Pakistan's economy during FY00 showed some signs of improvement and stability, along with a modest growth rate (see Table 1.1). However, a combination of domestic and external shocks coupled with structural shifts kept the economy under stress.

The residual vestiges of May 1998, the political uncertainty and the change of government in October 1999, were major domestic shocks to the economy. On the external front, a breakdown in negotiations with the IMF in May-September 1999, the spike in world oil prices, the lingering dispute with Hubco, and serious reservations in some international quarters on the emergence of a military government, exacerbated the situation. Since October 1999, the new government's economic agenda, which is based on accountability, improved governance, widening the tax net and closure of official avenues of hiding wealth, created major structural shifts in the economy. Although the Pakistani economy has been inherently resilient and weathered many shocks in the past, its capacity to absorb domestic and external shocks along with fundamental structural changes at the same time has been tested to the limits during FY00.

Although these structural changes may lay the foundations for a more sustainable and equitable growth in the future, the short-term transitional costs are significant. The withdrawal of investors who had built their fortunes on the basis of concessions, privileges, connections, tax evasion and loan defaults, has created a vacuum for the time being. The potential beneficiaries of the new system are yet to emerge and will take time to establish themselves. The government could have filled in this gap, but its own public finances are structurally weak.

The combination of a slowdown in the informal economy and the cumulative cut in productive public spending over the last few years, has not only reduced opportunities for economic expansion and employment generation, but may not be able to sustain the productive use of additions to the labor force. The only exception to this is the agriculture sector, which has resulted in a large infusion of purchasing power in rural areas.

As a result of strong agriculture performance, the real sector witnessed a turnaround and GDP growth rose to 4.8 percent from 3.1 percent a year earlier. Bumper crops of cotton and wheat, coupled with an increase in the production of rice, led to agricultural growth of 7.2 percent, which improved self sufficiency in food and the quantitative increase in exports.

The bumper cotton crop, low domestic cotton prices and falling interest rates created very favorable conditions for the textile sector. Value added in this sector grew by 13.0 percent in FY00 compared to 2.0 percent a year earlier. But this expansion was insufficient to offset the large decline in the sugar sector. Therefore, large scale (LS) manufacturing did not show any growth this year. However, if sugar is excluded, LS manufacturing did perform well with sectoral growth at 6.8 percent compared to 5.8 percent in the preceding year.

Table I.1
Selected Macroeconomic Indicators

After witnessing a decline of 7.9 percent in FY99, fixed investment grew by 4.4 percent. This increase was driven by private investment in textiles, agriculture and related services, while investment in other sectors remained depressed. This year, a larger volume of national savings financed this investment, while the share of external resources declined considerably.

These real sector developments were fully reflected in the external sector. On account of favorable conditions in the textile sector, quantitative exports posted an impressive increase, which should put to rest the view that Pakistan does not have the capacity to create an exportable surplus. This quantitative increase occurred despite a stable exchange rate, which did not provide an additional incentive to exporters. In overall terms, the textile sector felt optimistic enough to embark upon a modernization drive in the fourth quarter of FY00. Although this will increase Pakistan's import bill in FY01, such increases are productive.

Despite this quantitative rise, export revenues did not increase as expected following a collapse in international cotton prices; against recorded proceeds of US$ 5.0 billion in FY99, revenues only increased to US$ 5.7 billion in FY00. Although wheat and edible oil imports fell significantly in FY00, the problem was the doubling of international oil prices. The value of petroleum imports increased from US$ 1.5 billion to US$ 2.8 billion, which forced non-oil imports to fall in FY00, maintaining the declining trend since FY96. This shows Pakistan's vulnerability to international prices and its constrained external sector since the mid-1990s.

