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International Economic Situation
World economic conditions improved during last year; with aggregate GDP growth estimated at 3.4 percent in calendar 1999 compared to a projection of 2.2 percent. The real push came from the US economy, which continues to expand rapidly. After a brief slow down from 4.4 percent in 1998 to 4.2 percent in 1999, the annualized real GDP growth bounced back to 5.2 percent in the first half of 2000. The strength of the US economy has played a major role in world economic growth, where subdued inflation supported the exceptionally buoyant growth of consumer demand. This is also based on a significant wealth effect from IT- related stocks. This buoyancy has prompted a cautious strategy from the Federal Reserve Bank to put in place safeguards for a smooth landing of the overheated US economy. Following the Asian crisis of 1997, the US economy entered an unusual phase; while most countries were stagnating, the US GDP grew strongly. As a result, US exports fell in 1998, while imports correspondingly rose in early 1999, providing the growth impetus for its trading partners. Since then, the trade deficit has continued to worsen and inflation has increased marginally. Additionally, foreigners invested heavily in US Government securities, which drove the Dollar up against most major currencies.

The economic outlook has also improved for Europe and recent data suggests that the projected recovery is on track; real GDP growth increased to 3.8 percent (annual rate) in the second half of 1999 and continued at a similar rate in the first quarter of 2000. The forward momentum seems to have been maintained in 2000 as growth remains quite strong in France and a recovery is under way in Italy and Germany. On the other hand, the Euro continues to be extremely weak, mainly due to continuing differences in the business cycles between the Euro zone and United States, resulting in large outflows from EU to US.

After the recession in 1998, economic activity in Japan witnessed a rebound in early 1999, as private sector borrowing increased on account of strong fiscal initiatives by the government. This recovery, however, remains tentative and fragile. After falling through much of 1997 and 1998, real GDP recovered in the first half of 1999. However, in the second half of the year this process was reversed, as private consumption remained depressed on account of falling real earnings and uncertainty about employment prospects. Recent indicators provide some positive signs, including improvements in corporate profitability and a pickup in industrial production and business. Economic data also suggests that the recovery is broadening from manufacturing and mobile communications to services, wholesale/retail trade and restaurants. This recovery has impacted the Yen, which rose by over 10 percent in nominal terms between July 1999 and mid-March 2000.

The emerging economies in Asia staged a strong V-shaped recovery in 1999. The countries hit by the Asian crisis grew three times faster than what analysts had forecasted for 1999. In Asia, the rapid return of confidence demonstrates the efficacy of their stabilization strategies. In addition to sound macroeconomic polices, many Asian emerging economies adopted strong structural reforms, including actions to strengthen financial systems, bankruptcy procedures, fiscal and monetary policy co-ordination and promote corporate restructuring. Falling prices of intermediate inputs and strong demand for exports, have also helped fuel the recovery.

Higher oil revenues improved the economic prospects of most countries in the Middle East and certain countries in Africa. Although OPEC production quotas have restrained growth in oil output, the rapid increase in international prices has made a major contribution toward reducing fiscal and current account imbalances in oil-producing countries. It has also supported a general strengthening of domestic confidence, asset prices, and aggregate demand. Economic growth in Africa is projected to recover to over 4 percent in 2000 after slowing to less than 2.5 percent in 1999. A rebound in the three largest economies, Algeria, Nigeria, and South Africa, is expected to lead this recovery. Additionally, significant contribution is expected from many of the smaller countries including Ghana, Tanzania, Tunisia, and Uganda.

World trade volume increased to 5.1 percent in 1999 from 4.3 percent in 1998. This increase was on account of economic growth in the US and recovery in East Asia; growth in world trade is projected to increase sharply to 10.0 percent in 2000. In terms of volume, exports of developed and developing countries increased by 4.8 percent and 3.5 percent in 1999, respectively. As far as the import volume in 1999 is concerned, it increased by 7.6 percent in developed countries largely on account of higher petroleum prices, and declined by 0.3 percent in developing countries.

In 1999, net private capital flows to emerging markets increased sharply. Equity prices rallied strongly; the IFC/Standard & Poor’s emerging-market investable index rose by more than 60 percent in 1999, but a large part of this is because of a depressed 1998. The Institute of International Finance (IIF) expects net private flows to the main emerging economies to hit almost US$ 200 billion in calendar year 2000, up from US$ 150 billion in 1999. Although this is still short of the US$ 330 billion witnessed in the boom of 1996, it is a striking turnaround, given that 10 of the 27 countries (which accounted for more than 90 percent of all private capital inflows) suffered deep financial crises between 1997 and 1999.

Pakistan’s Balance of Payments
FY00 was a difficult year to manage in several respects.

