Memorandum of Economic and Financial
Policies
for the remainder of FY 2001/02 and for FY 2002/03
I. Developments during January-May 2002
1. The referendum held on April 30 confirmed strong support
for a continuation of the reform program and extension of President Musharraf's
tenure for the next five years. This outcome should provide medium-term
institutional and political stability, and strengthen the government's
capacity to proceed forcefully with the implementation of its economic
reform agenda. The parliamentary elections in October 2002 will provide
the opportunity to strengthen involvement of the political forces of the
country in the formulation and implementation of the reform program, and
to deepen public ownership. On the other hand, the hoped-for reduction
of military tensions on the eastern border is not yet in sight and this,
along with isolated terrorist acts, impedes a faster recovery of private
investment and growth. On a brighter side, the continuation of private
foreign exchange inflows and steady financial support by the international
community have allowed the State Bank of Pakistan (SBP) to build an unprecedented
level of foreign exchange reserves, thus reducing the economy's external
vulnerability. All quantitative performance criteria for end-March 2002
have been met, except (as discussed below) for the Central Board of Revenue
(CBR) revenue (Table 1(a)).
2. Macroeconomic developments have been broadly in line with the
program. While there has been some pick up of inflation in
recent months, the average consumer price index (CPI) over July 2001-April 2002
increased by only 2.6 percent compared to the same period last fiscal
year, consistent with the target of about 3 percent for the current
fiscal year. In the agricultural sector, latest available data on the
cotton crop indicate that the impact of various pests was less damaging
than anticipated and production better than originally forecast. Rice
and sugarcane production appear broadly in line with program expectations,
while the wheat crop may fall short of projections, reflecting the continued
shortfall in water availability from "normal" levels. Overall,
agricultural value added in FY 2001/02 is projected to grow by 2 percent,
in line with program projections. Growth in manufacturing is also close
to projection, with a strong performance of sugar refining and more moderate
growth in other manufacturing. Looking ahead, if tentative signs of a
pick up in manufacturing, particularly textile, cement, and automobile
firm up with the expected deepening of the incipient recovery in external
demand, real GDP growth should reach the targeted 3.3 percent for
this fiscal year.
3. The balance of payments position has continued to improve.
Available trade data (on a custom basis) through April 2002 confirm a
strong pick up in trade since March. Exports during March-April (in U.S.
dollar terms) were 2.9 percent higher year-on-year (against a decline
of 2.9 percent over the period July-February); and imports rose by
6.5 percent (against a decline of 10.1 percent over the period
July-February). The improved export performance reflects mainly a recovery
in textile orders from abroad, while higher imports reflect both the surge
in oil prices and strong volume growth in most categories of goods. Remittances
and private capital inflows were strong, in line with greater efforts
of banks to capture transfers from migrants, and growing confidence of
the business community, particularly of the expatriate community, in Pakistan's
economic outlook. Official transfers are accruing broadly as projected.
Official reserves reached US$3.7 billion at end-May 2002. Since early
2002, the rupee has been virtually stable, and the spread between the
kerb and interbank markets has remained at around 0.2 percent. We
expect these trends to continue in the coming months, and the current
account balance (including official transfers) to end up at a surplus
of about 1.0 percent of GDP. With a lower-than-anticipated capital
account deficit, gross official reserves should reach the unprecedented
level of US$3.5 billion, equivalent to 3.4 months of next year
imports, by end of June.
4. Following a period of accommodative monetary policy between September
2001 and early February 2002 in response to the weakening economy, we
have tightened our monetary stance to ensure continued low inflation.
The end-March ceiling for net domestic assets (NDA) of the central
bank and the flow on the net foreign assets (NFA) were respected with
wide margins. In line with the more comfortable reserve position, the
SBP stopped offering forward cover on banks' incremental foreign exchange
deposits (FE-31) from April 1, 2002, leaving this task to the market.
The 12-month increase in reserve money, adjusted for the effects of the
various exceptional operations in 2001 on the base, slowed to 5.8 percent
in March 2002 (down from the December 2001 spike of 14.3 percent).
However, broad money growth accelerated to 13.8 percent in the year
through March (from 11.8 percent through December 2001), driven by
large foreign exchange inflows. We decided not to fully sterilize these
inflows as we believe that this monetary expansion may reflect a shift
to higher money demand, in particular for rupee liquidity, reflecting
increased confidence in the domestic currency, as for example indicated
by the decline in foreign currency deposits and the stability of the exchange
rate. Factors related to the use of the rupee in Afghanistan may also
play a role. In light of some firmer signs of an economic upturn
and a slight pick up of inflation, we have since March 2002 tightened
the monetary stance through more active open market operations and increases
in refinancing rates; as a result, the weighted average yield on the six-month
treasury bill in March/April hovered at 6.5 percent in recent auctions,
compared to 5.6 percent at the mid-February auction. We expect these
trends to continue and are confident that the monetary targets for end-June
will be achieved.
5. The end-March performance criteria on net bank borrowing by the
government and on bank credit to public enterprises were also met.
Following what appeared to be excessively high bank borrowing by smaller
public enterprises in the months to December, we undertook a major exercise
to update the list of public enterprises and reconcile relevant data between
the Ministry of Finance, the SBP, and commercial banks. The
exercise confirmed that commercial banks had reported public enterprise
credit on the basis of outdated lists of public enterprises, including
firms that had been privatized in recent years, as well as a few cases
of liquidated or recapitalized enterprises whose liabilities had been
assumed by the government. The revised set of enterprises on which the
relevant credit aggregate is to be monitored is now consistent across
banks and agreed between the Ministry of Finance and the SBP. On this
basis, we have revised downward the data on outstanding public enterprise
credit, and revised upward private sector credit as well as government
credit back to June 2001. The revised data indicate that the end-December
2001 performance criterion was actually observed, while the end-March
2002 target has been met. The revisions do not alter earlier judgments
regarding compliance with program limits on bank credit to the government,
including under the recent stand-by arrangement.
