9.1 International Economic Scenario

The world output is estimated to have grown by 2.5 percent during calendar year 2001, which is substantially lower than the 4.7 percent achieved a year earlier. However, contrary to fears, the events of September 11, 2001 had only a short run impact on economic activities, and the contagion effects of Argentinean crisis were likewise limited. During 2002, while the US economy is still trying to recover from multiple shocks to the corporate sector and industry and the Japanese economy remains depressed, it is an expected upturn in Euro area together with better performance by Singapore, Taiwan, China, and economies-in-transition, which are projected to contribute to a growth of 2.8 percent in 2002 for the world economy.

In the USA, despite a 1.1 percent growth for the second quarter of calendar 2002, which is surprisingly lower than in the preceding two quarters, the Fed appears reluctant to ease monetary policy further as the federal funds target rate is already at 1.75 percent - the lowest since 1955.' The recent corporate bankruptcies, stock market crash and an unprecedented declining trend in fixed investment since the fourth quarter of 2000, suggest unfavorable economic prospects. A major impediment to a recovery is cautious bank lending following disclosure of inappropriate accounting practice of many US corporates that may hamper growth prospects. This in turn would hurt household savings and add to their debts, which are already under stress. On the other hand, the weak US Dollar, an expansionary fiscal policy, inventory buildup, productivity gains, and the fact that consumer spending remains strong despite the stock market collapse, are important positives for prospects of a modest recovery.

A moderate recovery is visible in the Euro area after the negative growth during the fourth quarter of 2001. The improvement is mainly due to the inventory buildup and an expansion in exports. Moreover, industrial production is also rising after touching a bottom in January 2002. In overall terms, the Euro-area GDP growth is expected at around one percent for 2002. The weakness in the German economy, however, remains a disturbing factor. In particular, the budget deficit for Germany is registered at 2.8 percent of GDP in FY02, which is close to the maximum allowed limit of 3.0 percent of GDP for individual Euro member countries. It is expected that the compensation to the victims of recent floods, will put further pressure on the fiscal balance.

The Japanese economy finally registered positive growth (albeit of less than 1 percent) in the second quarter of 2002 after showing sharp declines during last three consecutive quarters of 2001.2 The improvement was largely on account of stronger electronic exports to Asia and inventory rebuilding. However, problems in the financial sector, and the slow restructuring and reform processes are still impeding economic recovery. Similarly, despite the liberal monetary stance that prevented deflationary pressures from worsening, inflation is not likely to occur in the near future. The overall negative outlook of the Japanese economy also impedes recovery of other important Asian economies, though the growing trade among ASEAN countries, China and Korea may dampen these impulses.

In Latin America, Argentina faced another major crisis in December 2001 - the third in 20 years. The Peso had lost 256 percent of its value by end-June 2002; and inflation soared to 28 percent during January-June, FY02. The economy posted a decline of 16 percent during the first quarter of 2002

compared with the same period last year. This crisis underlines the importance of fiscal discipline for long-term economic growth and stability. This time, however, Argentina has not yet been offered any bailout package by the IFIs; this could be an important watershed, deterring moral hazard problems in future. In the past, expectations of a bailout have generally encouraged private investors to take unwarranted exposure despite high risks. Fortunately, the contagion effects of the Argentina crisis were not as strong as they were in 1980s. Although neighboring Brazil saw its currency - the real -come under attack, this was due more to political uncertainty arising from the presidential election. The real depreciated by more than 40 percent during January-June, 2002, and Brazil's industrial production also decreased due to a sharp decline in exports to Argentina. This led to a fall of 0.7 percent in Brazilian GDP during the first quarter of 2002.

The emerging economies of Singapore and Taiwan recovered during 2002 after registering a decline in output last year. China is estimated to grow below the trend level but still above 7 percent growth witnessed last year. The GDP and industrial growth for Russia are impressive. After many years, the outlook for most of the African countries is bright, with GDP estimated to grow by relatively higher rates. A better economic performance in this region would help to reduce poverty and improve the living conditions of millions of the poorest.

