SCENE SETTER FOR DEPUTY SECRETARY OF THE TREASURY

S E C R E T SECTION 01 OF 03 ISLAMABAD 000326

SIPDIS

E.O. 12958: DECL: 11/18/2019
TAGS: ECON EFIN PGOV PREL PTER CH PK
SUBJECT: SCENE SETTER FOR DEPUTY SECRETARY OF THE TREASURY
NEAL WOLIN

Classified By: Ambassador Anne W. Patterson for reasons 1.4 (b) and (d)
.


1. Summary: (C) Deputy Secretary Wolin's visit to Pakistan
comes at a time when Pakistan's long term stability depends
more and more upon the government's willingness to confront
difficult economic policy choices it has long sought to
avoid. Pakistan must begin to address a breadth of economic
challenges that would overwhelm many emerging economies:
overhauling the tax infrastructure, eliminating over $4
billion in circular debt in its energy sector, altering
revenue sharing agreements among the provinces and the
Federal Government, reversing a contraction in consumer
credit and expanding financial access, removing price
controls in commodity markets, preventing a crisis in water
distribution, and breaking Pakistan's dependence on external
financial support.


2. (C) At the same time, Pakistan must also finance an
increasingly expensive and difficult war along its Afghan
border, and provide humanitarian relief to those displaced by
the conflict. These security expenditures alone will make it
difficult for Pakistan to meet its fiscal deficit target of
4.9 percent of GDP, without the demands economic reforms will
put on the budget. This will make the upcoming review of the
IMF stand-by-arrangement, which begin in Dubai the week you
arrive, the most difficult yet. End Summary.

Shaukat Tarin, Successful, but Exhausted


3. (S) Since the balance-of-payments crisis in the Fall of
2008, staying on track with the IMF program has been an
exhausting, but essential, struggle for Pakistani policy
makers, particularly Finance Minister Shaukat Tarin. Tarin
has fought the cabinet on tax reform, revenue sharing, and
most fiercely on energy policy. Some initial objectives,
such as expanding the tax net to the agriculture sector, have
become a lesser priority due to intractable political
pressure. However, he has held firm against political
pressure when phasing out of subsidies and adjusting
administered energy prices. Tarin can also point to
successes in the economy as he leaves office: electricity
tariffs are increasing, large scale manufacturing has shown
modest improvement, portions of the agricultural sector are
showing life, and international remittances broke records in
the first half of the year. However, keeping the economy
relatively stable and keeping the IMF program on track, all
with little support from his fellow cabinet members, has left
Tarin exhausted and besieged.

The Unhealthy Equilibrium Between Tax Collector and
Businessman


4. (C) Pakistan's Tax Administration and Enforcement Agency,
the Federal Board of Revenue (FBR),is arguably Shaukat
Tarin's greatest administrative challenge. In the opinion of
several international donors, and the FBR's Chairman, the
organization is inefficient, corrupt, and widely unpopular
among the one percent of the population that file tax
returns. Pakistan's tax-to-GDP ratio hovers at an anemic 8.8
percent, and corruption and bureaucratic infighting plague
the FBR, hampering its efficiency. Further, tax exemptions
are very high in Pakistan. Although some concessions or
exemptions can be rationally justified, pressures from vested
interest group and strong corporate lobbies leave lower level
tax officials intimidated. Local tax officials admit to
receiving political pressure even when they try to tax small
businesses and shop keepers. Unions and Associations of
lawyers, doctors, and caterers also lobby politicians to
escape the tax net. Illustrating this problem, the service
sector contributes 50% of GDP, but contributes only 16.5
percent of taxes.


5. (C) It is not just political pressure that hampers tax
collection, governance and corruption problems within the FBR
are just as damaging. Echoing many of the concerns of the

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Finance Minister, and the business community, the UK's
Department for International Development (DFID) and the World
Bank have identified a culture of graft and abuse in the FBR.
The natural response among legitimate business owners and
individual tax payers is to simply avoid the tax system
altogether. The IMF program, and its tough deficit targets,
contributes to the business community's anxiety. Given the
narrow tax base, businesses complain the FBR is auditing them
several times a year and withholding refunds in order for the
GOP to meet its revenue targets.

Salim Raza's Monetary Policy: On the Right Track, but
Patience and Time Required


6. (S) Salim Raza recently completed his first year as
Governor of the State Bank of Pakistan (SBP),having replaced
the extremely capable, technocratic, and popular (at least
with the international donor community) Dr. Shamshad Akhtar.
Before departing office in December 2008, Akhtar raised the
policy rate 200 basis points to 15 percent in an effort to
bring down an inflation level that had reached 24 percent.
Akhtar often fought against a Finance Ministry (before
Tarin's arrival) that failed to resist policy decisions that
helped lead to the balance-of-payments crisis. However,
Akhtar's decision was a critical indicator to the donor
community, and the IMF, that Pakistan could make difficult
decisions in order to stabilize its economy. When Akhtar
left her post, there was some suspicion within the
international community about her successor, Salim Raza, and
his ability to act independently, given his close
relationship with President Zardari. Since taking the helm,
however, Raza has been a relatively successful central
banker, helping to bring down inflation from its high of 24.4
percent in late 2008, to its current level of 10.3 percent.