6. By improving further the management of federal current expenditure,
we met the end-March fiscal deficit performance criterion comfortably,
despite shortfalls in CBR revenue. CBR revenue for July 2001-March
2002 fell about PRs 8 billion short of the modified program
target. In part, this reflects lower-than-expected imports through February
and the appreciation of the rupee, which led to continued shortfalls in
customs duties and sales tax receipts (about 40 percent of which
derive from imports) but also in income tax, as much of the latter is
collected through withholding on imports and other transactions. Another
factor was lower withholding on interest income from securities, due to
declining interest rates. These exogenous factors were compounded by continued
shortcomings in tax administration, including difficulties to prevent
abuse of existing loopholes in the refund system. Nonetheless, in March
and April 2002, CBR revenue exceeded revenue collected in the same months
of 2001 by 6 percent and 16 percent, respectively, indicating
that some turnaround in tax collection is finally occurring. Furthermore,
the backlog of refunds has been reduced to levels reflecting normal procedural
lags, which we view as an important governance reform in itself. Revenue
from petroleum and gas surcharges has been on track through March, but
will likely come in below target for the year, following a temporary lowering
of petroleum taxes during April and May. The latter was motivated by the
desire to soften the impact of various other concomitant tax and gas pricing
measures on consumers, in the context of surging international oil prices.
Petroleum taxation has been fully restored from June 1, 2002 onwards,
and we do not intend to take any measures related to petroleum taxation
that will adversely affect the budget in the coming fiscal year. Nontax
revenue, including compensation for services to the coalition in the fight
against terrorism, was well above expectations, despite lower-than-expected
interest payments from the Water and Power Development Authority (WAPDA).
WAPDA's financial difficulties also reduced its principal repayments to
the budget, raising net lending above projections. Defense expenditure
picked up about as expected starting in January 2002, while other federal
current expenditure was lower than projected during the period January-March
2002. Development expenditure rose in most recent months and local governments
have now become operational to a degree which has allowed for an acceleration
in the execution of the Interim Poverty Reduction Strategy Paper (I-PRSP)
expenditure. These expenditures reached PRs 80 billion by end-March
2002, 17 percent below the programmed outlays, compared to a shortfall
by 25 percent during July-December 2001. We expect to meet the fiscal
deficit target for end-June, but are aware that this will require three
major elements to fall in place: First, that the recovery of imports,
some pick up in domestic activity, and the impact of the recent elimination
of a few exemptions, coupled with major collection efforts, will allow
CBR to further improve revenue collection. Second, that military tensions
in the region do not further intensify. Third, that budgetary support
for WAPDA can be limited to deferral of debt service payments to the budget
(PRs 23 billion).
7. Structural reforms are on track, as detailed in the attached Table 2,
with important steps in the tax administration reform implemented in February
and March 2002. In addition, we have stepped up the privatization
program. In early March 2002, a 90 percent stake in Pak-Saudi
Fertilizer for about PRs 8 billion was sold to domestic investors;
in April/May, minority public interests in seven oil and gas fields were
sold, mainly to foreign investors, for US$188 million. The sale of
United Bank Limited (UBL) will take place in early June; in this context
we have also replaced commercial banks' claims on the government due to
taxes paid through 2000 on interest accrued but not collected by government
paper for PRs 22 billion. In line with our commitment to bring
the Karachi Electric Supply Company (KESC) to the point of sale by July 31,
2002 (see below), the privatization commission recently invited expression
of interest by potential investors, so far two major international companies
expressed interest. In March, we dismantled the gas price agreement with
Petroleum Pakistan Limited (PPL) and as the first step in bringing the
PPL wellhead price gradually closer to the market price, increased it
by more than 50 percent. Concurrently, we increased consumer gas
prices by an average of 8.5 percent, in line with our commitment
to bring gas prices to reflect costs and gradually eliminate cross-subsidization
among different categories of consumers.
8. The financial restructuring of KESC is on track and the reorganization
of WAPDA has recently made progress. In April, the government repaid
the bulk of KESC's debt to banks for PRs 22 billion and debt
to suppliers for PRs 8 billion, increasing its equity correspondingly.
While the operation had been programmed to take place through the exchange
of bonds, because of favorable treasury bill rates we preferred a cash
operation, financed by a special issue of treasury bills. The cabinet
approved continued army support for collection enforcement to any new
owner of KESC. The National Electric Power Regulatory Authority (NEPRA)
is expected to formulate a set of multi-year tariff rules to provide regulatory
certainty. The cabinet also approved in April 2002 the transfer of
WAPDA's assets and liabilities to the new distribution (DISCOs), generation
(GENCOs), and the transmission company, and by end-April all the DISCOs
licenses had been issued. In mid-May, the government agreed with the World
Bank on a Financial Improvement Plan (FIP) for WAPDA and its successor
companies in agreement with WAPDA and NEPRA, as explained below. A first
tariff increase by an average of 4 percent took place in mid-May
combining the implementation of the increase under the fuel adjustment
clause, that had been delayed in April due to the difficult socio-political
context referred to above, with a partial implementation of the structural
increase needed to absorb fuel cost increases up to the year 2000.
We are confident that implementation of the agreed package will bring
WAPDA to financial viability and higher efficiency, thus reducing its
drain on the budget.
II. Economic and Financial Policies for FY 2002/03
A. Macroeconomic Objectives and Policies
9. Developments so far and the strengthening of the international
recovery bode well for a significant pick up in domestic economic activity,
and the ambitious macroeconomic objectives under the program for FY 2002/03
appear achievable. Assuming water availability at the level of recent
years and a recovery of export orders as security concerns subside and
international demand accelerates, real GDP growth (at factor cost) is
projected to reach 4.5 percent in FY 2002/03. Building on recent
price developments, assuming continued broad stability of the exchange
rate, and barring persistent increases in international oil prices, we
have lowered the inflation target from 5 percent to 4 percent.