Home remittances that have played an important role in financing Pakistan's current account deficit remained stagnant, implying that the burden of external financing fell on outright purchases from the kerb market. These inflows helped reduce the current account deficit from 3.9 percent of GDP to 1.6 percent in FY00. Despite this sharp reduction, there was no easing of pressure on external payments. Even with the relief provided by the debt rescheduling, the country still had to make payments of US$ 3.7 billion to preferred creditors and for non-rescheduled debt (see Table 1.2). In addition, the absence of fresh inflows from international financial institutions (IFIs), which had been a pivotal source of capital flows in the past, exacerbated the situation. In fact, Pakistan had to make net transfers of US$ 162.3 million to the IFIs. These adverse capital account movements resulted in a US$ 382 million draw down in liquid reserves, from US$ 1.74 billion in June 1999 to US$ 1.36 billion in June 2000 (see Table 1.3).

The foreign exchange markets remained calm throughout the year and the premium between the interbank and kerb rate was quite stable, staying within a narrow range of 4 to 5 percent. The interbank exchange rate depreciated for the first time during FY00 in end-May 2000, in response to pressure from devaluations by Pakistan's competitors and the appreciation of US Dollar vis-a-vis other world currencies.

The stable exchange rate was able to stem domestic dollarization, but the problems facing banks following the freeze of FCAs remained. Whereas, the bulk of conversions from frozen FCAs to Rupees were witnessed in FY99, there was a new development in FY00 - a fear amongst depositors that they could be held accountable for their bank deposits. The change in government, the resulting actions against loan and tax defaulters, and the complementary accountability drive, encouraged depositors to withdraw their funds from the banking system. Supported by heavy government borrowing from the central bank, there was a significant increase in currency in circulation.

Table I.2
Pakistan's External Cash Flow Position in FY00*
(US$ million)

*Numbers from Table 8.2 in the Annexure, and Table VIII.1 in Chapter VIII.

Table I.3
Pakistan's External Debt/Liabilities Servicing in FY00
(US$ million)

* The payments were not in foreign currency.
** The US$ 49 million under actual paid is on account of arrear payments from FY99.

With a stagnant Rupee deposit base and lower off-take of credit by the private sector, banks actually experienced a tighter liquidity position during FY00. While banks experienced

difficulties during FY99 in managing the shift of Rupee liquidity as depositors converted out of frozen FCAs, this was more a reshuffling within banks towards short-term demand deposits. In FY00, on the other hand, there was a systemic shift out of bank deposits.

FY00 was the second consecutive year where GOP retired its debt to scheduled banks (by Rs 84.1 and Rs 95.0 billion for the years FY99 and FY00, respectively). Although the government retired a greater volume of its debt to scheduled banks, borrowing from the banking system (scheduled banks and SBP) increased from negative Rs 75.2 billion in FY99, to positive Rs 40.0 billion during FY00. The key development in the year was that GOP borrowed Rs 135.0 billion from SBP, a very sharp increase from Rs 8.9 billion in FY99. Despite the overall reversal in government borrowing from the banking system, T-bill rates continued to fall for the second consecutive year. This is because T-bill rates are determined on the basis of government borrowing from scheduled banks, while borrowing from SBP is priced at the last weighted average T-bill rate. In effect, by retiring its debt to scheduled


banks, the government was able to bring down T-bill rates, while at the same time increasing its borrowing from SBP at a lower cost.

Net disbursements of credit to the non-government sector fell sharply from Rs 118.8 billion in FY99 to only Rs 26.2 billion in FY00. Although this reflects slack private sector interest, the numbers need to be qualified if these are to be used as a proxy for private sector investment (or confidence). More specifically, exceptional circumstances in both years must be accounted for to get a better sense for the pattern of 'normal lending'. As the subsequent analysis suggests (Chapter v), if adjustments are made for the increased scope of Export Finance Scheme, foreign exchange swap arrangements in FY99 and the impact of the loan recovery drive, the sharp fall in net credit availed overstates the fall in investor confidence during FY00. Nevertheless, comparing with net credit disbursements before FY99, it does show that normal lending has been impacted by the series of events following the nuclear tests.

Efforts to reduce the fiscal deficit in FY00 suffered a serious setback and the actual deficit of 6.5 percent of GDP was higher than 6.1 percent posted last year. There were a variety of reasons for this: (1) clearing up the backlog of dues by the Central Board of Revenue resulted in higher refunds/rebates of Rs 61.0 billion, equivalent to 1.9 percent of GDP, (2) a substantial decline in surcharge revenues due to higher oil prices, and (3) interest payments on NSS instruments were higher than anticipated. Although these factors increased the size of the fiscal deficit, the primary surplus remained positive and reached 1.9 percent of GDP.

