PAKISTAN'S ECONOMIC PERFORMANCE IMPROVING, BUT STRUCTURAL

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UNCLAS SECTION 01 OF 03 ISLAMABAD 002798

SENSITIVE

SIPDIS

E.O. 12958: N/A

TAGS: ECON, EFIN, PGOV, PREL, PK

SUBJ: PAKISTAN'S ECONOMIC PERFORMANCE IMPROVING, BUT STRUCTURAL

REFORMS INSUFFICIENT FOR IMF

REF: A. ISLAMABAD 2698

B. ISLALAMABD 1992

1. (SBU) Summary: Pakistan's macroeconomic outlook was mixed in the

first quarter of the fiscal year 2009-2010. While its year-on-year

inflation and balance of payments position improved, fiscal and real

sector performance remained tenuous. Lending to the private sector

declined, but the external current account balance improved

slightly, a result of the emerging global economic recovery. But

continued electricity shortages, limited progress on power sector

reforms, and ongoing fiscal stresses diluted some of these gains.

Although the International Monetary Fund (IMF) recognized GOP

efforts to further stabilize the economy, advance structural reform

and lay the foundations for sustainable growth, doubts about GOP

commitment to further electricity tariff increases and concerns with

delays in enacting meaningful tax reform, have outweighed progress.

The November 12 conclusion of the third review of Pakistan's

performance under its Stand-By Arrangement with the Fund has not

resulted in the hoped for disbursement of the third tranche of funds

for the GOP, although discussions will continue. End Summary.

2. (U) Private sector credit growth was down: $938 million in the

first quarter, compared to $978 million in the same period last

year. The growth rate for the large scale manufacturing sector,

however, although virtually flat at 0.17 percent in July-August

2009, is being viewed as a marked improvement over the -8.1 percent

growth in the same period last year. Advisor to the Minister of

Finance Sakib Sherani said the manufacturing growth rate had been

pulled down by the poor performance of the steel and petroleum

sectors (affected by the poor performance of Pakistan Steel Mills

and circular debt, respectively).

Cautious Optimism for the Economy

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3. (SBU) Sherani said there are grounds for cautious optimism for

the Pakistani economy. The textile sector (despite much industry

outcry to the contrary) recorded marginal improvement, while the

automobile sector had been boosted by strong performance in

agriculture: farmers and workers in related industries had

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sufficient funds to acquire automobiles and trucks, despite banks'

reluctance to finance these purchases. Domestic cement sales

indicate an uptick in construction activity and offset lower orders

from abroad, particularly from India.

4. (U) According to a survey on business sentiment conducted by the

Pakistan Institute of Development Economics (PIDE),60 percent of

major business concerns expect higher sales, increased capacity

utilization, and higher employment and inventory levels in

July-December 2009. These businessmen named slack demand as the

number one impediment to their business; the high cost of capital

was second on their list of concerns, followed by security and then

the energy shortage. Small and medium businesses, however, suffer

most from energy shortages, according to Sherani. Although the

recent bombings and general deterioration in the overall security

situation have badly affected FATA and NWFP businessmen, Sherani

said that bombings have had less effect on business sentiment

countrywide.

FDI Down, Portfolio Investment Up

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5. (SBU) Foreign direct investment (FDI) decreased by 58.8 percent

to $463 million in the first quarter FY 2009-2010, down from $ 1.1

billion in the same period last year. According to the PIDE

business survey, the majority of firms reported an unchanged level

of investment in their businesses from January-June 2009 and they

did not plan any significant investment in July-December 2009.

Major portfolio investment outflows were reversed from an outflow

-$172.9 million to an inflow of $208 million in the first quarter: a

220 percent increase. The Finance Ministry ascribes this turnaround

to attractive stock valuations in comparison to other countries in

the region and an upgrade in Pakistan's debt by international rating

agencies (Ref A).

Imports Down, Remittances Up

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6. (SBU) Weak demand caused Pakistan's total imports to decline from

$10.8 billion in the first quarter of FY 2008-2009 to $7.58 billion

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in the same period this year, a 29.8 percent drop, and contributing

to a 44.7 percent decrease in Pakistan's trade deficit compared to

last year. Supported by the continued strong inflow of worker's

remittances, this fall in import growth has resulted in an $82

million surplus in the external current account balance in August

2009. The cumulative July-August external current account deficit

of $527 million is still much lower than $2.67 billion deficit in

the same period last year. Workers' remittances increased by 24.5

percent to $2.33 billion in the first quarter, from $1.87 billion in

the same period last year. Remittances in September 2009 alone

totaled a record $806 million. Sherani ascribed the steady increase

to GOP measures such as a crackdown on illegal money changers (Ref

B).

Exports Expected to Increase

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7. (SBU) Sherani also pointed out that the 13.8 percent decline in

exports in the first quarter is worrisome and continues to pose an

underlying risk to Pakistan's balance of payments. The GOP expects

exports to grow at a rate of 3-4 percent in FY 2009-2010, however,

because order books for the textile firms "looked very healthy,"

reflecting improvements in the global economy; order books for the

spinning sector are fully booked for the next six months.

Improvements in spinning sector performance in turn bode well for

the health of the banking sector, Sherani said, because spinners are

major borrowers and can add to banks' bad debt if the sector's

performance falters. Finally, depreciation of Pakistan's real

effective exchange rate, due to falling domestic inflation and an

appreciation of India's currency, has increased the competitiveness

of Pakistani exports.