Higher imports related to the pick up of domestic activity as well as
a return of remittances closer to historical levels are expected to cause
the current account deficit--excluding official transfers--to slightly
widen to 2.3 percent of GDP (from 1.3 percent of GDP projected
for FY 2001/02), despite a strong recovery of exports. The latter
is expected to be driven by an improvement in unit prices, a shift to
higher value-added products in the textile sector, and the recent increase
in market access to major trading partner markets. Including official
transfers, which are expected to decrease from exceptionally high levels
in FY 2001/02, the current account is projected to move from a 1.0 percent
of GDP surplus to a 0.8 percent of GDP deficit in FY 2002/03.
This deterioration will be offset by a lower capital account deficit,
largely on account of lower public sector net short-term outflows (including
lower repayment of trade credits and of foreign currency deposits). Private
net inflows are expected to fall off from the exceptionally high levels
of FY 2001/02 that reflected a portfolio shift of Pakistani balances
abroad toward the domestic financial system. We expect that net exceptional
financing, notably in the form of rescheduled debt payments and program
financing from the International Financial Institutions (IFIs), will be
somewhat lower than in FY 2001/02, at about US$2.6 billion.
Gross official reserves would reach US$4.2 billion in June 2003,
equivalent to four months of imports of goods and nonfactor services.
10. In line with our strategy of fiscal consolidation to extricate
Pakistan from unsustainable debt levels, we formulated the FY 2002/03
budget with the aim to reduce the consolidated government budget deficit
(excluding grants) to 4.4 percent of GDP, while substantially raising
social expenditure. We expect this reduction to result from an increased
tax effort and reduced low-priority expenditure, so as to ensure the implementation
of the planned shift in public expenditure toward human development. This
shift will also be reflected in considerable additional transfers to the
provinces, in part related to World Bank loans to support provincial programs
centered on improvements in governance and the provision of social services.
In addition, should external budgetary cash grants plus capital grants
reflecting debt cancellation exceed the programmed levels, such excess
may be used for additional expenditure on I-PRSP categories for up to
0.5 percent of GDP, as specified in the Technical Memorandum of Understanding
(TMU). As in the past, should unforeseen developments threaten the fiscal
deficit target, we would reduce nonpriority expenditure and enact contingent
tax measures as specified below.
11. Achieving our fiscal deficit target while protecting human development
expenditure will require a significant improvement in tax revenue performance.
The target for FY 2002/03 on total tax revenue of 13.6 percent
of GDP implies an increase of around 0.9 percentage points of GDP
over the expected outcome for FY 2001/02. Part of this increase reflects
a base effect due to the one-off impact of the regional conflict (on imports
and exports) and change in sales and customs refund procedures, cautiously
estimated at 0.5 percent of GDP. Therefore our target implies a structural
increase in tax revenue of about 0.4 percent of GDP. While the impact
of improvements in tax administration have been disappointing so far,
we believe that an increasing impact of the reform of CBR together with
a few important tax policy measures will make this objective achievable.
The full-year impact of the recent elimination of GST exemptions on nonlife-saving
pharmaceuticals and fertilizers and of the January increase in diesel
taxation should yield 0.15 percent of GDP, while the elimination
of the exemption on domestic edible oil/vegetable ghee would add 0.1 percent
of GDP on an annual basis. In order to limit the negative impact on the
poor of the elimination of GST exemption on edible oil/vegetable ghee
and on medicines, we have strengthened the budgetary allocation to food
and food-for-work programs targeted toward the most vulnerable. We also
envisage establishing a few special programs in the poorest areas of the
country, such as distribution of food at schools to girls regularly attending
classes. In order to protect low-income earners, we increased the personal
income tax threshold from PRs 60,000 to PRs 80,000. To further
remove distortions in income taxation that impede the efficient allocation
of resources and provide privileged treatment to certain kind of incomes
or specific entities or sectors, the budget for FY 2002/03 includes
an income tax reform package that should be broadly revenue-neutral in
the short term. It includes the elimination of two minor withholding taxes,
the elimination of 55 income tax rebates, concessions, and nonstandard
exemptions from the CRITO-list, the lowering of the interest income withholding
threshold on National Saving Schemes (NSS), and a further step in unifying
corporate income taxes. In the context of the planned World Bank-support
operation to Sindh and North West Frontier Province (NWFP) and in view
of the poor collection from the agricultural income tax, we will work
with provincial governments to strengthen their tax policy and administration
and implement base-broadening and revenue-enhancing measures, including
stronger enforcement efforts on the agricultural income tax. We have also
further streamlined the system of excises with the 2002/03 budget, and
eliminated six minor excise taxes, while adjusting the rates of others
to maintain revenue neutrality. Finally, we will pursue our strategy to
harmonize petroleum taxation among the different products. Should revenue
fall short of the target by end-2002, we will implement appropriate revenue
measures.
12. Unfortunately, the continued tension on the eastern border constrains
our ability to create space for the much needed increase in human development
expenditure. Nonetheless, we intend to reduce the share of defense
expenditure in GDP to about 3.6 percent, thus reverting to our trend
aimed at maintaining defense expenditure constant in real terms over the
medium term. To ensure that human development expenditures are as effective
as possible we have been holding discussions with the World Bank staff
to assess the quality of the proposed Public Sector Development Program
(PSDP) and the I-PRSP programs. With the FY 2002/03 budget, the elected
district governments will be responsible for preparing their investment
budgets in line with the needs and priorities of the community they administer.
We expect that the devolution of investment expenditure to elected local
administrations will increase the effectiveness of such expenditure (see
below). We also expect that various reforms in government procurement
policies, the restructuring of WAPDA and KESC, and better monitoring and
greater accountability of public enterprises (as detailed below) will
achieve the programmed reduction of quasi-fiscal activities and of explicit
and hidden subsidies to public enterprises.