The inflation rate in FY00 was the lowest recorded in the past three decades. Although there is a general degree of skepticism about official inflation numbers, the improvement over last year can be explained by a number of factors: (1) the average consumption basket used to compute price changes, has a higher weightage on basic food items, (2) as agricultural produce was plentiful this year, pressure on food prices was relatively subdued, (3) the concentrated increase in money supply in the last two months of FY00, has dampened inflationary pressures, and (4) the limited pass through of international oil price increases to consumers. This also suggests that inflation has bottomed out in FY00.

Medium-term Prospects
The Government of Pakistan has recently concluded its negotiations for a stand-by program of assistance with the 1MF. The approval of this program will enable Pakistan to reschedule its external debt with official and commercial Creditors for the period beginning January 1, 2001. This will also trigger fresh inflows of concessional assistance from the World Bank and ADB. Export Credit Agencies of the OECD may also consider favorably providing cover to Pakistani risk.

Successful implementation of the IMF Stand-By Arrangement should lead to a three-year Poverty Reduction and Growth Facility, which may consolidate the gains of macroeconomic stability and accelerate economic revival. Although the contours of the medium-term program have yet to be spelled out in detail, its essential features will focus on: (1) a further reduction in the fiscal deficit by raising the Tax-GDP ratio, (2) increasing development and social sector spending, (3) a sharp decline in the ratio of interest payments to GDP, (4) improving the share of merchandise exports to generate a current account surplus, and (5) a modest recovery in the investment rate. These changes will require a three-pronged strategy.

The most obvious element of this strategy is the proposed adjustment in fiscal accounts. Pakistan has never been known for austerity and fiscal prudence, and the public savings rate has always been chronically negative. However, the recent attempt to capture unrecorded commercial transactions and extend taxes to retail trade/services, are steps in the right direction. Thus future fiscal adjustment will depend, to a large extent, on the success of current efforts to widen the tax base and bring in a larger segment of potential taxpayers within the net.

Export growth is the second key element of the government's strategy. Although a concerted effort has already been taken to keep Pakistani exports competitive by pursuing a market based exchange rate policy, serious efforts are still needed to remove non-price impediments, improve efficiency in production (and distribution) of exportable items and enhance the outward orientation of Pakistani exporters. The projected 15 percent export growth is certainly ambitious and in sharp contrast to actual outcomes in the last five years, but the attention given by policymakers to boost traditional exports and encourage nontraditional exports, should make a difference.

The third element, which will impact Pakistan's medium term prospects, is the speed at which new investment (foreign and domestic) can be attracted. The impending agreement with the IMF, and the three-year facility in particular, will provide some comfort to potential investors. However, a strong commitment and practice to honor contractual obligations will definitely help. More specifically, an early settlement of the lingering dispute with Hubco will go a long way in restoring foreign investor confidence in Pakistan. The three investment areas that appear promising in this respect are: Oil & Gas, textile modernization and Information Technology.

The above assumptions, if realized, should be able to help achieve the target growth of 6 percent in three years, reduce the need for additional debt rescheduling, boost liquid foreign reserves and return the economy to a sustainable path of economic development. However, this will require serious efforts by the implementing agencies and a favorable response by the private sector. Transparency, predictability, consistency and continuity of economic policies along with less intrusion by government agencies, will be critical to realize these goals. Since Pakistan's comparative advantage lies in agriculture and agro-based industries, it is likely that under a sensible set of policies and favorable weather conditions, this sector will provide the impetus for growth in the medium-term.

SBP's monetary policy can be relaxed in the medium-term to accommodate private sector credit if a tight fiscal policy is successfully implemented. Other factors that will also play a key role in interest rate determination are: (1) the resumption of external assistance that was not available in FY00, (2) an increase in non-bank sources of finance, as institutions that had been banned from investment in NSS instruments, will be able to place their long-term savings into the Pakistan Investment Bond (PIB), (3) if the government is able to retire its debt to the central bank as planned, and (4) the rate at which private sector credit demand picks up.

