STATE BANK OF PAKISTAN: ECONOMIC OUTLOOK LESS THAN ROSY

C O N F I D E N T I A L SECTION 01 OF 03 ISLAMABAD 000288

SIPDIS

SIPDIS

E.O. 12958: DECL: 01/15/2018
TAGS: ECON EFIN EINV PGOV PREL PK
SUBJECT: STATE BANK OF PAKISTAN: ECONOMIC OUTLOOK LESS THAN ROSY

REF: 07 State 5328

Classified by: CDA Peter Bodde for reasons 1.4 (b) and (d)

Summary


1. (C) Summary: In its January 5, 2008 first quarterly report, the
State Bank of Pakistan (SBP) reduced its June 30, 2007 - July 1, 2008
(FY08) growth rate target range to 6.6-7.0 percent from 7.0-7.4
percent due to deterioration in the investment climate resulting from
increased domestic instability, decreased global liquidity, and
below-target cotton and rice crops. The local IMF Resident
Representative, however, projected that growth would be at just six
percent. The World Bank Islamabad economists Hanid Muktar and Kaspar
Richter believe that growth will be about five percent, but
highlighted that the real story is the deterioration in Pakistan's
current account.


2. (C) Summary continued: The outlook for the services sector
(accounting for over half GDP) remains positive, backed by
acceleration in retail and wholesale trade, and better performance by
the financial sector. Although the large scale manufacturing sector
growth rate has slowed down to 6.9 percent in the first quarter, it
appears strong at 8.0 percent excluding electronics. SBP expects a
revival in the manufacturing sector driven by infrastructure
industries, which grew 8.3 percent annually in the first quarter of
FY08 versus 3.7 percent in the preceding year. The report, which
covers data through November 30, 2007, also comments quite frankly
for the first time that domestic and international developments put
continued economic growth at risk. End summary.

Good economic performance despite increasing uncertainties


3. (C) According to the SBP report first quarterly report released
January 4, Pakistan's economy performed "reasonably well" in the
initial months of FY2008, despite increased domestic and
international economic uncertainties. However, risks to the economy
are increasing because the "global and domestic economic environment
is not as benign as in the past few years." The SBP also forecasts
that the FY08 growth rate is likely to be below the 7.2 percent
annual target. The GOP, however, still has not revised its economic
targets. The Economic Adviser at the Finance Ministry, Dr. Ashfaque
Hasan Khan, agrees with the SBP that the GDP growth rate is likely to
fall short of the target and remain between 6.5 percent -7 percent.
In addition to recent violence and market closures, the below-target
cotton and rice crops because of pests and untimely rains contribute
to lower GDP growth estimates. Cotton production is estimated at
12.8 million bales, compared to the 14.1 million bale target and last
year's 13 million bale harvest. The IMF resident representative,
Henri Lorie, told Econoffs that the GDP growth is likely to be around
6 percent in the current fiscal year because of excessive government
borrowing from the Central Bank, increased commodity prices, and
decreased tax revenue.


4. (C) The growth rate of the large-scale manufacturing sector
slowed down in the first quarter of FY08, although disaggregated data
reveals a mixed picture. Many industries including fertilizer,
pharmaceuticals, petroleum refining and some metal and engineering
goods, rebounded strongly after disappointing performances in the
previous year. However, cotton yarn and cloth (weak export demand
and a poor cotton crop),automobiles (the government relaxed
imports),and edible oil and vegetable ghee (demand slackened in the
face of nearly doubled prices) performed poorly. Khan, however, was
upbeat about the manufacturing sector's performance, given the more
recent data. The large scale manufacturing sector recorded a growth
rate of 7.7 percent in July-Oct 2007, while in the month of October
it grew 9.8 percent. Sugar production, which represents 4.15 percent
of the overall manufacturing sector, grew 122 percent in December and
will likely bump up overall manufacturing production. The services
sector is likely to maintain its growth momentum, and is estimated to
grow at the rate of 8 percent in the current financial year.