7. (C) Considering that the State Bank of Pakistan has
remained highly biased towards managing inflationary
expectations rather than in minimizing the growing output
gap, it is likely that Raza will retain a conservative stance
until the end of the Pakistani fiscal year on June 30. Even
before their monetary statement on January 30, State Bank
officials have been citing inflationary pressures associate
with increasing commodity prices and increasing demand in
building materials. With a double digit policy rate, the
business community has been unsurprisingly vocal in wanting
quicker and sharper policy rate cuts. Raza, however, does
not admit to feeling political pressure for his policy rate
decisions. Moreover, his monetary policy is welcomed among
most of the CEO's of Pakistan's leading commercial banks.
Despite the contraction of consumer credit, bankers want to
lend money. However, they are concerned that if inflation
rebounds, it will impact on the high amount of government
paper on their balance sheets.

Energy and the Circular Debt


8. (SBU) Following a joint Asian Development Bank-World Bank
Plan, blessed by the IMF, the GOP took responsibility for $4
billion of intra-corporate bank debt from the state-owned
energy sector. Under the plan, the debt was to be removed
from the books of power sector firms and placed in a debt
holding company. The transfer of funds has yet to occur,
though the Ministry of Finance has taken over the debt
servicing. The transfer has been hampered by Ministry of
Finance bureaucratic inefficiencies as well as the hesitancy
of commercial banks to move their loans to a holding company
with zero assets. Though payment terms are low this fiscal
year, they will exceed $1.2 billion in years FY 11, 12, and
FY 13. The GOP has yet to come up with a plan to extend the
repayment period or lower debt-servicing costs.


9. (SBU) Following the ADB/WB plan, the GOP has raised power
tariffs by a 6 percent increase planned for April 1.
However, this has not been sufficient to close the gap
between costs and collections. Since September 2009, $1
billion of new debt has accrued on the books of the

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state-owned energy sector players; $300 to $400 million of
this could be collected from provincial governments that have
yet to pay their bills, the rest will fall squarely on the
GOP to cover. Currently, nearly the entire power sector is
controlled by PEPCO, a GOP holding company. Until the sector
is restructured, with state-owned distribution and generation
companies, there is little hope that the sector will turn
around. Tariff increases, without improvement in management
and collection, stand little chance of ending the accrual of
arrears in the sector.

Combating Terror Finance: Improving, but Hamstrung by
Inconsistent Policies

10.(S) In the past year, Pakistan has made steady progress in
combating money laundering and the financing of terrorism.
Earlier this year, Pakistan's Federal Investigation Agency
(FIA) partnered with the State Bank of Pakistan to crack down
on large licensed and unlicensed money service businesses
that were violating foreign exchange law and contributing to
money laundering. Regarding its legal structure, Pakistan is
close to passing its first anti-money laundering law. Much
of the impetus came from a sternly worded FATF statement in
October. Parliament will likely complete passage of the bill
before the end of the month. Using its existing
Anti-Terrorism Act, Pakistan has brought to book terrorist
financiers involved in the November 2008 Mumbai attacks. Of
all the suspects, nine are financiers, two of whom are in
police custody.


11. (S) These achievement are tempered by the fact the
government has not effectively cracked down on financial
support received by the Haqqani network, other Taliban
groups, and Lashkar-e-Tayiba. Pakistan still blocks attempts
by the international community to formally designate certain
terrorist groups operating in Pakistan. Despite the success
of the FIA in cracking down on illegally operating money
service businesses, financial facilitators for extremist
group still depend on Pakistan's largely undocumented economy
for their anonymity. State Bank of Pakistan officials
believe that the ratio of undocumented and documented
international remittances into Pakistan is approximately 1/1.
Since reported monthly figures measure $600 - $800 per
month, the FIA and SBP's plan to continue cracking down on
the money service businesses is a Herculean, but worthwhile
objective.

GOP Behavior Complicates Assistance Relationship


12. (S) One of the greatest challenges in providing
assistance to Pakistan and pressing for much needed economic
reforms is that there are deep suspicions of U.S. motivations
across a broad swath of Pakistani society. The military and
intelligence establishment in particular view the United
States as favoring India over Pakistan, and believe the U.S.
opposes Pakistan's nuclear weapons program, considered to be
essential for the country's national security. These forces
have, at times, interfered with the timely distribution of or
access to assistance, or memorandums of understanding. While
the Ministry of Finance and the State Bank of Pakistan are
willing partners, neither institution, nor indeed the
President or Prime Minister, can regularly prevail against
these powerful interests.
PATTERSON