In terms of interest rates, the sharp increase witnessed in September/October 2000, unhinged market expectations that had developed over the past two years. This sharp reversal in monetary policy did not reveal an overnight change in SBP's strategy, but was clearly an effort to stabilize the panic that had gripped the foreign exchange market. The move to a floating exchange rate system implies the economy should get accustomed to a different nominal anchor, which must be the yield curve on government securities. The role of the nominal anchor is to provide a stable price benchmark on which economic agents are able to make future projections; more simply, it is to anchor market expectations.

In next few years, kerb purchases will continue to provide financing of the external gap, albeit at a lower level. As stated before, this is a stopgap measure that needs to be taken given the structural nature of Pakistan's external imbalance and to ease the country's transition following the international sanctions. More specifically, the stagnant level of worker remittances in the 1990s (which have started falling since June 1998), the concentration of Pakistan's exports in low-value added items, and the reliance on imported oil, must be systematically addressed to make Pakistan's external gap more sustainable.

The preliminary projections for FY01 indicate that GDP growth will be around 4.5 percent. The impressive growth rate attained by the agriculture sector in FY00 is unlikely to repeat itself as the base has already risen significantly. There will be some resurgence in LS manufacturing, particularly in the textile sector, but its overall weight (19.1 percent) is still insufficient to have much of an impact. Inflation is projected around 6-7 percent, while the current account deficit is expected to slide further to 1 percent of GDP. Public finances are expected to improve significantly as a result of the documentation drive and tax survey. Consequently, tax revenues are projected to grow by 14.2 percent in FY01, to reduce the fiscal deficit to 4.6 percent of GDP. The realization of these projected increases in exports and tax revenues will determine the medium-term direction of this economy.

However, there are many areas of serious concern, which need to be addressed during the current fiscal year. GDP growth may remain sluggish on the basis of the following factors: (1) agriculture prospects may be dampened due to lower supply of irrigated water, (2) the revival of sick industries has been much slower than expected, (3) credit expansion to the private sector may remain supply constrained if the aggregate deposit base does not increase, while higher lending rates may deter private sector borrowing, and (4) higher inflationary expectations due to the continuous surge in the international price of oil and the recent depreciation of the Rupee, may require an upward revision of utility prices. These factors may reduce private consumption, which can lower aggregate demand through the multiplier effect. There is also a resulting risk that the fiscal deficit may not be contained within the projected level due to higher debt servicing and the price increase of imported components of development and recurrent expenditures. The Government will have to monitor this situation and take corrective and timely measures to mitigate the above risks, failing which, the goals set for FY01 may be difficult to achieve.

The projected outcomes assume a smooth resumption of relations with the IFIs including new inflows and further debt rescheduling. The prospects for this appear promising at this stage, but if these expectations are not realized, the path the country will have to formulate could be drastically different. In this eventuality, efforts to increase exports and tax revenues while compressing imports and public expenditures will have to be redoubled.

Against prevailing sentiments in the manufacturing and services sectors, Pakistan's agriculture sector posted very impressive growth. This sector single-handedly increased Pakistan's aggregate growth from 3.1 percent in FY99 to about 4.8 percent in FY00. GNP growth, on the other hand, was lower at 4.2 percent, primarily because of a sharp decline in net factor income from abroad. In more simple terms, the reduction in the current account deficit in FY00 was driven by the inability to solicit foreign savings into the country. To counter this fall in foreign savings, national savings increased from 11.2 percent of GNP in FY99 to 13.4 percent in FY00.

Gross fixed investment made a considerable recovery, achieving a growth rate of 9.5 percent, after a decline of 4.3 percent in FY99. The growth was driven by the revival of private fixed investment, which rose by 9.4 percent (to Rs 252.9 billion), from a decline of 11.6 percent in the preceding year. Although this seems to be inconsistent with the reduction in term lending by scheduled banks during FY00, a larger volume of self-financing, especially in the textile sector, agriculture and related services, could explain this increase in fixed investment.