13. We remain committed to a policy mix combining a flexible exchange
rate and prudent monetary policies, geared toward achieving the inflation
and reserves targets. The targets for broad money and reserve money
growth are broadly in line with the projected nominal GDP growth. We will
ensure that our interest rate policy as well as the pace of SBP purchases
of foreign exchange is consistent with the inflation objective and the
monetary/reserves targets, within the framework of a fully flexible exchange
rate. In light of the continued volatility in money demand, and notably
the uncertainty as to whether the recent decline in velocity is a structural
shift or only a temporary phenomenon, we will continue to closely monitor
inflation developments and prospects as well as monetary aggregates, and
stand ready to respond to any reemergence of inflationary pressures with
a more aggressive absorption of liquidity. Given the limited stability
of monetary aggregates, we are accelerating preparatory work toward moving
to an inflation targeting framework; an important step will be legal reforms,
to become effective before end-2002, enshrining greater independence of
the SBP in the law (see below).
B. Structural Policies
Tax policy and tax administration
14. As described above, an important income tax reform package will become
effective with the FY2002/03 budget, and income earned from July 1, 2002
will be covered by the new income tax law promulgated in September 2001,
notably including nonmonetary benefits in taxable income. On the sales
tax side, beyond the elimination of the GST exemption for nonlife-saving
pharmaceuticals last April, we will eliminate the exemption for edible
oil/ghee with the FY 2002/03 budget. We will also maintain, for FY 2002/03,
the special GST rate of 20 percent on certain inputs as it helps
to put pressures on traders to register under the GST to be able to get
credit for sales tax payments. We estimate the measure is yielding PRs 2 billion
per annum. Reform of the CBR will be pursued forcefully. We are on track
to make a large taxpayer unit (LTU) in Karachi operational by July 1,
2002, as a pilot to provide valuable lessons for the planned functional
integration of the administration of all taxes on a national basis. Ahead
of schedule, we will establish a model income tax office for small and
medium taxpayers in Lahore. Business procedures within CBR are being reformed,
with the help of World Bank-financed consultants. Human resources management
will be revamped over the next 12-15 months, including by late 2002,
recruitment procedures that will emphasize CBR relevant special skills,
a move to more merit-based promotion and remuneration rules, and developing
a system of performance-related bonuses. Modern information technology
will be introduced at all levels, with focus in the short term on providing
the LTU with a database integrated across taxes, and PC-based information
systems.
I-PRSP implementation, public expenditure
management, and fiscal transparency
15. I-PRSP implementation and reforms on improving fiscal transparency
and data quality are proceeding as envisaged under the program. Implementation
of the anti-poverty measures under the I-PRSP continue. Specific actions
in recent months include electricity subsidies for use of tubewells by
farmers in drought-stricken areas, and the launching of a program to reschedule
debt of small farmers in such areas. The recently established I-PRSP secretariat
has intensified the monitoring of pro-poor expenditures, which are now
regularly reported to the public on a quarterly basis, and with the Department
for International Development (DFID) and World Bank support we are in
the process of identifying suitable intermediate poverty indicators that
could be monitored by early 2003. We will improve our I-PRSP quarterly
monitoring as specified in Table 2. Three such
indicators have been incorporated into the regular reporting under the
program (see TMU), while recognizing that the outcome data reported by
the existing systems suffer from various shortcomings that will be addressed
over the coming months and year. On fiscal transparency and data quality,
we will continue to implement measures in line with the Accountable Fiscal
Management Framework (AFMF), and as agreed with the World Bank in the
context of the Pakistan Improvement of Financial Reporting and Accounting
(PIFRA) project. We will issue the FY 2003/04 budget call on the
basis of the New Accounting Model (NAM), in parallel with the old one,
for the federal government and NWFP, to push ahead with the eventual implementation
of this model at all levels of government. At the provincial level, fiscal
transparency and data work is being supported through the IFIs-financed
provincial structural adjustment loans. As part of these reforms, Sindh
Province will begin to publish quarterly fiscal data on its website, starting
with the first quarter of FY 2002/03.
Other governance reforms
16. Ongoing reforms in the areas of devolution, civil service, tax policy
and administration, and public financial management, as well as our ambitious
privatization program all derive from the core of our reform program,
that is to improve governance. Specific additional steps involve the reform
of police and the judiciary under an Asian Development Bank (AsDB)-supported
program, and public procurement reforms under the SAC II including the
passage of a law establishing the Public Procurement Regulatory Authority.
We recently invited Transparency International (TI) to assess the status
of our anti-corruption activities and to make suggestions how to make
them more effective. TI has clearly recognized our efforts and confirmed
its view that corruption at the top levels of government has very significantly
decreased. TI also made recommendations aimed at further reducing corruption,
in particular through a proactive information and transparency policy,
continued civil service reform, and reform of the procurement system,
which we will carefully review and as appropriate incorporate in our reform
agenda. A first step will be to increase accountability of public enterprise
managers by publishing quarterly performance reports for key public enterprises,
as detailed below.
Public enterprises
17. The privatization program suffered a serious setback due to the events
of September 11, but is now broadly on track, except that the privatization
of Pakistan Telecommunications Company Limited (PTCL) has been delayed
by a few months due to limited investor interest in the context of the
weak financial position of the international telecommunication sector.
We are also in the process to work out quarterly performance targets for
Pakistan International Airlines (PIA), Pakistan Railways, Pakistan Steel
Mills, and WAPDA/successor companies, to be ready in August 2002, with
quarterly public reporting on such targets to start in November and covering
the first quarter of FY 2002/03. In particular for designing a monitoring
and reporting framework for WAPDA, which is complicated by the ongoing
unbundling of WAPDA into various corporate entities, in line with the
strategy supported by the World Bank, we have requested urgent assistance
from the World Bank. The quarterly performance targets for WAPDA/successor
entities will be derived from the financial improvement plan (FIP) recently
agreed with the World Bank, covering the period through June 2004. The
key elements of the FIP include a request to NEPRA for a structural average
tariff increase of 16 percent in July 2002; enhanced efforts on billing
including prompt disconnection of consumers whose current bills are not
paid in a timely manner; limits on the growth in administrative expenses;
strict application of the automatic fuel adjustment clause; and realistic
targets for reduction of technical and distribution losses. On this basis,
WAPDA should not require any further budgetary support (deferral of debt
service or cash support) from FY 2003 onwards.
