STATE BANK OF PAKISTAN ISSUES 2007-2008 ANNUAL REPORT

UNCLAS SECTION 01 OF 03 ISLAMABAD 003853


SENSITIVE
SIPDIS


E.O. 12958: N/A
TAGS: ECON ETRD EAID EFIN ENGY EINV PGOV PK
SUBJECT: STATE BANK OF PAKISTAN ISSUES 2007-2008 ANNUAL REPORT


1. (U) SUMMARY: Pakistan's central bank, the State Bank of Pakistan
(SBP),released its 2007-2008 annual report on December 11. The
report presents a lucid explanation of the already well documented
deterioration of Pakistan's macroeconomic situation in Fiscal Year
2007-2008, ending in June. Pakistan's economic growth moderated to
5.8 percent in FY08 (well below the target of 7.2 percent). High
food and fuel prices, combined with heavy government borrowing from
SBP to finance the fiscal deficit, pushed year on year Consumer
Price Index inflation to 25 percent by October 2008 and food
inflation to 31.7 percent. The widening fiscal deficit coupled with
the rising oil and higher international prices of other imports
combined to double the external current account deficit to 8.4
percent of gross domestic product (GDP). In FY 2008-2009, the
government and the central bank developed a macroeconomic
stabilization package whose implementation is well underway. This
program is now a corner stone of the 23-month Stand-By Arrangement
negotiated with the International Monetary Fund (IMF).
Macroeconomic stabilization is predicated upon effective fiscal
discipline to ensure that the monetary tightening yields the desired
impact on inflationary pressures. END SUMMARY.

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OVERALL GROWTH
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2. (U) After strong growth during the past few years, Pakistan's
economic growth moderated to 5.8 percent in FY08 (well below the
target of 7.2 percent) due to a combination of insufficient domestic
energy production, disappointing crop harvests, and rising political
uncertainty. Similarly, critical water shortages at sowing time,
incidence of viral attacks, and a disproportionate rise in
fertilizer prices weakened the performance of agriculture. As a
result, the contribution of commodity producing sector to overall
GDP growth in FY08 was the lowest in the last six years. External
factors, including a rise in international commodity prices and
lower capital inflows, also slowed growth.


3. (U) An important contributor to the slowdown in GDP growth was
the weak investment activity in the country; reflecting investors'
cautious response to political uncertainty, the poor law and order
situation, and high inflation expectations. Domestic resource
mobilization lagged behind investment requirements and delays in
infrastructure investment resulted in acute power shortages,
impacting overall economic performance. The investment to GDP ratio
fell to 21.6 percent in FY08 from 22.9 percent in FY07. The savings
to GDP ratio dropped to 13.9 percent in FY08 from 17.8 percent in
FY07. Incipient economic stress magnified as the country faced
exogenous and endogenous shocks that eroded hard earned economic
gains.

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REAL SECTOR GROWTH
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4. (U) Real productive sectors performed below expectations due to
high input commodity prices, energy shortages, uncertainty during
political transition, and below-target harvest of some key crops
that were hit by water shortages.
The agriculture sector growth rate fell to record lows of 1.5
percent during FY08 -- the lowest growth since FY03 and
significantly lower than the 4.8 percent target for the year. Major
crops also had a disappointing performance because of issues
surrounding resource management and pricing policy. For instance,
area under cultivation of cotton, rice and wheat fell because of
water shortages at sowing time. As the government delayed
announcement of pricing policy, there were delays in harvesting of
wheat. Stubbornly high prices of fertilizers and pesticides also
led to lower usage of these inputs, resulting in depressed yields.


5. (U) The industrial sector suffered from a mix of economic,
political and structural setbacks in FY08. Rising fuel and raw
material prices and intensifying energy shortages in the country
obstructed industrial activities in FY08. The heightened political

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uncertainty and law & order issues during the year also took their
toll. Provisional estimates of FY08 industrial growth are 4.6
percent compared with 8.0 percent in FY07. Other than the
construction sub-sector, all industrial sub-sectors performed below
their long-term trend in FY08. Manufacturing sector growth
continued to decline for the third consecutive year and posted the
lowest growth in six years during FY08. Most of the slowdown was
seen in large scale manufacturing, due to a relative moderation in
domestic demand, power and gas outages, as well as capacity and
input constraints in certain industries.


6. (U) In sharp contrast to the weak performance by commodity
producing sectors, the services sector showed above-target growth
for the sixth time during the last seven years. The sector grew by
8.2 percent in FY08, significantly higher than the 7.2 percent
annual target for the year and the
7.6 percent growth seen in FY07. The resilience exhibited by the
services sector helped to keep GDP growth to a respectable level by
contributing about three-fourths of the total value added during
FY08.

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MONETARY POLICY
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7. (U) Inflationary pressures in the economy remained strong
throughout FY08. The steep rise in inflation in FY08 was the result
of the unanticipated strength of international commodity prices,
upward adjustment in administered prices of key fuels and pressure
on wheat prices (due to rationalization of its support price as well
as artificial shortages in some parts of the country) and a sharp
depreciation of the rupee. In particular, Pakistan witnessed a
sharp surge in food inflation since March 2008 as a result of a
steep rise in the prices of some essential food staples. Non-food
inflation showed sharp upward trend in the second half of FY08 on
account of pass-through of petroleum products prices to domestic
consumers, rising air and road fares, and gas & electricity charges.
By October 2008, year-over-year Consumer Price Index inflation rose
to record highs of 25 percent with food inflation hitting 31.7
percent and core inflation rising to 18.3 percent.


