1An Overview and Executive Summary

1.1 Overview

A strong surge in aggregate demand, sustained external account improvement, the resilience endowed by sound macroeconomic foundations, and good fortune, contributed to a broad-based acceleration in Pakistan's economy during FY03, raising real GDP growth to 5.1 percent. This moved the country closer to achieving the target long-term growth trajectory of 6 percent (or higher) by FY06, and led to substantial improvements in most economic indictors. In fact, a distinguishing characteristic of the FY03 performance, relative to that of FY02, is the scale and depth of the improvement. Harvests of key crops improved significantly, industrial growth rose to a 7-year high; exports increased to a record US$ 11.1 billion, and the current account surplus jumped to an all-time high of US$ 4 billion (5.9 percent of GDP); remittances also accelerated to a new high of US$ 4.2 billion, underpinning a substantial improvement in national savings as well as supporting the increase in the SBP forex reserves to a record US$ 10 billion; FDI flows, too increased defying the global downtrend; inflation remained subdued, dipping to record lows. Additionally, the achievement of the tax collection target that, together with disciplined spending, pushed the fiscal deficit to a 27-year low. The confluence of low government borrowings and adroit management of external inflows by the SBP also pushed interest rates to historic lows while supporting exports through the relative stability of the exchange rate (see Table 1.1).

The resurgence in agricultural growth to 4.1 percent compared to a negative growth of 0.1 percent in FY02 was arguably one of the more important components of the FY03 performance, given its strong downstream impact on the rest of the economy, its impact on rural poverty and contribution to employment. The rare combination of increased productivity of major crops together with increases in prices of many agri-products was a particularly welcome development.¹ Also, the FY03 aggregate sectoral growth incorporates strong contributions by both crops and livestock, in sharp contrast to FY02, when the crop sub-sector had witnessed a decline.

The agri-sector recovery was complemented by the continuation (and acceleration) of the H2-FY02 large scale manufacturing (LSM) growth momentum into FY03. Export-led demand, in particular, continued to rise, reflecting the improved access to key foreign markets as well as the supportive stance of the SBP in holding down the appreciation of the rupee while simultaneously pushing down interest rates to historical lows. The latter development also accelerated the rise in consumer lending that, in turn, further deepened and broadened the LSM output growth. As a result LSM growth during FY03 rose to a very impressive 8.7 percent as compared to a 4.9 percent growth recorded in FY02. The services sector too witnessed a reasonably strong growth, particularly in transport & communication, which has the strongest linkages with the commodity producing sector.

Thus, the 5.1 percent GDP growth recorded in FY03 incorporates strong contributions from all three major sectors of the economy. This not only represents an increase in the growth rate compared to FY02, but also shows a visible improvement in the quality of the recovery.

¹ It is important to remember however, that the FY03 improvement in agriculture was essentially driven by the fortuitous availability of water due to timely rains; this continued vulnerability to the vagaries of nature strongly underlines the need for heavy investments in improving water storage and management.

 

¹ During FY03, sectoral shares in GDP were as follows: agriculture (23.6 percent), industry (25.6 percent) and services (50.7 percent).

² Foreign exchange reserves for FY99 and FYOO include FE-13 deposits with SBP, whereas for FY01 to FY03, these include CRR/SLR

on FE-25 deposits.

³ Explicit liabilities include Special US Dollars Bonds, FEBCs, FCBCs and DBCs.

Another key pillar of the FY03 performance with significant positive, direct and indirect ramifications for the broader economy, were the external sector surpluses, which moved from strength to strength. Firstly, the current account surplus was substantially higher than in FY02. Moreover this improvement was supported by a small capital account surplus (the relatively lower FY02 current surplus had been further undermined by a large capital account deficit).

The structure of the improvement in the current account surplus also marks a striking difference from FY02, incorporating a reduction in the trade deficit (based on customs record), a lower services account deficit as well as a sharp rise in current transfers. The first stemmed from an exceptional export growth that comfortably outstripped the strong import growth; the second was essentially from two factors: (1) a decline in interest payments, reflecting the on-going focus on retirement of expensive debt and liabilities; and (2) the payments for logistics support to international forces. Finally, the increase in the current transfers largely emerges from a substantial increase in remittances flows.