Of Pakistan's 4 major crops, cotton, wheat and rice showed impressive growth. Despite the fall in the production of sugarcane, major crops were able to push up agricultural growth to 7.2 percent in FY00, against a paltry 1.9 percent the year before. The disproportionate role of Pakistan's major crops can be gauged by the fact that minor crops were only able to show a growth of 2.7 percent in FY00 against 4.3 percent last year. Timely announcement of support prices, favorable weather and low incidence of pest attacks, played an important role in this recovery. Although this strong agricultural response has added to the increase in money supply (via lending for commodity operations), its ability to spur the textile sector and to contain imports of edible oil and wheat, make it a very welcome development.

On the other hand, despite the resurgence of the textile sector, growth in the industrial sector was limited to 3.0 percent against a target of 5.5 percent for FY00. Although this growth rate was higher than what had been posted last year (2.5 percent), a look at specific items of the industrial sector paints a less impressive picture. Looking specifically at the manufacturing sector, growth in FY00 was 1.1 percent against a realized growth of 4.2 percent last year. The picture is even bleaker for LS manufacturing, which only managed a growth of negative 0.7 percent during FY00 against 3.7 percent in FY99. Beyond the manufacturing sector, the areas that played an important role in improving Pakistan's industrial growth over last year are: (1) mining & quarrying grew by 7.7 percent against 3.6 percent in the previous year, (2) construction increased by 6.2 percent in FY00 against an equivalent decline the year before, and (3) electricity & gas distribution grew by 7.8 percent against 3.5 percent in the previous year.

During FY00, the services sector showed modest improvement with 4.5 percent growth (compared with 4.1 percent in the preceding year), mainly due to forward spillovers from the growth in the agricultural sector. However, growth in finance and insurance declined to 6.9 percent in FY00 from 15.0 percent last year, which is largely attributable to the credit squeeze associated with the slowdown in financial intermediation and investment activity in the banking sector.

Public Finance and Fiscal Policy
The tax to GDP ratio declined in FY00 despite higher total revenue receipts driven by non-tax receipts. However, this additional revenue was not enough to match the higher increase in current expenditures. The resulting increase in the budget deficit (from 6.1 percent of GDP in FY99 to 6.5 percent in FY00) was the main reason for the sharp increase in government borrowing from domestic sources. About two-thirds of the Rs 206.8 billion deficit was financed through domestic borrowings in FY00. Development expenditure declined during the year, while the increase in current expenditure exceeded the nominal rate of growth of GDP. Despite efforts to enhance tax revenues by building the necessary infrastructure, FY00 still showed insufficient revenue collection.

On a positive note, the initial steps taken by the military government against loan and tax defaulters, and the subsequent accountability drive, signaled their intent to rectify the structural weakness in the taxation system. On the fiscal side, the emphasis was to increase documentation and close off options to hide wealth. In broad terms, the sequential steps taken by the government during the year were: (1) a public campaign against loan and tax defaulters in mid-October 1999, (2) various tax exemptions were removed from bearer instruments of savings and foreign currency accounts in December 1999, (3) to provide an avenue to declare hidden wealth, a Tax Amnesty Scheme was announced in March 2000, and (4) a comprehensive Tax Survey was launched in May 2000. Given the nature and scope of the Tax Survey, this initiative is only expected to yield results in second half of FY01. It is hoped that this will not be a one-time jump in tax revenues, but the needed broadening of the tax base. If successful, this will increase the buoyancy and elasticity of taxes, which will make fiscal policy a more effective policy instrument.

Price Developments
FY00 maintained the declining inflation trend that had started in FY98. However, after reaching their lowest levels in the past three decades (CPI posted an increase of 3.58 percent in FY00), official inflation figures have started losing public credibility. This is surprising on two counts: (1) the compilation of the three price indices (CPI, WPI, and SPI) has not changed since FY91 - and actually recorded double digit increases in FY97, and (2) the price indices are designed to measure the impact on the average Pakistani, whose basket of goods is dominated by basic food items.