Adverse international prices continued to plague Pakistan as the price of oil continued to increase much beyond projected levels. In the case of international cotton prices, the commodity price quoted in New York fell by 20.04 US cents/lbs during FY99 (to 55 US cents/lbs in June 1999), but was only able to post a modest increase of 2.11 US cents/lbs in FY00 (see Figure VIII.1).

Absence of IFI assistance in FY00 (with the exception of an inflow of US$ 125.0 million from ADB in end-June 2000) coupled with normal repayments to these IFIs, resulted in net outflows to these institutions. This forced Pakistan to become more self-reliant in financing its external payments.

Despite these adverse developments, Pakistan’s official exchange rate was kept stable. Hence, the kerb premium did not exhibit much volatility, and liquid reserves were above US$ 1.4 billion till end-April 2000, after a level of US$ 1.6 billion in end-July 1999.

It was only in March 2000, that discussions with the IMF began after the change in government in October 1999. On the basis of these initial discussions, it is expected that Pakistan will have a 10-month Stand-By Arrangement (SBA) in place by end-November 2000. In view of these developments, it is clear that the urgency to have the IMF on board is not so much in terms of financing a difficult external sector, but to get the needed rescheduling after the consolidation period ends in December 2000.

Unlike FY99 where the external sector had to bear the brunt of the radical changes following the freeze of FCAs, FY00 was relatively calm after the unification of the exchange rate regime in May 1999. Except for a brief period following the change in government on 12th October 1999, when import margin requirements were introduced and partially removed later in the month, the overall policies governing the external sector were of a positive orientation.

Policy changes were in line with the new government’s efforts to increase accountability by limiting the avenues to hide wealth, and capitalize on the sense of unease concerning placement of hard currency in FCAs. More specifically, new guidelines were announced concerning the operations of money changers (MCs) to ensure that only licensed operators were able to buy and sell foreign currency. Furthermore, these players were asked to restrict their activities to foreign currency notes and coins, and not operate through telegraphic transfers or travelers checks. In terms of accountability, the immunity clause on FCAs was revoked in December 1999, and FCAs were made liable to a 10 percent withholding tax. Also, to be consistent, the wealth tax exemption of Special US Dollar Bonds and the implicit immunity on these instruments was also revoked. In this spirit, future sales of FEBCs and FCBCs were also stopped on December 16th 1999.

More broadly, against a target of US$ 800 million, which entailed imports of US$ 9.8 billion and exports of US$ 9.0 billion, the actual trade deficit was US$ 1.7 billion. Although the targets for FY00 were consistent with the general thrust of the ESAF/EFF programs revived in early 1999, the realized numbers were lower than target for both imports and exports. While export revenues increased, what helped was the containment in Pakistan’s import bill despite the sharp increase in international prices. In fact, excluding POL products, Pakistan’s import bill has been falling consistently in Dollar terms since FY96 (see Table VIII.6b). This is not an encouraging sign for the manufacturing sector, since it is not just an indication of the causal link emanating from poor investor confidence, but a reflection of the constrained external position that predates the nuclear tests.

Current account
A summary of Pakistan’s balance of payments is shown in Table VIII.1. It shows a sharp reduction in the current account deficit from US$ 2.2 billion in FY99 to US$ 1.0 billion in FY00 (see also Figure VIII.2). In broad terms, this is largely because of a reduction in the trade deficit and higher inflows of outright purchases during FY00. Hence, a smaller current account deficit reduces Pakistan’s financing needs either in the form of foreign capital inflows (debt or equity) or the need to dig into liquid reserves; this explains the sense of calm during FY00.

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Source: State Bank of Pakistan
P: Provisional

Looking at services, the deficit under this head has increased by US$ 148 million mainly due to a rise in interest and other payments (see Table VIII.1). Despite the fact that some interest payments have been rescheduled, these are nevertheless shown as outflows because of the accrual basis of accounting (see Box VIII.1 for the rationale for using accrual based accounting). A detailed analysis of services is given in Appendix VIII.1.

In terms of current transfers, the summary Table VIII.1 captures the real problem facing Pakistan’s external sector. As stated earlier, the foreign exchange shortage is a function of the size of the current account deficit, while the capital account problem is inherited from the past. Before the freeze of FCAs, large gaps in the trade and services account were financed on the basis of stable workers’ remittances, growing inflows of resident FCAs and external borrowings (both commercial and official inflows), while the swing factor was Pakistan’s liquid reserves.

Following the freeze of FCAs, the authorities were able to contain both the trade and service deficits. Nevertheless, the reversal in the capital account coupled with lower inflows of transfers (remittances and resident FCAs) tightened the external sector during FY99. The reversal in the capital account is the immediate manifestation of the freeze, in the sense that repayments on borrowed funds continued but fresh inflows dried up. The magnitude of the reversal and the subsequent increase in FY00 is an indication of the short-term nature of this funding and the fact that the bulk of these transactions have been rolled-over (see Box VIII.1).