ForEx Improves

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8. (U) Cash injections from the IMF, both for budgetary support

($745 million) and the increased allocation of special drawing

rights (some $1.2 billion),substantially improved Pakistan's

external financial account balance. As a result, SBP's foreign

exchange reserves reached $10.9 billion on September 28, 2009 - an

increase of $1.8 billion since July 1. This is also reflected in

the $1.58 billion increase in net foreign assets, which contributed

to the economy's improved liquidity and brought stability to foreign

exchange markets. Despite an impressive drop in credit default

swaps from 30 to 8 percent, Pakistan's rate (Note: On par with

Argentina. End Note) is still high for it to raise money through

the Eurobond markets.

But Revenue Collection Is Still Too Low

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9. (SBU) Tax collection is down by 0.95 percent to $3.12 billion in

the first quarter, from $3.15 billion in the same period last year,

further complicating fiscal management, according to Sherani. He

was hopeful that shortfalls in collection could be made up in coming

quarters, however, because first quarter collection is based on FY

2008-2009 corporate profits and incomes - all of which were low due

to the economic slowdown. The GOP blames slower than expected

disbursements from donor countries for the fiscal challenges - both

revenues and expenditures -facing the Finance Ministry.

Borrowing Is Down - Or Is It?

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10. (U) Pakistan's fiscal deficit was 1.5 percent of GDP in the

first quarter, marginally higher than the IMF-agreed target of 1.3

percent. Sherani said the slight slippage on the fiscal deficit was

not a cause for concern, as the GOP had had to make advance salary

payments on the occasion of the post-Ramazan Eid holiday. The

government also retired $882 million-worth of debt to the State Bank

of Pakistan during July 1-October 3 in order to meet the IMF zero

net borrowing condition. However, the GOP borrowed extensively from

commercial banks: some $1.4 billion during July-September 2009, vs.

the retirement of $1.27 billion-worth of commercial debt in the same

period last year. This borrowing crowded out private sector credit,

which fell by $940 million in the first quarter.

Good News on Inflation

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11. (SBU) Both consumer price inflation (CPI) and core inflation

(non-food, non-energy inflation) decreased in July-September 2009.

CPI dropped to 10.7 percent and core inflation fell to 12.9 percent,

down from 24.5 percent and 16.1 percent respectively in the same

period last year. Despite this positive news, former Advisor to the

Minister of Finance and now Dean of the National University of

Science and Technology Dr. Ashfaque Khan pointed out that the pace

of decline in inflation has been slow. Furthermore, a 0.5 percent

increase in inflation in September over August, coupled with poor

management of the food supply chain (Note: leading to shortages of

such staples as sugar and wheat. End Note) and projected increases

in electricity prices could well fuel higher inflation in coming

months. Unpredictable increases in international oil prices were

also an underlying risk to inflation as well. In response to

ongoing concern about inflation, the State Bank kept the policy rate

unchanged at 13 percent in its October monetary policy

announcement.

Not Enough for the IMF?

--------------

12. (SBU) Working level contacts in the Ministry of Finance and the

IMF/Islamabad office reported November 13 that the IMF has

registered concern over the slow pace of agreed structural reforms,

especially the slow pace of tax reforms and imposition of a value

added tax (VAT),at the third review under Pakistan's Stand-By

Arrangement (SBA) in Dubai November 2-12. Tasnim Aslam, Senior

Economist at the IMF, said that the lack of progress on tax reforms

has resulted in a revenue shortfall in the first quarter of the

current fiscal year. The IMF team in Dubai also expressed concern

about the GOP failure to implement the automatic fuel adjustment

mechanism, which will more effectively pass on changes in fuel

prices to electricity consumers.

13. (SBU) Comment: Sherani's predictions that Pakistan would have an

easier time in its third review than it had in its second (Note:

which dragged on for over a month. End Note) do not appear to be

borne out. The GOP hoped making changes in the Banking Companies

Ordinance and SBP Act to enhance the Bank's autonomy (Note: The Act

is currently with the National Assembly. End Note),coming in more

or less on the mark with the fiscal deficit target, and in

particular implementing the six percent electricity tariff increase

would outweigh Pakistan's shortcomings. However, the Fund's concern

with the GOP's inability to move forward with meaningful tax reform

and to collect taxes already levied seem to have prevailed; the

conclusion of the third review has been suspended from its scheduled

November 12 date (septel). Continued doubts about the GOP

commitment to further increases in electricity tariffs (Note: two

more increases are due in the next six months. End Note) also

contribute to the Fund's caution. Minister of Finance Shaukat Tarin

told media November 13, however, that he expected Pakistan's third

tranche of funds to be released "soon."

14. (SBU) Comment cont'd: Uncertainty regarding the timing of

official foreign inflows, continued pressure on the country's fiscal

management and limited progress on resolution of Pakistan's serious

electricity problems remain a drag on economic growth and stability.

If expectations of a recovery in at least some exports are

mistaken, the low export figures will constitute a major threat to

the country's balance of payments; low imports are already having an

adverse effect on revenue, as 40 percent of GOP revenue income comes

from import taxes. Instituting a value added tax (VAT),essential

to improving Pakistan's dismal 9 percent tax-to-GDP ratio, is making

only slow progress in the face of thorny constitutional issues

requiring federal and provincial government agreement. End

Comment.

PAKISTAN'S ECONOMIC PERFORMANCE IMPROVING, BUT STRUCTURAL

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