Improved availability of agriculture and food products, has kept a firm check on the prices of milk, wheat, rice, beef, mutton .and poultry meat. Since the goal of tracking price increases is to assess the impact on the average Pakistani consumer, the lack of proper declaration of income also keeps the official indices biased towards low-income households.

Furthermore, despite the tempered pass-through of the sharp increase in international oil prices, the price sub-indices that show the highest increases are Fuel & Lighting and Transport & Communication, which posted increases of 6.0 and 8.6 percent in FY00 against 1.7 and 8.3 percent in FY99. Nevertheless, with the current trend in oil prices, the rise in domestic interest rates, and the sharp depreciation of the Rupee, it is clear that these price indices have bottomed out and are likely to increase during FY01.

Money, Banking and Monetary Policy
Unlike FY99, growth in the supply of money was almost as high as what had been envisaged in the Credit Plan for FY00. Hence, there was little fear of a monetary overhang this year, which was borne out in falling inflation rates. However, unlike what had been anticipated in the Credit Plan for FY00, the government was unable to retire its debt from the banking system by the targeted Rs 7 billion, and ended up borrowing Rs 78.1 billion during the course of the year. This was primarily because net borrowing for budgetary support was Rs 40 billion against retirement of Rs 75.2 billion in FY99, while government borrowing for commodity operations increased by Rs 40.1 billion during FY00 against Rs 3.6 billion last year. This sharp increase in budgetary support was due to reduced inflows of external finance.

In terms of non-government borrowing, the headline numbers are disappointing. Net credit disbursements fell from Rs 118.8 billion in FY99 to Rs 26.2 billion during FY00. However, accounting for certain exceptional developments in both years, lending to the private sector has not fallen as sharply. Since there is a tendency to use private sector credit as a barometer of investor confidence, the following developments must be accounted for to create a more even basis to compare borrowing by the private sector in FY99 and FY00:

Export finance disbursed during FY99 included yarn that is no longer eligible since December 1999. This has brought down net disbursements from Rs 26.0 billion to net retirement of Rs 8.4 billion during FY00.

Lending by specialized banks fell sharply in FY00, but this was driven more by the need to wean certain banks (like ADBP) off outside sources of funding and improve cash recoveries, than a reflection of lower credit demand.

In FY99, certain investment banks entered into foreign exchange swap transactions that provided them with substantial Rupee liquidity that was lent out. This exceptional financing did not occur in FY00.

There was a vigorous loan recovery drive by the National Accountability Bureau (NAB) in November 1999, which resulted in cash recoveries of Rs 19.1 billion. Not only did this reduce net credit disbursements, it also dampened demand for new loans and made banks more cautious in their lending decisions.

It is therefore clear that the headline numbers (which do not account for these developments) overstate the perceived loss of private sector interest.

The composition of money supply indicates a disturbing increase in currency in circulation within overall M2 growth. While generalizations are suspect, it can be said that FY99 witnessed systemic shifts in the composition of bank deposits as frozen FCAs were placed in more lucrative Rupee instruments (e.g. NSS or revamped banks deposit schemes) or used to purchase hard currency from the kerb market. The resulting shift from FCAs to demand deposits is a reflection of this systemic shift. However, with few lucrative Rupee alternatives and a fear that funds placed in banks could be investigated, there was a systemic shift out of bank deposits in FY00. With a sharp increase in government borrowing from SBP (accompanied by printing currency notes), there was a voluntary move from bank deposits into cash.

The resulting liquidity crunch was visible in the money market. Looking at open market operations (OMOs), there was a perceptible shift from net absorption of liquidity in FY99 to net injections during FY00. Despite this injection of liquidity, the average daily volume of discounting at SBP still increased from Rs 4.0 billion in FY99 to Rs 5.9 billion during FY00. Furthermore, against bids of Rs 774.7 billion in the primary auctions in FY99, banks offered only Rs 469.2 billion during FY00.