However, the real issue is tackling the fundamentals, which in this context refers to maintaining the same level of inflows through transfers and to continue narrowing the trade/services deficit. Although, the government and SBP are no longer in favor of encouraging FCAs as a means of financing the external deficit, it is important to realize that the inflows of resident-FCAs before and after May 1998, are based on domestic dollarization via the kerb market. With the freeze of FCAs and the inevitable reduction in such inflows, SBP had little choice but to directly approach the kerb market and purchase the hard currency outright.

The declining flow of worker remittances deserves special attention. As shown in Table VIII.2, the bulk of these inflows into Pakistan come from the Gulf region. However, these inflows began tapering off during FY98 and have continued this downward trend. Excluding inflows from Kuwait (which experienced lumpy inflows as part of the special compensation for those impacted by the Kuwait war), cash remittances from the Gulf region fell from US$ 791.0 million in FY98 to only US$ 546.7 million in FY00. This fall goes against the perceived sense of buoyancy in the Gulf region following the increase in the international price of oil. It is hoped that this may also be on account of a possible lag effect whereby the flow of Pakistani workers to the Gulf will increase in the future. However, since the slowdown was most pronounced from Saudi Arabia and the UAE, it is more likely that the Hundi network is the main factor behind this fall in official remittances.

Another disturbing trend is the corresponding fall in remittances from the US and Europe. Although the Hundi system also operates in these countries, anecdotal evidence suggests that the premium given to remitters is not as high, since the network in these countries is smaller and less efficient than the Hundi network in the Gulf. A partial explanation could be increased emigration to the West, as expatriate workers may have opted to settle abroad given relatively lenient emigration laws in the West for skilled workers.

In terms of the sharp fall in resident-FCAs in FY99, this was expected given the freeze in May 1998. As this is a manifestation of domestic dollarization, inflows of resident-FCAs during FY00 would have been larger (despite the shake up in confidence) had it not been for the stability in the exchange rate. One must recall that during FY99, SBP maintained a two-tiered exchange rate regime where the floating interbank rate (FIBR) witnessed a significant degree of volatility touching Rs 57.7 per Dollar on 11th November 1998. It was only in May 1999 that the composite exchange rate system was unified, and subsequently stabilized. During FY00, the induced stability in FIBR coupled with calm in the kerb market, quelled the incentive to dollarize. This was all the more impressive given the fact that while international interest rates were rising, domestic returns on savings (bank deposits and NSS instruments) were falling.

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Despite the urgent need to secure hard currency inflows into the official sector, the authorities were clear about the need to discourage domestic dollarization. The new FCA scheme that was launched in June 1998 (FE 25) was designed more as a service to select depositors who still felt the need to hedge against exchange rate devaluations, than an avenue for banks to mobilize deposits for their operations. To provide comfort to depositors that the country cannot afford another freeze of FCAs, deposits that are placed with the central bank are now explicitly categorized as such in Pakistan’s liquid reserves (see Figure VIII.3).

As stated earlier, a large part of the comfort in the external sector during FY00 was on account of substantial outright purchases of hard currency from the kerb market. In view of the drawing down of liquid reserves during FY00, the US$ 1.6 billion purchased from the kerb market was used entirely to finance the external deficit. Although the advantages of the outright purchases over inflows through FCAs are clear (purchases are not a liability and do not impose a forward cover charge on SBP), this is not a sustainable avenue to procure foreign exchange. However, as an interim measure to finance a structural imbalance that was clearly exposed with the freeze of FCAs, the results are positive. Till the structural problems and adverse movements in Pakistan’s terms of trade are rectified, this avenue will continue to be used as a stopgap measure. In terms of the priority to rectify the structural problems in Pakistan’s external imbalance, the following list is not exhaustive: (1) increase official remittances from those countries that have posted a significant decline, (2) contain imports with a specific emphasis on edible items and discourage consumer/luxury items, and (3) place Pakistan’s export sector onto a different trajectory that focuses on value added cotton items and non-traditional exports. In terms of the last point, in addition to government efforts already underway to encourage diversification, quality control and exposure in non-traditional markets, a new spirit of entrepreneurship must be cultivated amongst Pakistan’s exporters.

Capital account
The capital account shown in Table 8.2 in the Statistical Annexure shows net foreign investment (non-debt based) and all net capital flows (debt) from official/sovereign/ commercial sources. In broad terms, what is interesting to note is the increase in net outflows in the capital account during FY00; against outflows of US$ 1.9 billion during FY99, FY00 witnessed outflows of US$ 3.4 billion. This was primarily driven by lower inflows in FY00, as debit entries (gross outflows) remained in the range of US$ 6.4 to 6.5 billion in both years, while gross inflows fell from US$ 4.6 billion to US$ 3.0 billion in the same period. A comparison of these two years is justified since both years operated under substantial debt rescheduling. A more detailed item-by-item analysis of Pakistan’s capital account is included as Appendix VIII.1 (based entirely on Table 8.2).