8. (U) Capital flight put pressure on the exchange rate, and drained
liquidity from the interbank rupee market. So great was the
liquidity drain that interest rates in the money market spiked,
triggering rumors of runs on banks. SBP promptly diffused the
liquidity risks by easing statutory reserve requirements.


9. (U) During fiscal year 2007/2008, the central bank had to tighten
its monetary policy stance in three rounds, which cumulatively
resulted in an increase in SBP Policy rate by 350 basis points.
With the unabated rise in core inflation, the SBP raised policy rate
by 200 basis points again in November.

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FISCAL POLICY
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10. (U) Fiscal management weaknesses surfaced more glaringly as the
budget for 2007/2008 was grossly underestimated and the spending was
not aligned properly to the resource availability. The tax/GDP
ratio has been stagnant for some years and higher than budgeted
interest and subsidies expenses contributed to a larger fiscal
deficit. A slowdown in revenue growth coupled with a strong rise in
total expenditures (driven by exceptionally large interest payments
and consumption subsidies) caused serious deterioration in fiscal
performance in FY08. Fiscal deficit in FY08 reached 7.4 percent of
GDP, a level not observed since FY99, against the budget target of
4.0 percent of GDP for the year and compared to 4.3 percent of GDP
witnessed in the preceding year. The intensity of the surge in
international prices was severe but consumption remained robust as
the transitional government did not pass through higher costs to
consumers.


11. (U) After consistent improvement from FY01 to FY07, Pakistan's

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debt position deteriorated sharply in FY08, reflecting the country's
large fiscal and current account deficits, as well as slowing
economic growth. The stock of Pakistan's total debt and liabilities
(TDL) increased by 27 percent year over year, to PKR 6,417.4 billion
(USD 80.7 billion at 79.5 rupees per dollar),with a commensurate
deterioration in the debt sustainability indicators. In particular,
the ratio of total debt and liabilities to GDP, a broad measure of
the country's capacity to sustain debt, saw an end to a seven-year
declining trend, rising in FY08 to 60 percent. Domestic and
external debt contributed almost equally to the sharp increase in
TDL stock during FY08. The rise in the growth of domestic debt
reflected a larger FY08 fiscal deficit relative to the previous year
and also the relatively low availability of external financing
receipts. The accelerated growth in the rupee value of external
debt in FY08 was the result of a larger current account deficit and
substantial depreciation of the rupee.

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OUTLOOK FOR FY09
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12. (U) The pressures on the economy have intensified in the initial
months of FY09, as seen in all key macroeconomic indicators, and
downgrades of the country's sovereign credit ratings. Inflation is
persisting at 25 percent in October 2008 with food inflation
touching a staggering 31.7 percent year-over-year. Monetization of
the deficit through central bank lending during Jul-Nov 17, FY08
reached PKR 378.9 billion (USD 4.8 billion),as compared to PKR 74.7
billion (USD 940 million) in the same period last year, supporting
inflationary pressures. The growth of the external account deficit
has also accelerated sharply. It grew 98 percent year-over-year to
reach almost USD 6.0 billion during Jul-Oct FY09, as compared to USD
3.0 billion in the same period last year. At the same time
international financing flows have dropped sharply to a mere USD 1.1
billion from USD 3.1 billion in Jul-Oct FY08, reflecting weakening
fundamentals of the domestic economy and the deepening international
financial crisis.


13. (U) The drain on the country's foreign exchange reserves has
continued in FY09. The reserves dropped to USD 11.4 billion by
end-June 2008 from the end-October 2007 peak of USD 16.5 billion.
Foreign exchange reserves declined to USD 6.4 billion by November
25, 2008. Growing uncertainty emanating from the drop in foreign
exchange reserves combined with the weakening macroeconomic
fundamentals, resulting in cumulative depreciation of 23.3 percent
of the rupee between July 2007 and November 25, 2008. The pressures
on the economy continued to persist and intensified during the
initial months of FY09 with soaring inflation, slowing growth, a
substantially increased current account deficit, low foreign
exchange reserves and downgrades in sovereign credit ratings.


14. (U) Comment: In FY 2008/2009, the government and the central
bank have together developed a macroeconomic stabilization package
whose implementation is well underway and has helped to have a
buy-in from the international agencies. This program is now a
corner stone of the 23-month Stand-By Arrangement negotiated with
the International Monetary Fund. Macroeconomic stabilization is
predicated upon effective fiscal management, and to ensure that the
monetary tightening reduces inflationary pressures. On the fiscal
side, the government has phased out most subsidies. The government
has now widely acknowledged the inflationary impact of its sizeable
borrowings from the central bank that reached undesirable levels
close to PKR 380 billion (USD 4.78 billion) during Jul-November

2008. End Comment.

PATTERSON