PAKISTAN -- SIX MONTH MACROECONOMIC REVIEW

UNCLAS SECTION 01 OF 03 ISLAMABAD 000318

C O R R E C T E D C O P Y
REMOVE SENSITIVE CAPTION

SIPDIS

E.O. 12958: N/A
TAGS: ECON EFIN EAID PGOV PK
SUBJECT: PAKISTAN -- SIX MONTH MACROECONOMIC REVIEW

ISLAMABAD 00000318 001.2 OF 003



1. (U) Summary: Pakistan's economy is poised to stage a modest
recovery, turning in a GDP growth rate of nearly 3 percent in
Pakistan's 2010 fiscal year (FY10). There was a sharp drop in
consumer price inflation in the first half of the fiscal year, but
in coming months, as global commodity prices spike and domestic
electricity subsidies are phased out, the inflation rate is likely
to pick up again. Trade and current account balances improved
substantially, despite a fall in exports, thanks to a dramatic
decline in imports in the first half of the fiscal year. While
foreign direct investment dropped significantly, a substantial
increase in remittances still managed to support the balance of
payments. As mandated by IMF conditions, the GOP contained its
borrowings from the central bank for budgetary support, but instead
turned to massive borrowings from commercial banks, washing out any
benefits from restrained central bank borrowings. Other sources of
concern for the IMF during its up-coming review will likely be
Pakistan's on-going shortfall in tax collection, huge borrowings
from banks for commodity financing and massive cuts in development
expenditures to finance defense spending. Overall, the large build
up in external and domestic debt remains the primary risk to
Pakistan's economic stability and prospects for economic growth.
End Summary.

- - - - - - - -
GDP Growth Rate
- - - - - - - -


2. (U) The State Bank of Pakistan (SBP) currently projects that the
real gross domestic product (GDP) growth rate in Pakistani FY10
(Note: July 1, 2009 to June 30, 2010) will likely be between 2.5
percent and 3.5 percent. If these projections bear out, the GDP
growth rate will be close to the annual target of 3.3 percent and
will also be higher than the 2.0 percent growth seen in FY09. The
SBP expects that the services sector will be the driving force
behind this growth.

- - - - - - - - - - - - - -
Major Economic Indicators
- - - - - - - - - - - - - -


3. (U) Some key economic indicators improved in the first half of
the current fiscal year as compared to the previous year.
Remittances continued to surge and reached $4.53 billion in the
first half of the current fiscal year, growing by 24.4 percent. The
SBP estimates workers' remittances will total between $7.8 billion
and $8.8 billion in FY10. A decrease in the trade deficit and this
growth in remittances both contributed to the massive decline in the
current account deficit from $7.84 billion in July 2009 billion to
$1.75 billion in December. A revival in import demand from the
manufacturing sector and rising commodity prices may limit the
improvement in the current account balance going forward. Although
both exports and imports are down, the fall in imports more than
balanced the drop in exports. In the first half of FY10, exports
decreased by 7.8 percent from the same period last year, falling
from $10.09 billion to $9.3 billion, while imports dropped by 17.9
percent from 18.3 billion to $15 billion. Total exports are
projected to range between $18.5 billion and $19 billion, while
imports are likely to range between $30.5 billion and $31 billion in
FY10. Exports showed a 13 percent year-on-year increase in
December, which, if sustained, bodes well for Pakistan's trade
balance.

- - - - - -
Inflation
- - - - - -


4. (U) Average consumer price inflation has decreased significantly
to 10.3 percent in the first half of FY10 from 24.4 percent in the
same period last year. Tight monetary policy and sharply controlled
monetization of the fiscal deficit eased the demand pressures that
have plagued the economy in the previous three years, reducing the
inflation rate sharply. The SBP, however, projects that the
inflation rate will be between 10 and 12 percent in FY10, exceeding
the annual target of 9 percent for the year. Rising international
fuel prices and cuts in electricity subsides have led the GOP to
adjust the prices of key fuels upward, which should strengthen
inflationary pressures.


5. (U) A major economic challenge for Pakistan is the improvement of
the tax-to-GDP ratio. Tax collection has only increased 4.7 percent
year-on-year during the first half of FY10 and the Federal Board of

ISLAMABAD 00000318 002 OF 003


Revenue Chairman Sohail Ahmet told Emboffs that his organization
will not be able to meet the tax target agreed to with the IMF.
Identifying tax exemptions and a slowdown in economic growth as the
major reasons for the expected shortfall in tax collection, he cited
the example of the sugar industry, which has been exempted from
taxes this year in order to lower sugar prices. Total tax revenues
stood at $6.87 billion in the first half of FY10, compared to $6.56
billion in the same period last year. (Note: In FY09, the
tax-to-GDP ratio dropped by 1 percentage point from FY08 to 8.8
percent. End Note.)