FY02 proved to be one of the most positive years, in terms of external sector developments, in the history of Pakistan, as reflected in the unparalleled surplus ofUS$ 2.7 billion in the overall balance of payments. A number of inter-related developments propelled this improvement: (1) the kerb premium collapsed and the Rupee appreciated sharply, both in the kerb and the interbank markets, following the international crackdown on undocumented currency transactions; (2) this, in turn, caused a phenomenal increase in remittances through the banking channel, helping the country post its largest-ever current account surplus; (3) at the same time, improved relations with major creditors, due to greater credibility of economic policies and support to the international anti-terrorism campaign, led to greater assistance from sovereign creditors and IFIs; and (4) successful PRGF negotiations that, in turn, paved the way for a generous re-profiling of external debt by Paris Club creditors. The debt-re-profiling is expected to offer a sharp Net Present Value (NPV) reduction on external debt (between 27 to 43 percent) without having a HIPC or IDA only status.

Not surprisingly therefore, the FY02 current account picture is notable for the depth of improvement, witnessing a surplus of US$ 2.7 billion during FY02 compared with US$ 0.3 billion in FY01 (see Table 9.1 & Figure 9.1). In fact, even excluding official transfers and kerb purchases, the current account still shows an improvement of US$ 2.6 billion during the year. Indeed, the country's vulnerability to external shocks has reduced considerably.

Table 9.1: Balance of Payments - Summary

Source: Statistics Department, SBP

By contrast, outflows under the capital account increased by US$ 0.4 billion to US$ 1.0 billion during FY02. The reasons can be traced to the following: (1) the Rupee repayment and redemption of maturing Special US Dollar bonds; (2) higher notional payments of long-term public & publicly guaranteed debt; (3) termination of swaps; and (4) repayment of commercial and PAYE loans/credits. Interestingly, the above developments had only a limited cash impact, as most of the payments are either notional or denominated in Rupees.

Nevertheless, the overall balance posted a surplus of US$ 2.7 billion compared to US$ 0.3 billion in the corresponding period last year, which in turn boosted the foreign exchange reserves to an unprecedented level of US$ 6.8 billion at end-June 2002.

This improvement in the external sector also has a major impact on SBP policies. In particular, the need to protect exporters from eroding competitiveness compelled SBP to set a floor for the Rupee/Dollar parity in the inter bank market. Furthermore, the resultant mopping up of Dollar flows from the formal market led to an unparalleled buildup of reserves and allowed the retirement of expensive commercial and short-term liabilities. Indeed, the reserve accumulation also has implications for the conduct of monetary policy, as the absence of pressures on the exchange rate allowed SBP to reduce the Bank discount rate to all-time low.

It is significant that the positive turnaround in the balance of payments was partially the outcome of external shocks following September 11 events, and in particular, the international crackdown on undocumented fund flows. In fact, foreign exchange flows through the informal channels have been a major issue troubling Pakistan's external sector for the past decade, and it was this leakage due to lax international practices that had essentially forced the SBP to purchase forex directly from the kerb market. Also, the past attempts to attract remittances through formal channels were somewhat unsuccessful mainly due to the sheer outreach of the informal system.

Thus, from Pakistan's perspective, the international focus on undocumented flows has been a major boon for the domestic economy, diverting the forex flows from informal to formal channels. However, the resulting 129 percent growth in FY02 inward cash remittances only emphasizes the vulnerability and underlines strongly the urgency to cement and institutionalize the increased current transfers, in order to protect against any adverse developments in the future.

Although the current account has been steadily improving over the last three years, the FY02 recovery is the first that is very broad-based. The trade deficit narrowed due to savings from lower oil prices in the international market; the services account showed lower net outflows following receipt of payments for logistic support; transfers receipts rose on account of buoyant growth in workers' remittances and a large grant from the US (see Figure 9.2). This FY02 upturn is reflected in almost all key indicators of the external account.