In terms of lending and deposit rates, the fall in T-bill rates and inflation during FY99 and FY00 did result in an appreciable decline in nominal lending rates. However, while the combined 3.2 percentage point fall in average lending rates was evenly distributed in the two years, the 1.8 percentage point fall in deposit rates was concentrated in FY00. Other than the lag in adjusting deposit rates, the hesitancy to pass on revenue pressures to depositors could also be explained by the fear of losing deposits in an environment characterized by systemic shifts in the preference of depositors.

Finally, even before the change in government, the non-performing loan (NPL) issue was being addressed. Although suspect loans were not being sanctioned following the freeze of FCAs, by enhancing the public profile of this problem, the new government was able to accelerate the implementation of proper accounting. This initiative was boosted by the month-long recovery drive in October/November 1999. As cash recoveries in this month were liquidity constrained while classification criteria were strictly enforced, the outstanding volume of defaulted loans increased during FY00. Nevertheless, the ratio of defaulted loans to total advances declined from 18.1 percent in end-FY98 to 15.5 percent in FY00. As dominant players, NCBs spearheaded this reduction showing an impressive fall from 28.9 percent to only 18.6 percent in this two-year period.

Balance of Payments & Exchange Rate Regime
Despite difficult circumstances, Pakistan's external sector was calm till the fourth quarter of FY00. The sharp increase in the international price of oil (with no corresponding fall in domestic consumption), low international cotton prices, no fresh inflows of IFI assistance,
and falling worker remittances, worked against the country's balance of payments in FY00. Nevertheless, the induced stability in the exchange rate quelled the incentive to dollarize domestic savings, while comfortable liquid reserves kept importer's and exporters unperturbed till end-May 2000.

Outright purchases of over US$ 1.6 billion from the kerb market during the course of the year played an important part in allowing SBP to defend the exchange rate and maintain liquid reserves at above US$ 1.4 billion till April 2000. Although this made SBP the single largest buyer in the kerb market, this buying pressure did not create any volatility in the kerb premium. With a stable interbank rate, and a cautious strategy to purchase only when demand conditions in the open market were subdued, SBP effectively played the role of the swing buyer. Hence, with continuous purchases by SBP, the premium stabilized and averaged 4.75 percent in FY00 against 8.46 percent during FY99.

These inflows were primarily responsible for bringing down the current account deficit from US$ 2.24 billion in FY99 to just above US$ I billion during FY00. This appreciable fall in the country's foreign exchange needs, allowed the authorities to maintain stability in the foreign exchange market despite the persistent increase in Pakistan s oil bill. The sharp fall in the current account deficit was also made possible by the reduction in the realized trade deficit. Nevertheless, worker remittances continued to fall in FY00, dipping below US$ 1 billion per annum for the first time since the early 1980s. Inflows of resident-FCAs also fell in FY00, which was to be expected given the stability in the exchange rate and concerted efforts by SBP to discourage such deposits by limiting returns despite the increase in international interest rates.

FBS figures (which are more comprehensive since they record all trade bookings) show that the 10.2 percent increase in total export proceeds was spearheaded by an impressive 13.8 percent increase in the value of textile exports. This would have been even higher if the unit price of textile goods had not fallen. Had prices remained at FY99 levels, the increase in textile exports would have been US$ 611.6 million rather than US$ 276.5 million, which would have pushed overall export revenues to US$ 8.9 billion in FY00.

The import side, on the other hand, was dominated by oil payments. While the oil import bill almost doubled in FY00, its share in imports increased from 15.5 percent in FY99 to over 27.2 percent in FY00, making it the single largest item in total imports. Once again, if prices
had not increased as sharply as they did, Pakistan s oil import bill would have been US$ 1.6 billion instead of US$ 2.8 billion. This would have reduced total imports to US$ 9.1 billion. In effect, if international prices had not worked against Pakistan, the trade deficit in FY00 (using FBS figures) would have shrunk to just US$ 173.9 million.

In terms of the capital account, outflows (on an accrual basis) increased from US$ 1.9 billion in FY99 to US$ 3.4 billion during FY00. The main contributing factors for this change was a sharp fall in fresh inflows from IFIs and bilaterals during FY00. Since no fresh commitments were made in the year, net negative transfers of US$ 162.3 million were made to preferred creditors. The composition of Pakistan's external debt and foreign exchange liabilities are analyzed in Box 1.1.

