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. -------------- OVERALL GROWTH -------------- ¶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. -------------- REAL SECTOR GROWTH -------------- ¶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 ISLAMABAD 00003853 002 OF 003 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. -------------- MONETARY POLICY -------------- ¶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. -------------- FISCAL POLICY -------------- ¶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 ISLAMABAD 00003853 003 OF 003 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. -------------- OUTLOOK FOR FY09 -------------- ¶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