State Bank says economy grows by 2.4% in FY11 despite devastating floods

Karachi: Pakistan’s economy managed to grow by 2.4 percent in fiscal year 2010-11 (FY11), despite devastating floods in the early part of FY11, says State Bank’s Annual Report on State of the Economy released here Monday. It said one-fifth of the country’s agricultural heartland was inundated, which interrupted production processes and disrupted subsequent supply of both labour and capital. It is estimated that 6.6 million of Pakistan’s labour force was out of work for 2 to 3 months, and capital stock worth US$2.6 billion (1.2% of GDP) was lost.

While international response to devastation was below expectations, it is commendable that the government was able to address these challenges despite severe fiscal constraints. Furthermore, inherent resilience of agri. sector allowed it to post a bumper wheat crop in Rabi season and sizable production of minor crops (potato, onion, pulses, etc.), which spearheaded revival, Report said, adding that a spontaneous community effort towards rehabilitation and government support in form of cash payments to flood affectees, providing free seeds, fertilizers, allowed the country to overcome this natural disaster.

Manufacturing sector suffered a serious setback. Industrial growth was negative 0.1% in FY11, due to flood-driven supply chain interruptions; prolonged power outages; reduction in gas supplies. Services, on other hand, supported growth on back of a rise in government salaries and defence spending. Overall growth in services was 4.1% in FY11, which was lower than target 4.7%, but this still accounted for 90% of real GDP growth.

It said Pakistan’s fiscal position remained under stress during FY11, with budget deficit of 6.6% of GDP, compared to target of 4.0%. The implementation of reformed general sales tax; broadening of income tax net to include agriculture and services; phasing out of subsidies in a timely manner; and restructuring of loss-making public sector enterprises – were either delayed, or not implemented.

On positive note, government was able to contain its spending compared to FY10. Budgetary expenditure in FY11 was 18.9% of GDP, against 20.5% in preceding year. The large fiscal deficit directly impacted Pakistan’s debt burden, as stock of public debt and liabilities (accumulated deficits) posted increase of Rs 1,763 billion in FY11, to Rs 11.0 trillion (60.9% of GDP). Interest payments alone accounted for 32.8% of government revenues last fiscal year, which means further squeeze on government’s ability to use fiscal policy to promote economic growth.

However, Pakistan’s external debt remains comfortable, especially within context of acute problems facing the Euro zone, SBP Report said adding that during FY11, most of increase was on account of currency revaluation, as dollar lost value against other hard currencies. Funding that Pakistan actually received during FY11 was largely utilized for servicing of external debt.

It stressed that financing of fiscal deficit was, and still remains, challenging. “With a decline in external funding following suspension of IMF Stand-By Arrangement (SBA), government had little choice but to rely increasingly on domestic sources. During FY11, government borrowed Rs 1.1 trillion from domestic resources, which accounted for 91.0% of fiscal deficit,” it said, adding that within domestic sources, heavy reliance on commercial banks not only crowded-out private sector, but also complicated monetary management, as banks focused increasingly on short-term T-bills to place their surplus liquidity.

As a result, private sector credit only grew by 4.0% in FY11, as compared to increase of 74.5% in government borrowing from commercial banks. “In our view, since commercial banks were lending to the government at attractive rates, this left little incentive to fund private businesses.”

It said retail prices also increased because of supply side factors, including impact of floods and rise in international commodity prices.

Food inflation was particularly hard hit, posting sharp 21.3% year-on-year increase in September 2010, compared with 10.4% in same month a year earlier – food inflation remained about 19% in first half of FY11.

With headline CPI inflation also in double-digits throughout the year (it averaged 13.7% for year), SBP resorted to monetary tightening with increase in policy rate from 12.5% in end-FY10, to 14.0% in November 2010 – for remaining part of FY11, policy rate was kept unchanged.

Acknowledging importance of energy as a key factor of production, Report devoted a full chapter to assess Pakistan’s energy shortage.

It said government’s response to energy shortfall was threefold: (1) commissioning of rental power projects (RPPs); (2) resolving circular debt issue by injecting Rs 120 billion; and (3) increasing electricity tariffs to pass on higher cost of production. “In spite of these measures, the overall situation remained largely unchanged.”

“Commissioning of RPPs to increase generation capacity was misplaced, as Pakistan is operating well below its installed capacity due to circular debt problem. Rs 120 billion injected by the government (to restart funding of furnace oil) only happened in May 2011. In effect, for most of FY11, acute problems in power sector went unaddressed.” Presenting FY12 projections, SBP Report said: “we project GDP growth to be in range of 3-4%.

The likelihood of achieving non-tax revenue target (as shown in Federal Budget) is also low for several reasons. In view of this, SBP projects a fiscal deficit of 5.5 to 6.5% of GDP, with a bias on upside. In our view, policymakers may consider formulating a comprehensive medium-term fiscal reform master plan, which is staggered and sequenced on basis of hard lessons of recent past.

Coordinated documentation; transparent collection with oversight; an equitable plan to capture all commercial businesses and institutions into tax net; a restructuring agenda for loss-making PSEs; and credible enforcement mechanism, must anchor this master plan. We expect inflation to be within a band of 11.5 – 12.5% in FY12, which is broadly in line with Annual Plan target of 12%.”

On monetary policy side, it said, sharp cut in discount rate in FY12, surprised the market. “With inflation easing somewhat and banks increasingly inclined to place funds with government, degree of crowding out of private sector required policy intervention. Although SBP is still watchful to ensure that lending rates do not become negative in real terms, we share global concerns about stagnant growth and rising unemployment. SBP identified a window of opportunity, whereby private investment and employment generation would be given due importance. There was also a need to halt growing dominance of debt servicing in Federal budget.

“Finally, outlook for Pakistan’s current account balance remains a source of concern, but we remain hopeful of some upside on strong worker remittances and a possible recession in global economy. Although data for first four months of FY12 shows a current account deficit of $1.6 billion, we attribute this to temporary events (bulky oil payments and a seasonal pause in remittances in September 2011, and engineered shortage of hard currency in parallel FX market). Going forward, we expect a current account deficit of 1.5 to 2.5% of GDP, which is relatively small given our past performance.

However, financing of this current account deficit could be challenging. We also think market is over-reacting to Pakistan’s FX debt payments in FY12. One must realize that while repayments on IMF’s $8.9 billion SBA will start this fiscal year, outflows are only $1.4 billion and are scheduled for latter half of fiscal year,” SBP Report pointed out.

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