Despite a lowering of the current account deficit, large capital outflows resulted in a decline in liquid reserves to US$ 1.3 billion from US$ 1.7 billion at the end of FY99. The gap in the balance of payment was met by exceptional financing of US$ 4.0 billion, almost the same level as in FY99. This gap comprises of rescheduling, restructuring, partial payment relief and the rollover of official and commercial debt and central bank liabilities. There is however a misconception that should be clarified - despite a larger volume of rescheduled official debt relative to commercial credit, the exceptional financing gap is largely composed of commercial credit repayments. In FY99, the commercial component of the financing gap was 59 percent, which increased to 65 percent in FY00. This is a clear indication that most debt repayments before the nuclear tests (on a yearly basis) were made to service commercial credit because of the expensive and short-term nature of these borrowings. Looking into FY01 and FY02, actual repayments on commercial credit will dominate debt payments, as the rescheduling of commercial credit has been done over a much shorter timeframe than the terms set in the Paris Club agreement.

In terms of the exchange rate, the interbank sell rate was Rs 51.81 at the end of June 1999, and closed the year at Rs 52.30 in end-June 2000 (the corresponding kerb sell rates were Rs 54.30 and Rs 55.00, respectively). Following the extraordinary developments in the foreign exchange regime during FY99, and a volatile first week after the unification of the exchange rate on 19th May 1999, the authorities realized that some stability needed to be induced by the central bank. Although the external imbalance did narrow in FY00, this cannot explain the stability. The key factors that allowed SBP to maintain this level of calm are: (1) SBP directly financed large foreign exchange payments for oil and debt using outright purchases from the kerb market, (2) the sharp fall in domestic inflation rates did not let the Rupee appreciate much, and (3) the debt rescheduling reduced the actual volume of external payments. Although this calm has ended in the first quarter of FY01, a more detailed discussion of this issue will follow in SBP's Quarterly Report for July - September 2000.

Table I.4:
Pakistan's External Liabilities
End FY00 (US$ million)

* Provisional numbers
** Some of these loans are > 1 & < 2 year maturity.

Box I.1: Pakistan's External Liabilities
This question has evoked a great deal of speculation, conjectures and wild guesstimates in the press and elsewhere. The conflicting
numbers that have been cited and the resulting confusion arises due to differences in coverage, and the categorization and measurement of external debt. Minor differences also arise from the use of varying Rupee conversion rates. Some commentators stop at public and publicly guaranteed debt, while others include private non-guaranteed debt. Most, however, neglect obligations that have to be serviced and/or repaid in foreign exchange. Table 1.4 provides a comprehensive and all-inclusive picture of Pakistan's foreign exchange obligations. As shown in Table 1.4, Pakistan's total external debt outstanding on 30th June 2000 was US$ 32.7 billion or 53.8 percent of GDP. If other foreign exchange liabilities such as foreign currency accounts are added, the total external liabilities rise to US$ 37.3 billion or 61.3 percent of GDP. Debt servicing on account of these liabilities amounted to US$ 7.8 billion or 95.9 percent of the country's realized export earnings in FY00. As it was not possible to pay this amount fully and still meet the economy's demand for imports, more than half the contractual debt servicing had to be rescheduled (Paris Club), restructured (Eurobonds), partially paid (FE-45 deposits) or rolled-over (central bank deposits and commercial financing of imports). Contrary to popular perception, the rescheduling agreed by Paris Club creditors for FY00 was only US$ 1.3 billion; relief on the larger amount (US$ 2.6 billion) was obtained outside the framework of the Paris Club. Of the total amount falling due in FY00, US$ 3.7 billion was actually paid out of the country's foreign exchange earnings and by drawing down liquid reserves. The amount eligible for rescheduling/rollover in FY01 is projected at US$ 2.2 billion, which is 56.4
percent lower than the US$ 3.9 billion rescheduled in FY00.