Continued growth in net credit and strong aggregate demand


5. (SBU) Growth in net credit to the private sector appears to be
stabilizing at around 15 percent annually, indicating that the
domestic economic growth is continuing at the same pace. Companies,
which have found it cheaper to borrow overseas, may revert to the
domestic markets given the widening of Eurobond and other
international financing spreads, possibly further increasing credit
growth. The State Bank of Pakistan is following a tight monetary
policy to dampen inflation. Increased GOP borrowing, however, is
expanding the money supply, eroding the effectiveness of the SBP's

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policy and pushing up the inflation rate.


6. (SBU) Strength in aggregate demand coupled with the impact of
rising global commodity prices is reflected in the persistence of
high domestic inflation. Consumer price index inflation rose to 9.3
percent annually in October 2007 primarily driven by a 14.7 percent
annual jump in food inflation. Since May 2007 core inflation
(non-food non-energy) has also been increasing. Excessive government
borrowing from the State Bank has enhanced monetary expansion by six
percent, and is also increasing inflationary pressures. Excessive
government spending and significant increases in international
commodity prices are also fueling inflation. As of January 5, the
GOP has borrowed a record $3.93 billion from the banking system since
the beginning of the current fiscal year July 1, as compared to only
$1.02 billion during the same period last year. These inflationary
pressures will rise further, once the government makes the difficult
political decision to pass along the increase in international oil
prices. The GOP has already overshot its subsidy budget by over 100
percent this fiscal year. (reftel)


7. (C) In recent public statements, the caretaker Finance Minister
Salman Shah has highlighted the need to increase oil, gas and power
prices to reduce current expenditures. Shah warned that the fiscal
deficit target will not be met if the GOP continues these subsidies
and does not begin to pass on higher energy costs to consumers. As
the inflation rate continues to increase, it will be more difficult
to pass along these increases. Khan attributed the recent wheat
crises in the country and high food inflation to international food
shortages and wheat smuggling from Pakistan to India, Afghanistan and
Iran due to lower prices in Pakistan. Khan told Econoffs that
Pakistan accounts for 600,000 tons for Afghanistan's wheat
requirements in its target calculations, but that this year,
Afghanistan has chosen to import the majority of its wheat from
Pakistan because of lower prices than other suppliers. Pakistan
usually exports 600,000 tons of wheat to Afghanistan, and Afghanistan
imports the remaining approximately 1 million tons from Central
Asian. Khan also commented that Iran is stockpiling wheat in the
event of additional sanctions.

Fiscal deficit expands; tax revenue target unlikely to be met


8. (C) The SBP highlighted that all key fiscal performance
indicators have deteriorated significantly in the first quarter of
FY2008. Development expenditure, which principally includes
infrastructure projects, rose 89.5 percent in 1Q FY08, is one of the
major contributors to higher fiscal deficit. Most observers consider
that this dramatic increase is tied to the upcoming elections. The
government's budgetary borrowings from the banking system from July 1
through December 1 rose by Rs. 191.3 billion ($3.08 billion) compared
to Rs. 97.6 billion ($1.57 billion) in the same period last year. The
difference between total revenue and current expenditures moved from
a surplus in the first quarter of FY2007 to a deficit in the first
quarter of FY2008, despite an impressive growth of 22.3 percent in
total revenues during this period.


9. (C) IMF ResRep Henri Lorie told Econoffs that recent data paints
an even less rosy picture, with tax revenue increasing only 4 percent
versus the 22 percent target. Khan acknowledged that the GOP will
certainly miss its fiscal deficit target of four percent because of
tax collection shortfalls, the U.S. decision to shift the $200
million in budgetary support to projects, and delays in Coalition
Support Fund (CSF) reimbursements, according to Khan. He further
elaborated that the delay in CSF reimbursements is causing the
government to borrow money from the State Bank of Pakistan. In
response to EconCounselor's question, Khan did acknowledge the
contribution of increased fuel subsidies to the growing fiscal
deficit. Most analysts expected that the fiscal deficit will come in
at 4.5-4.9 percent this fiscal year.