The crucial point here is that a major part of the FY03 improvement in the current account surplus is derived from structural elements. In fact, even if the potentially non-repeating flows such as the Saudi Oil Facility, the logistics support payments and official grants are deducted, the FY03 current account remains substantially in surplus,² in contrast to the picture in the preceding years. This development is the first visible evidence that the improvement in the external account since FY01, may be a permanent feature of Pakistan's economy. If true, this would mark a seismic shift in the management of the domestic economy, since it was the persistent external account deficits, particularly through the 1990s, that had contributed to onerous demand management policies.

Table 1.2: External Cash Flow Position

 

* Reserves comprise SBP forex reserves (US$ 9.5 billion), reserves with banks (US$ 1.2 billion) and sinking fund (US$ 0.9 billion) (for extinguishing central banks deposits placed with SBP or prepayments of other expensive loans).

One concern that has emerged in recent months has been a modest decline in remittance flows during the initial months of FY04. While certainly unwelcome, the decline in remittances is by no means unexpected; the target for remittances announced in the budget for FY04 was US$ 3.6 billion and the flows during the first three months clearly correspond to this target. A key plank of the SBP's conservative stance, curtailing the appreciation of the rupee, has been the concern over the sustainability of these flows. Importantly, SBP projections indicate that, barring shocks, even if the rather conservative assumptions of a large fall in remittances are realized, the current account would still record a sizable surplus.

A significant by-product of the SBP's efforts to stabilize the rupee in the face of rising current account surpluses, has been the sharp increase in the country's foreign currency reserves; in fact, the structure of the rise in Pakistan forex reserves shows that these non-debt creating flows were the principal contributors to the aggregate increase in Pakistan's forex reserves during FY03. While debt flows also helped contributed to the FY03 growth in forex reserves, these were on quite concessional terms. This increase in the forex reserves through either non-debt creating inflows is extremely positive, leaving Pakistan well placed to further lower its debt burden, especially through the early-repayment of expensive external debt and liabilities (see Table 1.2).

The other significant impact of the SBP purchases was on monetary policy. In contrast to the FY02 position, when the SBP essentially mopped up the rupee liquidity resulting from its forex market interventions, FY03 saw a very deliberate reduction in these sterilization operations, despite a sharper rise in the forex purchases. The resulting liquidity flooding the banking system raised competitive pressures and led directly to a massive fall in lending rates. This policy shift by the SBP in FY03 was engendered by the experience of the preceding year, when the fall in lending rates had been much lower than the reduction in discount rate by the SBP. The success of the new policy stance is clearly evident in the massive 454 basis point reduction in the weighted average lending rates in FY03, compared to the more gradual 185 basis point decline in FY02.

The net growth in monetary assets was a very substantial 18.0 percent in FY03, up sharply from the 15.4 percent increase in FY02. More importantly, as a result of the lower sterilization of larger purchases, reserve money growth rose from 9.6 percent in FY02 to a far more robust 14.5 percent in FY03. However, despite this exceptional rise in monetary aggregates, inflationary pressure remained subdued through FY03. While this was in fact a key comfort point for the SBP in pursuing the expansionary monetary stance, it must also be recognized that such increases are unlikely to be sustained in the months ahead, unless forced by an unwarranted jump in interest rates.

Inflationary pressures further subdued during FY03 mainly due to: (1) stable food prices, and (2) imported deflation (due to both appreciating rupee and lower international commodity prices). Interestingly, despite the apparent weakness in firm's pricing ability, corporate profitability appears to have improved in FY03, probably reflecting the rise in aggregate demand (raising sales volumes), as well as lower interest rates and stronger rupee (both positively affecting margins).

Another very positive development during FY03 was the substantial increase in tax revenues, which rose by 16.2 percent, in contrast to the 8.3 percent increase in FY02. This is impressive given the fall in the tariff rate, the appreciation of the rupee (which lowers the base for ad-valorem taxes) and low inflation (resulting in loss of seigniorage revenues). The rise in the GST receipts, in particular, suggests a welcome increase in domestic demand as well as a broadening of the tax base. This improvement in revenues, coupled with disciplined spending, saw the fiscal deficit fall to 4.4 percent of GDP - the first time it has fallen below 5 percent of GDP in over 25 years. In fact, the only blemish in the FY03 fiscal performance is the surprising (and unfortunate) shortfall in development expenditures, despite the available fiscal space.³

Table 1.3: Commercial, Short-term and Foreign Exchange Liabilities Paid