Agriculture and marketing reforms
18. Our strategy in agriculture centers on better water management, providing
better extension service to improve yields and reduce vulnerability to
drought and pests, and to gradually reduce government involvement in the
marketing of agricultural commodities, as specified in a reform program
supported by an AsDB loan. A policy statement setting out the government's
policies in this regard will be issued shortly. However, during FY 2001/02
the private sector has been quite slow in assuming a greater role, especially
in investing into wheat storage facilities. In part this reflects uncertainty
as to whether the recent wheat surpluses will be sustained (and with it
the possibility to export freely), or whether a return to deficits would
imply a return to the rationing and control mechanisms of the past. In
part, it also reflects a continued policy of supporting the wheat price
through public procurement at a fixed price. However, private traders
and mills seem now ready to embark on a significant storage building program,
owing to an incentive package including (a) interest rate subsidies
to allow private traders to borrow at the same rate as public procurement
agencies for procurement and storage building; (b) guarantee of occupancy
of new storage facilities by the Pakistan Agricultural Storage and Services
Corporation (PASSCO, the public procurement agency managing the national
security stock) for the first five years; (c) support for private
exporters toward the cost of upgrading domestically procured wheat to
export quality; (d) setting up of export silo facilities at Port
Qasim; (e) the ongoing rapid development of laboratories certifying
for international, and perhaps soon to be developed national, standards;
and (f) a policy of gradually rising issue prices starting in September 2002,
to reflect the physical and financial cost of storage. The incentive package
will be reviewed at the latest by June 2004.
Financial sector and exchange system reforms
19. Banking sector reform is proceeding as planned, centered
on the privatization of the nationalized banks (UBL in June, Habib in
the fall of 2002, and further floating of the National Bank of Pakistan
(NBP) shares in 2002/03) following extensive restructuring of the branch
networks, staffing, and balance sheets in the context of a World Bank
project. We are also modernizing the prudential framework, particularly
for SME and consumer financing. We plan to pursue an evolutionary approach
to Islamic finance, encouraging the development of Islamic banking alongside
traditional financial institutions, while adapting regulations for the
supervision of chartered Islamic banks. We look forward to discussing
our strategy in detail with the planned IMF/World Bank Financial Sector
Assessment Program (FSAP) mission, and finalize specific actions in particular
(a) to protect the financial system against illicit use, by bringing
anti-money laundering rules up to best practices; (b) further modernize
the prudential framework; and (c) phasing out the remnants of administered
credit allocation (such as prescribed lending to agriculture). In the
context of a capital market reform program supported by an AsDB
loan, we will aim to further strengthen stock market supervision, develop
secondary markets for government paper, and streamline the instruments
of the national saving scheme. With the FY 2002/03 budget, we will
take further steps toward harmonizing withholding rates across all financial
instruments (including NSS) and rationalizing interest rates for NSS instruments.
A new central bank law will be adopted by end-October 2002, strengthening
SBP independence in particular in the area of reserve management, in line
with Fund safeguard assessment recommendations. To further deepen the
foreign exchange market, and strengthen monitoring of inward transfers,
we will enact a legal and regulatory framework for the transformation
of moneychangers into foreign exchange companies (which will be allowed
inward transfers) by August 2002, and subsequently allow banks to purchase
foreign exchange from moneychangers at freely negotiated rates, thus moving
further toward unification of the interbank and the kerb market.
C. Financing Issues
20. We are confident that the program is fully financed for FY 2002/03.
We are working to conclude the bilateral agreements implementing the recent
Paris Club Agreed Minute as scheduled on favorable terms, and have initiated
discussions with all creditors. In line with the Paris Club Agreement,
we will seek to ensure treatment of our debt due to all bilateral creditors
on terms comparable to those agreed with the Paris Club creditors. During
meetings with our official development partners, notably during the recent
Pakistan Development Forum in Paris, partner countries and multilateral
institutions indicated strong support for our reform strategy, as laid
out in the I-PRSP, and we expect to obtain financial support at least
at the levels assumed in the program, including possibly sizable debt
swaps (for social expenditure) in the context of the aforementioned bilateral
debt restructuring agreements, as well as in some cases outright debt
cancellation. We are also firmly determined to meet the conditionality
attached to program loan disbursements with the AsDB and World Bank to
ensure the projected disbursements on time.
III. Data Issues
21. In the context of the project to revise and change the base year
of national accounts, five additional studies, including on agriculture,
construction, and large scale manufacturing, have been completed and will
be sent to IMF staff for comments shortly. Three other studies, including
on saving and investment, that had to be outsourced should be ready by
June 2002. Our plan to publish producer price indices has been somewhat
delayed, and is now scheduled for late 2002. Due to administrative capacity
constraints, the planned steps toward improvement in statistical data
dissemination outlined in the March 2002 MEFP could not be taken. These
steps will however be implemented by June 30, 2002. Work on institutional
reform plans for the statistical system has been carried on. With the
help of a foreign technical advisor, we expect to finalize a restructuring
plan by mid-2002.
IV. Program Monitoring
22. The proposed quantitative performance criteria and indicative targets
for end-September and end-December 2002 are set out in Table 1.
Table 2 reports on the status of the structural
performance criteria and benchmarks; it also includes the new measures
we intend to take in FY 2002/03 and the actions we intend to take
prior to the Board discussion of the second review. To clarify the definition
of program targets and to extend the reporting requirements under the
program to additional variables considered essential for appropriate monitoring,
the existing TMU has been amended. Starting July 1, 2002, the attached
TMU will replace the existing one for the definition of performance criteria
and for program monitoring purposes; it now specifically includes a few
monitorable social sector targets. We expect the third review to take
place as scheduled by end-September 2002. The review will focus on
public enterprise finances and the monitoring of I-PRSP expenditures and
intermediate outcome indicators.
