WORLD BANK LOAN NOT YET FINALIZED

C O N F I D E N T I A L SECTION 01 OF 02 ISLAMABAD 002165 SIPDIS E.O. 12958: DECL: 06/17/2018 TAGS: EFIN ECON EINV MARR MASS PGOV PREL PK SUBJECT: WORLD BANK LOAN NOT YET FINALIZED Classified by: Deputy Chief of Mission Peter W. Bodde for reasons 1.4 (b) and (d) ¶1. (C) Summary: World Bank Senior Economist Dr. Hanid Mukhthar briefed Economic and Commercial Counselor on the recent Bank efforts to negotiate a USD 500 million structural adjustment loan with the Government of Pakistan (GOP). Despite over two months of negotiations, the loan has not been finalized, but the Bank hopes to finalize it by the end of July. Mukhthar was optimistic that if the GOP took measures to phase out fuel subsidies by the end of the year and increase tax revenues, it could meet its fiscal deficit target of 4.7 percent of GDP in the 2008-09 fiscal year. However, the World Bank believes that the GOP's projected growth rate of 5.5 percent is overly optimistic and will contribute to further deterioration in Pakistan's current account balance and foreign exchange reserves. The IMF and World Bank are projecting 3.5 to 4.5 percent GDP growth. End Summary. ¶2. (C) World Bank Senior Economist Dr. Hanid Mukhthar briefed Economic and Commercial Counselor on the recent Bank efforts to negotiate a USD 500 million structural adjustment loan with the Government of Pakistan (GOP). Negotiations have been on-going since March 2008, but the Bank hopes to finalize the loan by the end of July. Loan negotiations remain hung up on what measures the GOP must undertake to contain the country's rising fiscal and current account deficits. THE FISCAL DEFICIT - - - - - - - - - ¶3. (C) On the fiscal deficit, the World Bank remains concerned about the excessive level of GOP borrowing from the State Bank of Pakistan (SBP),which reached a record Rs 550 billion (USD 8.25 billion) during the 2007-08 fiscal year. The Bank wants the GOP to publicly issue a policy statement indicating that it will limit SBP borrowing and encourages Pakistan to use the SBP only as a lender of last resort. However, the GOP is reluctant to restrict its deficit financing options. The World Bank is "disappointed" with the fiscal measures contained in the recently released fiscal year 2008-09 budget bill, particularly the absence of a capital gains tax on equity transactions and the lack of a property transaction tax. The Bank and the GOP have also yet to agree on a fiscal deficit target. ¶4. (C) In terms of financing the fiscal deficit, Mukhthar believes that the proposed GOP issuance of Rs 40 billion (USD 600 million) worth of commercial paper is "modest." Markets will be able to absorb a greater quantity, he believes, given that it will be offered at market rates. Mukhthar was also encouraged by the May 2008 tax collection statistics, which show that an economic slowdown has yet to occur. PHASING OUT SUBSIDIES - - - - - - - - - - - ¶5. (C) Mukhthar emphasized the importance of phasing out subsidies, preferably by the end of 2008. World Bank calculations indicate that a 45 percent increase in the price of diesel would be required to fully eliminate subsidies. The GOP and World Bank agree that fuel price subsidies have to be phased out over a set period of time. Mukhthar was pleased to see that the FY08-09 budget bill indicates that the GOP plans to front-load the subsidy phase out. Fuel prices would then be adjusted to remain at parity with international prices. (Note: Pakistan uses Arab light crude, which is running at approximately USD 110-112 per barrel as compared to the New York price of approximately USD 140 per barrel. The GOP used an optimistic target price of USD 108 per barrel in its budget calculations. End note.) CONCERN OVER THE GROWING CURRENT ACCOUNT DEFICIT - - - - - - - - - - - - - - - - - - - - - - - - ¶6. (C) Mukhthar reported that the Bank's greatest concern is the growing current account deficit. If Pakistan's economy grows at 5.5 percent next fiscal year, as projected by the GOP, then the country's fuel import bill would rise 43 percent. Other imports are relatively inelastic, given the weight of industrial and agricultural inputs and ISLAMABAD 00002165 002 OF 002 machinery in Pakistan's total imports. Reserves held by the State Bank of Pakistan have dropped from USD 14.5 billion to USD 8 billion since October 2007, and the rupee-dollar exchange rate has depreciated by 16 percent over the same period. Pakistan's growing trade deficit is the result of the increasing imbalance between growing imports and relatively flat exports. Even a one percent decrease in imports only saves USD 300 million. Mukhthar concluded that Pakistan must either reduce growth or attract significant new foreign inflows to curb the current account deficit. He believes that a proposed Saudi Arabia-financed oil facility, as reported in the local press, would help. PRIVATIZATION - - - - - - - ¶7. (C) Economic and Commercial Counselor inquired whether the Bank had any information on GOP plans to revive the dormant privatization program. Mukhthar was skeptical, highlighting the fact that the ruling Pakistan Peoples Party (PPP) traditionally opposed the privatization of public sector assets. Nonetheless, the Bank understands that the Cabinet has approved an expanded list of assets to privatize, despite blocking the issuance of global depositary receipts for several Pakistani firms. Mukhthar has seen considerable expressions of interest from Gulf firms in investing in Pakistan, either via privatization or directly in the agricultural sector. ¶8. (C) Comment: The Bank is keen to see the GOP resolve its fiscal deficit and to contain the growth of its current account deficit as much as possible, given continual increases in international commodity prices. Given that textiles comprise the majority of Pakistan's exports, closing the gap by increasing exports will be next to impossible. The GOP, however, is convinced it must continue a pro-growth policy at the expense of the current account deficit. We continue to believe that phase out of fuel subsidies by the end of the year is overly optimistic, but agree with the Bank that the GOP must sacrifice growth to put its macroeconomic house in order. End comment. PATTERSON