By contrast, improvements in previous years were largely concentrated under current transfers (see Table 9.2). The reason for this was simple: (1) as falling unit prices for key exports neutralized much of the gains in export volumes, over time, prospects of improvements in the trade account became a function of changes in oil prices in the international market. Similarly, (2) the services account was hostage to the debt servicing payments-any substantial drop in interest payments would require not only a reduction in overall debt stock but also

Note: EE: Export Earnings; FEE: Foreign Exchange Earnings;

NICAB: Non-interest Current Account Balance; FDI: Foreign Direct Investment changes in its composition. Under such circumstances, current transfers become the only head in the external account that could show improvement in the short term.

On the basis of SBP exchange records, the trade deficit declined by US$ 909 million to reach US$360 million during FY02, mainly due to lower oil prices in international markets. In fact, this outturn could have been even better if not for the continuing fall in unit prices of key exports, and the negative impact of risk perceptions due to the war in neighboring Afghanistan and subsequently, border tensions with India.6 Fortunately, the increased access to the EU markets through larger textile quotas and reduced tariffs, provided some relief towards the end of the fiscal year and helped exports to cross the US$ 9.0 billion mark marginally (see Trade Section for more details).

This deficit narrowed by US$ 0.5 billion to US$ 2.6 billion in FY02. The receipt ofUS$ 300 for logistic support in the war against terrorism, and increased earnings of PTCL (both appearing under 'other goods, services & income ') were the main contributing factors to this improvement.7 In addition, the net receipts under 'shipment improved by US$ 74 million as lower imports offset higher per unit shipment charges during the year; 'other transportation' increased by US$ 42 million due to higher aviation and bunker charges; and 'travel' receipts jumped by US$ 35 million following the influx of foreign media personnel and journalists for the coverage of war in Afghanistan.

On the other hand, 'investment income' witnessed a higher outflow ofUS$ 150 million in FY02 over the last year, despite falling interest rates in international markets and diminishing stock of external debt & liabilities (e.g. FE-45 deposits. Special US$ bonds, and commercial & private loans). The increased outflows mainly reflect higher notional payments on long-term publicly guaranteed debt. Moreover, the higher repatriation of dividend and income from sale of crude oil by foreign companies engaged in oil/gas extracting activities in Pakistan led to more outflows under 'profit and dividend'.

Although the events following September 11 influenced all categories of the external account, the impact was more intense for the current transfers, which experienced an unambiguous structural shift in the composition of private transfers (see Figure 9.3). The share of workers' remittances rose to 42 percent in FY02 from 23 percent last year, whereas the share of kerb purchases fell from 46 to 24 percent during the same period. It may be noted that the overall level of private transfers in FY01 (US$ 3.9 billion) and FY02 (US$ 4.3 billion) showed a slight change reflecting the fungibility between workers' remittances, inflows through kerb market and foreign currency deposits. In addition, Pakistan received a US$ 600 million grant from USA.

The cash remittances registered a phenomenal growth of 129 percent during FY02, which stretches to 145.5 percent after adjusting for receipts on account ofHajj Sponsorship Scheme (HSS) and payments to Kuwait war affectees (see Table 9.3). During the first quarter of FY02, cash remittances recorded an inflow ofUS$ 325 million only. Indeed, the turning point was the international crackdown on the Hundi network, and the consequent collapse of the kerb premium that favorably changed the market dynamics of remittance inflows; as a result the remittances posted an inflow ofUS$ 2.0 billion during the last three quarters ofFY02 (see Figure 9.2).8

HSS: Hajj Sponsorship Scheme
KWA: Kuwait War Affectee
Source: Statistics Department, SBP

Although remittances from all countries (except Kuwait) posted a double-digit growth during FY02, the inflows from the UAE & the US were exceptional, accounting for 70 percent of the total increase (see Figure 9.4). It seems that the increasing international restrictions on undocumented transactions have reduced Dubai's role as a hub of the Hundi network, which explains the larger formal sector flows into Pakistan directly from countries of origin.