Technical Memorandum of Understanding on the Program
Supported Under
the Poverty Reduction and Growth Facility
(June 18, 2002)
1. With effect from July 1, 2002, this memorandum replaces the Technical
Memorandum of Understanding (TMU) relating to the monitoring year under
the PRGF-supported program, dated March 2002. The main qualitative changes
from the March 2002 TMU involve specification of extended reporting requirements
on Water and Power Development Authority's (WAPDA) financial performance,
while removing the monitoring of arrears on account of priority connections
(along with the corresponding performance criterion). Throughout, "government"
is meant to comprise the federal and provincial governments, except in
relation to the external debt ceiling performance criteria, where it also
comprises local governments, as well as public sector enterprises and
government-owned banks. The latter refers to enterprises or banks in which
the government holds a direct majority ownership interest (i.e. equity
participation of above 50 percent).
I. Definitions of Monitoring Variables
Valuation of foreign exchange denominated assets and liabilities
2. For the purposes of monitoring under the program, all assets and liabilities
as well as debt contracted, denominated in SDRs or in currencies other
than the U.S. dollar, will be converted into U.S. dollars at
their rates prevailing as of March 29, 2002, as published in
the International Financial Statistics (IFS). The U.S. dollar value
of all foreign assets and liabilities, as well as external proper financing
and cash grants, will be converted into Pakistan rupees at the end-March 2002
exchange rate of PRs 60.07 per US$1.
3. Reserve money (RM) is defined as the sum of: currency outside
scheduled banks (deposit money banks); scheduled banks' domestic cash
in vaults; scheduled banks' required and excess rupee, as well as foreign
exchange deposits with the State Bank of Pakistan (SBP); and deposits
of the rest of the economy with the SBP excluding those held by the federal
and the provincial governments.
4. Net foreign assets (NFA) of the SBP are defined as the difference
between its foreign assets and foreign liabilities. Foreign assets of
the SBP consist of gold, foreign exchange, balances held outside Pakistan,
foreign securities, foreign bills purchased and discounted, net IMF position
and SDR holdings. The definition of foreign assets of the SBP will be
consistent with the Data Template on International Reserves and Foreign
Currency Liquidity. Gold will be valued at SDRs 35 per fine troy
ounce. Foreign liabilities of the SBP include deposits with the SBP of
foreign governments, foreign central banks, foreign deposit money banks,
international organizations, and deposits of foreign nonbank financial
institutions (NBFI).1
5. Net domestic assets (NDA) of the SBP are defined as the difference
between RM and the NFA of the SBP.
6. Net borrowing from the banking system by the government is
defined as the difference between the banking system's claims on the central
and provincial governments and the deposits of the central and provincial
governments with the banking system. For purposes of this memorandum,
claims on government exclude credit for commodity operations; government
deposits exclude outstanding balances in the Zakat Fund. The stock of
bonds which were issued to banks in substitution of outstanding nonperforming
loans to certain public entities, and which are being fully serviced by
the government, are included in banking system claims on government (e.g.
bonds issued in 1995, 1996, and 1998 by GCP, RECP, CEC, TCP to UBL, Habib
Bank, and NBP).
7. The definition of the overall budget deficit (excluding grants)
under the program will be the consolidated budget deficit excluding grants,
excluding the operations of local governments financed from local funds.
It will be measured by the sum of (a) the total net financing to
the federal and provincial governments; and (b) the total external
grants to the federal and provincial governments. The former is defined
as the sum of net external budget financing (defined below), net borrowing
from the banking system (as defined above), and net domestic nonbank financing
(defined below). The latter is defined as the sum of project grants, the
rupee counterpart of the Saudi Oil Facility, cash external grants for
budgetary support, and capital grants reflecting the principal amounts
of external debt cancellation or swaps.
8. Net external budget financing is defined as net external program
financing plus all other external loans for the financing of public projects
or other federal or provincial budget expenditures. Net external program
financing is defined to include external privatization receipts; budget
support loans from multilateral (other than the Fund, but including the
World Bank's BSAC and any World Bank and Asian Development Bank (AsDB)
provincial structural adjustment loans), official bilateral, and private
sector sources; rescheduled government debt service and change in stock
of external debt service arrears net of government debt amortization due
on foreign loans, the latter including any implicit accelerated amortization
related to debt swaps or debt cancellation recorded as capital grants.
It includes foreign loans onlent to financial institutions and companies
(public or private) and emergency relief lending. Program financing excludes
all external financing counted as reserve liabilities of the SBP (defined
above). Amounts assumed for net external program financing and external
grants are provided in Tables 1(a) and 1(b).
9. Net domestic nonbank financing of the budget is defined as:
domestic privatization receipts plus the change, during each fiscal year,
in the stock of (a) permanent debt, which consists of nonbank holdings
of prize bonds, all federal bonds and securities; plus (b) floating
debt held by nonbanks; plus (c) unfunded debt, which consists of National
Savings Scheme (NSS) debt, Postal Life Insurance, and the General Provident
Fund; plus (d) stock of deposits and reserves received by the government
(public accounts deposits); plus (e) suspense account; plus (f) any
other government borrowing from domestic nonbank sources net of repayments;
minus (g) government deposits with NBFIs. Nonbank holdings of permanent
and floating debt is defined as total debt outstanding, as reported by
the SBP, minus holdings of banks as per the monetary survey. Total treasury
bill and other relevant government debt is valued at discount value.
10. Net claims of the banking system on public sector enterprises
comprise the banking system's claims on all public sector enterprises,
excluding credit for commodity operations. Net claims include both credit
and holding of corporate paper, netted against outstanding deposits on
the special account with the SBP for payments on public enterprises' rescheduled
debt.
External debt
11. The performance criterion on contracting or guaranteeing of medium-term
and long-term nonconcessional external debt by the government or the SBP
applies not only to debt as defined in point No. 9 of the Guidelines
on Performance Criteria with Respect to Foreign Debt (adopted by the IMF
Executive Board on August 24, 2000), but also to commitments contracted
or guaranteed for which value has not been received.2
Excluded from this performance criterion are (a) foreign currency
deposit liabilities of the SBP; and (b) the outstanding stock of
debt of Foreign Exchange Bearer Certificates (FEBCs), Deposit Bearer
Certificates (DBCs), and Foreign Currency Bearer Certificates (FCBCs).
