likely to meet targets
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5. (SBU) Fortunately, non-tax revenues are likely to meet their
targets. The GOP budgeted $370 million (Rs.23.17 billion) for
coalition support fund reimbursements, rather than the $1.28 billion
budgeted (Rs.80 billion) in the previous fiscal year. Given the
reimbursements already dispersed this year, and those in the
pipeline; this target is likely to be met. However, the loss of two
hundred million dollars for budgetary support does contribute to the
GOP fiscal deficit. As a result, the Ministry of Finance is
encouraging the Embassy to assume projects already budgeted rather
than designing new projects. In other non-tax revenue items, the
GOP has budgeted State Bank profits at $960 million (Rs.60 billion),
and dividends from public enterprises at $1.25 billion (Rs.78.7
billion). The State Bank has already contributed $752 million to the
GOP exchequer to finance the budget deficit in the first quarter of
FY08.

Increased energy, food subsidies contribute

ISLAMABAD 00001035 002 OF 002


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6. (SBU) Expenditures are exceeding their target due to increased
spending on energy and now food subsidies. According to the IMF,
prior to the March 1 fuel price increases, oil subsidies ran at 1.5
percent of GDP, or close to $2.4 billion (Rs.150 billion). According
to the GOP, oil subsidies are $2.17 billion (Rs.136 billion). We
note that there is a discrepancy between GOP and the IMF estimates
of oil subsidies. Our calculations show that the GOP will save only
$197 million after fuel price increases through the June 2008 end of
the current fiscal year. The full cost of these subsidies is not
reflected in the GOP budget statistics since the oil marketing
companies effectively finance a portion of the fuel subsidies. The
GOP regularly delays payments to the oil marketing companies.
According to the IMF, the oil marketing companies have taken out
short-term loans amounting to $800-960 million (Rs.50-60 billion)
from commercial banks to finance new fuel purchases. The GOP has not
accounted for this money in the budget, but has provided sovereign
guarantees to the commercial banks for the full amount of the loans.


GOP borrowing from the State Bank sets new records
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7. (SBU) GOP borrowing from the State Bank of Pakistan (SBP) are
already at record levels with four months of the fiscal year
remaining. The half percent increase in the cut off yield for
treasury bills and the rise in the discount rate to 10.5 percent
have not reduced GOP bank borrowings. Despite resistance from the
State Bank governor, the GOP is continuing to depend on the SBP to
finance its fiscal deficit. Government borrowing from the State Bank
of Pakistan to finance the budget stood at $3.79 billion (Rs.237.1
billion) for July-January FY08 versus $1.13 billion (Rs.70.9
billion) for the same period last year. The below-target performance
from tax revenues and privatizations, combined with larger than
targeted expenditures have left the GOP with few options other than
borrowing from the State Bank of Pakistan. In addition to oil
subsidies, wheat subsidies are also likely to influence the fiscal
deficit. The GOP has imported wheat amounting to $208 million in
July-January FY08. Since September 2007, the GOP has placed orders
for the purchase of 1.7 MMT of wheat valued at $801.5 million. The
estimated government subsidy on this imported wheat is $480
million.

Comment
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8. (SBU) Pakistan has established a solid macroeconomic framework
in the last five to eight years, taking advantage of political
stability, good policy choices, a successful privatization program,
and growing exports. The global environment was also congenial to
emerging economies. A new government, high international commodity
prices, an economic slow down in Pakistan's biggest export market,
and decreased international liquidity will test whether Pakistan can
preserve its good macroeconomic fundamentals. So far, the economy
has shown resilience in the face of both domestic and external
shocks, indicating the underlying strength of the economy. Despite
the increases in international commodity prices and the GOP's recent
decision to begin to pass them along to consumers, growth is still
forecast to reach a respectable 5-6 percent this year. However, we
do not believe that this growth is necessarily sustainable, given
high subsidies to the domestic sector, continued low rates for tax
collection, and the growing fiscal deficit. The rise in the fiscal
deficit is likely to raise Pakistan's country risk and may lead to
further downgrades in its ranking by international credit rating
agencies. This in turn may reduce foreign inflows, especially the
FDI inflows and adversely affect GDP growth. End comment.

PATTERSON