- - - - - - - -
Fiscal Deficit
- - - - - - - -


6. (U) The SBP projects that the fiscal deficit will range between
4.7 percent of GDP to 5.2 percent of GDP. The GOP contained its
borrowings from the SBP and retired $266 million of debt to the
central bank between July 1, 2009 and January 9, 2010, compared to
borrowings of more than $3.36 billion in the same period last year.
This restrained borrowing only applied to the SBP, however, as the
GOP borrowed nearly $2.43 billion from commercial banks between July
1, 2009 and January 9, 2010, compared to the retirement of $231
million in the same period last year.

- - - - - - - - - -
FDI on the Decline
- - - - - - - - - -


7. (U) Foreign direct investment (FDI) is down by 57 percent to
$1.01 billion in the first half of the current fiscal year compared
to $2.35 billion in the same period last year. Finance Ministry
contacts maintain that two large transactions in the telecom and
banking sectors artificially inflated FDI last year (Note: the
purchases of Instaphone and Union Bank. End note.) Portfolio
investment has performed well, up by 244.5 percent to $272.1 million
in the first half of the current fiscal year versus a loss of 188.3
million in the same period last year.


8. (U) Thanks in large part to the IMF Stand-by Arrangement,
Pakistan's foreign exchange reserves have improved substantially,
moving from a low of $3.52 billion in October 2008 to $11.4 billion
in January 2010. Unrealized expectations of foreign economic
assistance, however, have left foreign reserves lower than
anticipated. Also concerning is a buildup in domestic and foreign
debt. Pakistan's external debt rose to $53.79 billion in September
2009 from $44.46 billion in the same period last year, while
domestic debt rose to $50.82 billion in December 2009 from $42.24
billion in the same period last year. This large build up in debt
could compromise Pakistan's economic stability and future economic
growth.

- - - - - -
IMF Review
- - - - - -


9. (U) The areas most likely to raise IMF concerns during the
February 8-15 review are the shortfall in tax collection and
excessive GOP borrowings for commodity operations. Tax collection
has fallen short of the target by 25 percent in the first half of
the current fiscal year. The GOP believes it will be able to reduce
future shortfalls through new measures such as the Audit Plan and
the Tax Enforcement Plan, which includes provisions for identifying
and prosecuting the estimated 8,000 tax evaders who spend large
amounts on foreign travel, but do not pay taxes in Pakistan.
However, Finance Ministry sources anticipate that tax collection
will decrease by between $95 million and $120 million due to the
Supreme Court's revision in the oil pricing formula.


10. (U) The GOP has borrowed the huge amount of $3.6 billion for
commodity operations, which has increased public sector exposure and
crowded private sector credit. Since public sector organizations
carry out commodity operations, including the purchase of wheat and
sugar, the large borrowings effectively increased the GOP's
contingent liabilities and will be a source of concern for the IMF
during the upcoming review.


11. (U) The GOP allocated $4 billion for defense expenditures in the
FY10 budget, however Pakistan's defense expenditures will likely
exceed this budget allocation by $774 million by the end of the
fiscal year. To cope with the increased defense spending, the GOP

ISLAMABAD 00000318 003 OF 003


is cutting down its development expenditures by more than 40
percent.


12. (U) Both the State Bank and the Finance Ministry expect the
inflation rate to grow in coming months due to a spike in global
commodity prices. The IMF may again ask the SBP to tighten its
monetary policy to contain inflation, especially as the SBP has
reduced the policy rate by 250 basis points since April 2009, easing
monetary policy. These policy measures were supported by
substantial moderation in demand pressures.

- - - - -
Comment
- - - - -


13. (U) Pakistan's economy has shown great resilience in the face of
the country's current war and its on-going law and order problems.
The GDP growth rate, though much lower than other countries in the
region, such as India, is still in positive territory despite
Pakistan's security problems. Similarly, a sharp reduction in
inflation, contained government borrowing from the State Bank, a
substantial contraction in external imbalances and exchange rate
stability are all likely to preclude economic volatility. However,
major risks, including a decreased overall volume of trade, poor tax
growth, lower than expected receipt of aid and, in particular, the
increased fiscal deficit, continue to threaten economic revival.

PATTERSON