The inflows in resident FCAs fell by US$ 249 million to US$ 285 million in FY02. Although, the Rupee/Dollar parity is still showing a depreciation of 5.0 percent on annual average basis, the reversal of devaluation expectations coupled with the meager dollar returns on FCAs, quelled incentives for the dollarization of savings in the economy. This opinion is also re-affirmed from Figure 9.5 which portrays the direst relationship between inflows in resident FCAs and the annual average depreciation of the Rupee/US Dollar parity.

The SBP purchases from the kerb market during FY02 were US$ 1.4 billion against US$ 2.2 billion last year (see Table 9.1). Initially, the SBP purchased heavily from the kerb market to maintain the foreign exchange reserves in view of end-quarter debt payments. After September 11, these purchases dipped before strengthening again in December 2001, as SBP purchased US$ 859 million during the Dec 01-May 02 period (see Figure 9.2).9'10 Nevertheless, as the country attained a comfortable position, SBP stopped purchasing from the kerb market with effect from June 2002.

Despite lower inflows under Saudi Oil Facility (SOF), official transfers improved by US$ 630 million during FY02. The main contributing factors were the grants received from the US (US$ 600 million) and other countries to compensate for the revenue shortfall and a decline in exports following the war in Afghanistan. In terms of SOF, the inflow decreased by US$ 104 million as oil prices fell in the international market.

As discussed earlier, the current account has been improving over the last three years. During this period, the external sector has witnessed a narrowing of the trade deficit, an increase in non-debt creating inflows, reduction in debt servicing, and higher inflows of concessional loans.

Despite these improvements, the FY02 upturn in the current account is better than the combined improvement in the earlier three years. Nonetheless, Table 9.4 also highlights the fact that a significant contribution to the FY02 improvement was from factors that may be absent in future years.

This not only underlines the prudence of the SBP moves to boost forex reserves through market purchases, but also the urgency to document the informal market flows.

The successful completion of IMF's Stand-by program by Pakistan led to a major shift in the relationships with International Financial Institutions (IFIs). Also, Pakistan's decision to join hands with the international community in the war against terrorism revived the previously strained relationship with bilateral creditors. These developments had a positive impact on the capital account as well, in terms of higher official assistance, on concessional terms, from multilateral and bilateral creditors, and re- profiling of bilateral debt on particularly generous terms. At the same time, the sharp appreciation of the Rupee has not only triggered the realization of outstanding export bills but also encouraged extinguishments of maturing special US$ bonds, through local currency payments as well redemption in dollars. The higher current account inflows also gave teeth to the debt management reduction strategy, enabling the country to retire most of its expensive debt. In overall terms, the capital account deficit increased by US$ 407 million during FY02 to US$ 1,050 million (see Table 9.1). The higher outflows are on account of maturing Special US$ bonds and termination of swap contracts. Since most of the above-mentioned payments were made in the Rupees, the notional hard currency outflows were offset by inflows under errors and omissions. Furthermore, the hard currency payments on account of rescheduled PTMA and FE-45 deposits resulted in the reduction of exceptional financing by US$ 557 million to US$ 135 million this year (see Table 9.5).

Net portfolio investment comprises of foreign investment in stock exchange and government securities. Looking at Table 9.6, the outflows from stock market fell to US$ 8 million in FY02 against US$ 140 million last year (for detail, see chapter on Capital Market).12

The repayment of Special US$ bonds, which started maturing from August 2001, dominated the outflow ofUS$ 482 million from investments in government securities during FY02. In order to

PTMA: Pakistan Trade Maintenance Agreement
Source: Statistics Department, SBP