The performance criterion setting a limit on the outstanding stock of
short-term external debt refers to debt (as defined in footnote 2) with
original maturity of up to and including one year. Medium- and long-term
external debt comprises debt with initial maturity of over one year. The
external debt will be expressed in U.S. dollar terms, with debts in currencies
other than the U.S. dollar converted into U.S. dollars at the market rates
of the respective currencies prevailing on March 29, 2002 as published
in IFS.
12. Nonconcessional borrowing is defined as borrowing with a
grant element of less than 35 percent, following the methodology
set out in the staff report SM/96/86 and approved by the IMF Executive
Board on April 5, 1996. The discount rates used to calculate
the grant element will be the six-month and ten-year Commercial Interest
Reference Rates (CIRRs) averages, as computed by the Policy Development
and Review Department of the Fund. Six-month CIRRs are updated mid-February
and mid-August (covering the six-month period preceding the date of update)
and the ten-year CIRRs averages are updated mid-December (covering a period
of 10 years preceding the date of the update). Six-month CIRRs averages
are to be used for loans whose maturity is less than 15 years, while
ten-year CIRRs averages are to be used for loans whose maturity is equal
or more than 15 years.
13. Poverty-related and social public spending ("I-PRSP expenditure")
consists of central provincial and district government spending under
the current budget and the Public Sector Development Program (PSDP), as
defined in Table 2. The indicative Interim
Poverty Reduction Strategy Paper (I-PRSP) expenditure targets will be
adjusted upward by any nondebt creating relief on external interest payment
as a result of bilateral debt restructuring and debt swaps.
II. Adjustors
14. The floors on the NFA of the SBP and ceilings on the NDA
of the SBP will be adjusted (a) upward/downward (respectively
downward/upward) by the cumulative excess/shortfall in net external program
financing (as defined below; Table 1(a));
and (b) upward/downward (respectively downward/upward)
by the cumulative excess/shortfall in external cash budget and capital
grants resulting from debt cancellation and debt swaps (as defined below;
Table 1(b)). Downward adjustments of NFA
and upward adjustments of NDA will be capped at US$400 million.
15. The ceiling on net bank borrowing by the government will be
adjusted downward/upward by the cumulative excess/shortfall in net external
program financing plus external cash budget and capital grants resulting
from debt cancellation and debt swaps; and upward by any downward adjustment
in the budget balance in conjunction with higher I-PRSP expenditure as
set out below. Total upward adjustments will be capped at US$400 million.
The ceiling will also be adjusted upward by the increase in net claims
of the banking system on the government resulting from (a) the takeover
of NBFI by a scheduled bank; and (b) the government's paying-off
residual debt of Karachi Electric Supply Corporation (KESC) toward banks
or suppliers in the context of privatization, up to PRs 11 billion.
16. The ceilings on the NDA of the SBP will also be adjusted downward/upward
by the amount of (a) banks' rupee reserves freed/seized by any reduction/increase
of the daily CRR of 4 percent; (b) banks' reserves freed/seized
by any reduction/increase in the total reserve requirements on foreign
currency deposits of 25 percent; and (c) any reduction/increase
in the reservable deposit base that is related to definitional changes,
as per the following formula: ∆NDA = ∆rB0 + r0∆B
+ ∆r∆B, where r0 denotes the reserve requirement
ratio prior to any change; B0 denotes the level of the reservable
deposits in the initial definition; ∆r is the change in the reserve
requirement ratio; and ∆B denotes the change in the reservable deposits
as a result of definitional changes.
17. The floor on the consolidated overall budget balance (excluding
grants) will be adjusted downward for the cumulative excess in external
cash budget grants and capital grants resulting from debt cancellation
or debt swaps for up to PRs 5 billion at end-September 2002,
PRs 10 billion at end-December 2002, PRs 15 billion
at end-March 2003, and PRs 20 billion at end-June 2003.
Downward adjustments in the floor will have to be matched by identical
increases in actual budgetary I-PRSP expenditures above the program levels
(Table 2). The floor will also be adjusted
downwards by the government's outlays for paying-off residual debt of
KESC toward banks or suppliers in the context of privatization, up to
PRs 11 billion.
18. The ceiling on net claims of the banking system on public sector
enterprises will be adjusted downward for the amount of repayment
by the government of bank credit to KESC outstanding as of July 1,
2002, in the context of KESC privatization. The ceiling will also be adjusted
downward by the amount of net claims reclassified as claims on the private
sector as a result of the privatization of any public enterprise.
III. Program Reporting Requirements
19. The following information, including any revisions to historical
data, will be provided to the Middle Eastern Department of the Fund through
the office of the Senior Resident Representative of the IMF in Pakistan,
within the timeframe indicated:
- Monthly provisional statements on federal tax and nontax revenue,
within one month.
- Deposits into and withdrawals from the privatization fund for each
quarter of 2001/02, within one month. Withdrawals will be reported with
the following breakdown (a) those which constitute budgetary use
of privatization proceeds; (b) those which constitute costs of
privatization; and (c) other (with explanation of the purpose of
other withdrawals).
- Quarterly statements on budgetary capital receipts and disbursements,
including repayments of bonds, recovery of loans from provinces and
"others", within two months.
- Monthly (unreconciled) provisional data on federal expenditure and
net lending (with separate data on disbursements and repayments), within
one month.
- Quarterly statement on consolidated budgetary expenditure, with federal
data approved by the Auditor General Pakistan Revenue (AGPR), within
two months.
- Quarterly provisional data (from AGPR and AG) on social sector and
poverty-related budgetary expenditures, as defined below (Table 2),
as well as on the subcategories eligible for additional grant-financed
expenditure, as defined in Table 2, within six weeks.
- Quarterly data on the stock of domestic government debt, broken down
by instrument, within one month.