Box VIII.1: Significance of Accrual Based Accounting Practice
Since Pakistan has been living with a structural imbalance in the external sector for almost two decades, there was a need to ensure that the temporary relief from debt rescheduling was not used to show an artificial improvement in the external sector. In effect, by showing "normal payments" as if they have been made, the accrual basis of accounting allows one to assess the actual gap resulting from the freeze of FCAs and international sanctions. Since these developments dried up fresh inflows but did not impact contractual repayments, the gaps shown in the capital account in FY99 and FY00, reflect the inflows that would have been required just to pay-off past obligations.

It is important to note that the accrual basis implies that loans that have been rescheduled on a year-on-year basis are shown as being rolled-over. This implies that the rescheduled loan will be reflected in the same head as an outflow the next year. Add to this actual repayments that have been made and additional inflows needed to finance the current account deficit, the remaining amount is the financing gap in the balance of payment.

The following points capture the broad thrust of Pakistan’s capital account:

Net foreign investment in FY00 showed an outflow compared with inflows during FY99. This was due to a sharp reversal in portfolio investment on account of the restructuring of Pakistan’s Eurobonds and fall in conversions into Special US$ Bonds. Foreign direct investment, on the other hand, maintained last year’s level.

Despite inflows under ADB’s Capital Market Development Program Loan and Saudi Oil facility, net long-term capital showed an outflow in FY00 compared with an inflow during FY99. This is due to lower disbursements as pipeline inflows were not replenished, a decline in inflows to MNCs operating in Pakistan and fall in suppliers credit.

Short-term capital showed an improvement in the sense that outflows were lower in FY00 compared with FY99. This is due to the short-term maturity of such flows. Since additional inflows were stopped following the nuclear test, repayments were concentrated within FY99.

Outstanding export bills recorded a sharp increase during FY00 as exporters have postponed repatriation of their earnings (until after the due date) in an effort to gain from additional depreciation of the Rupee.

The errors and omissions entry reflects the conversion of non-resident FCAs into Rupees or Special US$ Bonds. These are shown as ‘inflows’ since under normal circumstances, deposit holders would not have converted to Rupees. However, since the maturity of all non-resident FCAs have been shown as if they have been made, conversions are being shown as if new inflows have been realized to neutralize those hard currency repayments that never have to be made. The fall in errors and omissions in FY00 is due to the decline in the volume of conversions compared to FY99. In more normal years, the errors and omissions item covers lags and leads in reporting external transactions, differences in what was documented and what was realized, and exchange rate changes for multi-currency transactions. This is needed to ensure that all debit and credit entries in the balance of payment sum to zero.

Foreign Exchange Reserves
Looking at Pakistan’s liquid reserves, it is important to realize that while IMF assistance and repayments are lumpy, the net effect is diluted within all foreign exchange transactions that impact Pakistan’s reserves for the year. In effect, the actual change in Pakistan’s liquid reserves shows there was an increase in FY99 from US$ 930 million to US$ 1,730 million, while reserves closed at US$ 1,352 million in end-June 2000.

Given the special nature of IMF assistance (and repayments), the US$ 430 million net inflow realized from this IFI during FY99 played an important role in the increase in liquid reserves, while the US$ 280 million outflow to the IMF contributed to the depletion of Pakistan’s reserves in the course of FY00. This ties up with the sharp increase in Pakistan’s liquid reserves in January/February 1999, when the IMF paid out from both the ESAF/EFF programs and the special CCFF fund that was availed on the basis of weak export earnings.

The impact of the rescheduling of Pakistan’s external debt is captured in the exceptional financing gap. This simply says that net payments of about US$ 4.0 billion that should have been made in FY99 and FY00, have been rescheduled. More specifically, this item shows rescheduled debts to sovereign creditors, to commercial banks (for trade financing), the rollover of FE 45 swap funds, special loans provided by central banks and other sources. For FY00, an inflow of US$ 610 million is also shown as a credit entry to record the successful restructuring & rescheduling of Pakistan’s Eurobonds.

Trade account
The trade deficit in FY00 stood at US$ 1.7 billion, showing an increase of US$ 88.4 million over FY99. Value of exports increased by 10.2 percent to US$ 8.6 billion, while imports increased by 9.3 percent to US$ 10.3 billion, which is slightly above the FY98 level (see Figure VIII.4). FY99 was the first year that captured the full impact of the international economic sanctions following nuclear tests in May 1998. Hence, absolute or percentage comparisons with FY99 should be viewed with caution as it represents a low base following the exceptional developments in FY99.