Central Bank's Third Quarter Report - Growth Fragile,

UNCLAS SECTION 01 OF 02 ISLAMABAD 001269

SIPDIS
SENSITIVE BUT UNCLASSIFIED

E.O. 12958: N/A
TAGS: ECON EFIN ETRD PREL PK
SUBJECT: Central Bank's Third Quarter Report - Growth Fragile,
Inflation Stubborn


1. (SBU) Summary: On June 4, the State Bank of Pakistan released
its third quarterly report (through March 30),which projected GDP
growth for the fiscal year at 2-3 percent, a prediction unchanged
from the previous quarter. Large-scale manufacturing, the engine
that funds tax collection, fell by almost 8 percent in the first
nine months of the fiscal year. Inflation has remained stubbornly
high - year on year over 17 percent as of April, compared to an IMF
target of 11 percent, although food inflation has come down sharply
from 34 percent to 17 percent. Inflation, deterioration in external
accounts, and declining industrial output have all contributed to
lower growth, although this is offset to some extent by the strong
performance of the agricultural and services sectors. Although
overall macroeconomic indicators have continued to improve since
November (the current account deficit, foreign exchange reserves,
the exchange rate, fiscal discipline),major economic weaknesses
persist and could hamper economic recovery. End Summary


2. (SBU) Agriculture and Services Perform: The State Bank of
Pakistan's third quarterly report predicts that the agriculture
sector will perform quite well, as evidenced by record wheat and
rice harvests and the prospect of good overall yields in lentils,
oilseeds, and horticultural crops. These high growth rates are due
to higher government purchase prices and favorable weather, although
there has been lower water availability and a decline in fertilizer
usage. The livestock sector benefited from improved fodder,
following the extended monsoon and winter rains, as well as the
absence of any major outbreaks of disease during FY09.
Notwithstanding a slowdown in the trade, transportation and
communication sub-sectors, the services sector overall is also
expected to perform well.


3. (SBU) Manufacturing Slumps: In March, growth in large-scale
manufacturing (LSM) was negative for the tenth consecutive month.
LSM growth dropped by 7.6 percent from July through March, compared
with a 5 percent increase a year earlier. This remains a major drag
on prospects of improving real GDP growth. While the decline in LSM
growth is a reflection of weaker domestic and external demand, other
domestic factors have contributed significantly as well:
infrastructure bottlenecks (e.g., power and gas shortages),
increasing risk aversion by banks, and persistent inflation.


4. (SBU) Stubborn Inflation: Headline inflation - measured by the
consumer price index (CPI) - dropped to a 17.2 percent annual basis
in April from its peak of 25.3 percent in August 2008. In
particular, a sharp decline in food inflation, from 34.1 percent in
August to 17.0 percent in April, provided relief to the poorest
sectors of society. The decline in inflation was due to favorable
international prices, as well as a slow-down in domestic demand.
The latter, in particular, reflected the State Bank's monetary
tightening, as well as the complementary improvement in fiscal
discipline since November 2008.


5. (SBU) By April 2009, broad money growth (time deposits, current
deposits and currency in circulation) was still quite weak, at 1.9
percent year-to-date, down sharply from 8.4 percent in the same
period last year, reflecting the continued fall in domestic demand.
Because of this, the SBP projects the drop in inflation will be even
sharper in the next few months.


6. (SBU) Tax Receipts Fall Short: Recent discussions with
Ministry of Finance officials indicate that the budget deficit for
the first three quarters of FY09 is likely to be 3.1 percent of GDP,
compared with 4.7 percent in the same period last year. There will
likely be a shortfall in tax receipts for FY09 as well; in the first
ten months of the fiscal year, tax receipts amounted to $11.23
billion, compared with $9.54 billion in the same period in 2008, an
increase of almost 18 percent. This falls short of the 24 percent
growth required to attain the IMF's target of $15.6 billion for the
fiscal year. As of April 30, total tax collection had reached 71.9
percent of the year end target.


7. (SBU) Current Account Improves; Capital Accounts Deteriorate:
The improvement in Pakistan's overall external account that began in

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November 2008 has continued. A large part of this is due to the
23.5 percent contraction in the current account deficit, primarily
due to a fall in imports. Unlike the improvement in the current
account, however, capital and financial accounts deteriorated
sharply during the first ten months of FY09. While loan inflows
revived to a large extent after IMF Stand-By Arrangement, foreign
investment inflows continue to decline.


8. (SBU) Foreign Exchange Reserves Up: The relative improvement
in Pakistan's external accounts was reflected in its foreign
exchange reserves, which have gradually improved since the Stand-By
Arrangement was agreed. By April 30, foreign exchange reserves had
returned to the level of end-June 2008, or $11.4 billion, after
hitting a low of $6.8 billion in October 2008. This also alleviated
pressure on the exchange rate, helping it to stabilize between 78.8
and 80.86 rupees per dollar.


10. (SBU) Fiscal Deficit Under Strain: The fiscal deficit for the
year through March was reported at 3.1 percent of GDP, which is
consistent with the annual target, but there are significant issues
with the sustainability of this trend. The growth in tax
collections has already slowed, and may decline further in the
fourth quarter of FY09. Non-tax revenue receipts are also expected
to weaken. Rising international prices are expected to diminish the
proceeds of the Petroleum Development Levy, for example, which had
supplied the GOP with billions of rupees in revenue over the past
year as domestic oil prices were not lowered along with
international prices. The government's expenditure budget will also
be stretched by the ongoing war on terror and the need to support
internally displaced persons (IDPs) fleeing the conflict areas. The
current improvement in the fiscal picture is the result of a
temporary sharp cut on development spending, which is neither
sustainable nor desirable in the long term.


11. (SBU) Comment: The State Bank of Pakistan's economic reports
are highly regarded by multilateral agencies and academics due to
their independent assessment of the economic situation. The current
report characterizes the improvement in macro-economic indicators as
"tenuous" and rightly points out underlying risks. For example,
gains in the current account balance can be eroded quickly if
remittances falter and there are further drops in foreign
investment. There will likely be more slippage in the fiscal
deficit targets if tax collection efforts do not improve. The level
of international commodity prices plays a large role in Pakistan's
fight against inflation, and increases in electricity prices
mandated by the IMF will also contribute to inflationary pressures.

PATTERSON