Exports grew at 11.3 percent annual rate, but the current account
deficit a concern


10. (C) Exports grew at an 11.3 percent annual rate from
July-October 2007 due to a 23.1 percent increase in non-textile
exports. Khan said that the GOP is likely to meet its 10 percent
growth rate target in exports, despite an expected dip in exports in
December due to delays caused by the post-Bhutto assassination
violence. Despite only a 6.6 percent increase in textile exports,
Khan was confident that Pakistan could meet its 10 percent target
because of the 10.5 percent growth in the overall export growth.
Non-textile exports have increased significantly.


11. (C) Managing the growing current account deficit will continue

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to be a challenge in FY08. Increasing international oil prices are
mainly responsible for widening current account deficit. Higher oil
prices have increased Pakistan's oil import bill to $7.3 billion in
FY 07, according to Khan. Oil imports represent 27.5 percent of
Pakistan's total import bill.


12. (C) The trade deficit remains high despite the increase in
exports and decrease in non-oil imports. The impact of 22 percent
growth in remittances was diluted by continued service and income
account deficits. In addition, profit and dividend outflows
increased 14.3 percent over the previous year to $398 million. The
SBP forecasts a 5.2 percent of GDP annual account deficit. During
July-October 2007, Pakistan recorded a surplus of US$ 3.2 billion in
the capital and financial accounts, compared to a US$ 2.8 billion
surplus last year. The increased surplus was mainly due to increased
debt because of external borrowing. Equity flows were negatively
affected by portfolio investment outflows and postponement of new
privatization programs.


13. (C) World Bank Senior Economists Hanid Muktar and Kaspar
Richter highlighted their concern with Pakistan's current account
deficit and decreased foreign inflows. Muktar commented that "the
government needs to get over its obsession with growth rates" and
focus on reducing the current account deficit. Both agreed that the
GOP needs to cut back on energy subsidies, particularly since
Pakistan has not yet felt the true cost of oil imports due to
long-term contracts at below spot market prices and export growth is
not sufficient to compensate for increased prices of imported
commodities. They hoped the foreign exchange rate flexibility would
continue. Muktar was also concerned that tight SBP monetary policy,
excessive government borrowing, and increased Pakistan Eurobond
spreads would create a credit crunch and hurt private sector growth.


14. (C) Mr. Khan told Econoffs that he expects FDI inflows to
continue despite present uncertainties. FDI was up by 15.6 percent
in the first five months of the current financial year, principally
due to a few large transactions including a $5 billion UAE refinery
project. In January 2008 Barclays Bank came to Pakistan. Tamarserk,
the Singapore's investment arm, has taken a long term view of
investment prospects in Pakistan. NIB bank taken over by Tamaserk
and later merged with Picic is now the fourth largest bank in
Pakistan.


15. (C) Merrill Lynch believes that foreign flows into Pakistan
are structural, not cyclical. Though short-term jitters cannot be
ruled out, it expects sustained FDI inflows attracted by the market
potential from Pakistan's young population (average age: 20) and
strong economy. Portfolio investment outflows have, however, been a
problem for Pakistan during recent months. Citibank sources, however,
see grim prospects for foreign investment in Pakistan due to law and
order problems and political turbulence in the run up to elections.

Comment


16. (C) The State Bank report was drafted prior to the December 27
Bhutto assassination using data through the end of November.
Analysts expect that the economic situation will look even worse once
the December numbers are released, due to the nationwide three day
closure following the Bhutto assassination. We agree with the IBRD
economists that the current account and fiscal deficits are more
worrisome than knocking off a point or two of economic growth. As an
open economy, Pakistan is a price taker for international
commodities. Until the GOP can pass along increased oil costs to
consumers and figure out a way to rationalize power tariffs, it will
continue to absorb these costs and run up a larger current account
deficit. Despite anecdotal evidence that Gulf investors continue to
be interested in coming into Pakistan, we have not heard anything in
the way of new foreign direct investments. We are also watching the
increased GOP borrowing and its effect on private sector growth
carefully. Most businessmen that we have talked to in the past few
weeks continue to put any expansion plans on hold until after the
elections scheduled for February 18. The new government will face
some difficult decisions in a challenging international environment
to keep Pakistan on its solid economic trajectory. End comment.

Bodde