- Quarterly data on WAPDA receivables (see Table 3),
within one month.
- Monthly provisional data on external budget financing, including
proceeds from the Saudi Oil Facility, and cash external grants for budget
support (as defined below) as well as capital grants related to debt
write-off/swaps, within one month.
- Quarterly data on the revenues and expenditures of the four public
enterprises as per Tables 5(b) to 5(e)
of the March 2002 TMU (KESC, Pakistan International Airlines, Pakistan
Steel Mill Corporation, Pakistan Railways), and for WAPDA and its successor
entities in the format of attached Table 4,
within one month.
- The following monthly monetary data on a last-Saturday basis, both
at current and program exchange rates, within four weeks:
- The same tables as in the preceding item, but on an end-quarter basis
(last business day), both at current and program exchange rates, within
four weeks.
- SBP Table on outstanding stock of foreign currency deposits, amended
to include the classification of new FCA according to the residency
of the holder.
- Daily data on exchange rates (interbank, free market, and Telegraphic
Transfers for SBP purchases on the free market), SBP's sales and purchases
in the free and interbank foreign exchange markets, swaps and forward
outright sales, within two business days.
- Monthly data on the outstanding stock of the SBP's forward foreign
currency operations, including swaps and outright forward sales and
purchases, within two weeks. The terms of any new transactions (including
rollover/renewal of existing ones) will also be provided.
- Monthly data on the SBP's foreign exchange reserves, with details
on the currencies, instruments, and institutions in which the reserves
are held, within one month.
- Monthly data on net bank claims on public enterprise as per attached
list and including details on the six autonomous bodies, within one
month. The data will show separately the total amount of direct credit
and bank holdings of corporate bonds.
- Monthly data on SBP direct or bridge loans to nationalized banks
in the context of the restructuring and privatization operation, within
four weeks.
- Monthly data on any other quasi-fiscal operations undertaken by the
SBP, on behalf of the government.
- Monthly data on SBP holding of discounted export finance credit under
the export finance scheme, within one month.
- Monthly data on outstanding credit to agriculture under the Agriculture
Mandatory Credit Targets, within one month.
- Monthly data on scheduled banks' credit for commodity operations,
with separate subcategories for Pakistan Agricultural Storage and Services
Corporation (PASSCO) and Punjab Provincial Food Department operations,
within four weeks.
- The following data on external debt, within six weeks:
(i) Quarterly stock of public- and publicly-guaranteed external
debt (including deferred payments arrangements), by maturity (initial
maturities of up to and including one year, and over one year),
by creditor and by debtor (central government and publicly guaranteed),
and for Paris Club debt, with breakdown in pre- and post-cutoff
date stock;
(ii) Quarterly contracting on guarantees of nonconcessional medium-
and long-term government debt; and
(iii) Monthly statements on rescheduling agreements on public-
and publicly-guaranteed debt reached with creditors.
- Quarterly data on external payments arrears on public- and publicly-guaranteed
debt with details as in (i) of the preceding item, within six weeks.
- Copies of new or revised ordinances/circulars regarding changes in:
tax policy, tax administration, foreign exchange market regulations,
and banking regulations no later than three days after official
issuance, or notification that ordinances have been posted on the Central
Board or Revenue (CBR) and SBP websites.
- Copies of official notification of changes in gas and electricity
tariffs (automatic or structural) and in ex-refinery petroleum product
prices.
- Monthly data on the import parity prices as well as central depot
prices of the six major oil products, within one month.
- Quarterly data on the following indicators, within two months after
the end of the quarter:
(i) Three intermediate poverty indicators identified in the I-PRSP
(utilization rate of first level health care facilities for curative
care, population covered by Lady Health Workers, and number of functional
schools); and
(ii) Social safety net beneficiaries as identified in the I-PRSP
(temporary employment generated by Khushal Program by province,
number of beneficiaries of Zakat by province and type of assistance,
number of borrowers and size of credit under the PPAF and Khushali
Bank programs by province, number of beneficiaries of the Food Support
Program by province, acres of land distributed, and beneficiaries
by province).
1
The definition of NFA of the SBP used here implies that, for program monitoring
purposes, disbursements and/or purchases from the Fund are to be recorded
in the monetary accounts as external liabilities of the SBP, rather than
deposits of the government.
2
The definition of debt set forth in No. 9 of the guidelines reads as follows:
"(a) For the purpose of this guideline, the term "debt"
will be understood to mean a current, that is, not contingent, liability,
created under a contractual arrangement through the provision of value
in the form of assets (including currency) or services, and which requires
the obligor to make one or more payments in the form of assets (including
currency) or services, at some future point(s) in time; these payments
will discharge the principal and/or interest liabilities incurred under
the contract. Debts can take a number of forms, the primary ones being
as follows: (i) loans, that is, advances of money to obligor by the
lender made on the basis of an undertaking that the obligor will repay
the funds in the future (including deposits, bonds, debentures, commercial
loans, and buyers' credits) and temporary exchanges of assets that are
equivalent to fully collateralized loans under which the obligor is required
to repay the funds, and usually pay interest, by repurchasing the collateral
from the buyer in the future (such as repurchase agreements and official
swap arrangements); (ii) suppliers' credits, that is, contracts where
the supplier permits the obligor to defer payments until some time after
the date on which the goods are delivered or services are provided; and
(iii) leases, that is, arrangements under which property is provided
which the lessee has the right to use for one or more specified period(s)
of time that are usually shorter than the total expected service life
of the property, while the lessor retains the title to the property. For
the purpose of the guideline, the debt is the present value (at the inception
of the lease) of all lease payments expected to be made during the period
of the agreement excluding those payments that cover the operation, repair
or maintenance of the property. (b) Under the definition of debt
set out in point 9(a) above, arrears, penalties, and judicially awarded
damages arising from the failure to make payment under a contractual obligation
that constitutes debt are debt. Failure to make payment on an obligation
that is not considered debt under this definition (e.g., payment on delivery)
will not give rise to debt."
