On September 4, 2013, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV Discussions with Pakistan¹ and approved a three-year arrangement under the Extended Fund Facility (EFF) for Pakistan in support of the authorities’ structural reform and growth program (see Press Release No. 13/322).

Economic performance in Pakistan has been substandard in recent years. GDP growth has averaged only 3 percent over the past five years, which is insufficient to significantly improve living standards or fully absorb the growing labor force. Severe problems with the electricity supply, a difficult security situation, the presence of loss-making public sector enterprises in key economic activities, a poor business climate, and a distorted trade regime have been important factors in anemic growth.

Headline inflation has fallen sharply in recent months, but underlying inflationary pressures remain. The external position has weakened significantly and central bank reserves have declined to US$6 billion (below 1½ months of imports) as of end-June 2013. The rupee depreciated around 5 percent against the dollar during the Fiscal Year 2012/13 (July-June), leaving the real effective exchange rate roughly unchanged.

The 2012/13 fiscal deficit (excluding grants) is estimated to be 8 percent of GDP, well above the original budget target of 4.7 percent of GDP due to slippages on both revenues and expenditures. The revenue shortfall is largely explained by the underperformance in tax collections in the previous fiscal year, inadequate tax administration, and a slowdown in economic activity. Higher expenditures reflect higher energy subsidies, including clearing the power sector arrears. Moreover, the provincial surplus envisaged in the budget has not materialized. With very low external financing, the deficit has been almost entirely domestically financed.

Monetary policy continued to be accommodative to lift weak private investment and growth, in light of falling headline inflation. In 2012/13, the policy rate has been cut repeatedly by a cumulative 300 basis points to 9 percent, while direct financing of the large fiscal deficit continues to drive growth in monetary aggregates. However, this accommodative policy did not bear fruit in terms of private sector stimulus—private credit shrank in real terms.

The financial system is dominated by banks that have been relatively healthy as capital and liquidity indicators continue to be boosted by large holdings of government securities. Nevertheless, nonperforming loans remain high at 14.7 percent at end-March 2013 with few banks falling below minimum capital adequacy requirements.

Executive Board Assessment

Executive Directors noted that Pakistan’s economic vulnerabilities and crisis risks are high, with subpar growth and unsustainable fiscal and balance of payments positions. A lack of reliable electricity supply and a difficult security situation in large parts of the country have contributed to the deterioration.

Against this backdrop, Directors welcomed the authorities’ ambitious economic program aiming to reverse the current mix of large fiscal deficits, accommodative monetary policy, and low reserve coverage, and to foster sustained and inclusive growth. They stressed that short-term measures must be complemented by significant reforms in fiscal management, the monetary policy framework and financial markets, the energy sector, public sector enterprises, the business climate, and trade policy.

Directors highlighted that further consolidation will be required to ensure fiscal sustainability. While the 2013/14 federal budget represents an important initial step, a more efficient and equitable tax system is needed, and a significant increase in the tax-to-GDP ratio will be key to create room for social and investment spending while lowering the deficit. This will involve broadening the tax base through a reduction in exemptions and concessions, the extension of taxation to areas not fully covered by the tax net, and an overhaul of tax administration. Directors underscored that fiscal sustainability can only be achieved if the provinces are full partners in the adjustment effort.

Directors emphasized that monetary and exchange rate policies must be geared to rebuilding external buffers and to maintaining price stability over time. They stressed the need to cease direct lending to the government and underscored the importance of monetary policy independence in paving the way for improved price stability.

Directors underlined that continued financial sector stability and steps to deepen financial markets will contribute to boosting economic growth. They considered that risks to the banking sector are manageable, but encouraged the authorities to promptly address the undercapitalization of a few banks and to monitor closely non-performing loans.

Directors welcomed the authorities’ new energy policy, which is geared to addressing long-standing problems that constitute the most critical constraint on growth and have generated large fiscal costs. They encouraged the authorities to work closely with donors and secure broad-based support for the continued strong implementation of their energy sector strategy. Directors also called for efforts to liberalize the trade regime, restructure or privatize public sector enterprises, and improve the business climate to reduce rent-seeking behaviors and increase both foreign and domestic productive investment.

Directors stressed that protecting the most vulnerable from the impact of fiscal consolidation and price adjustments is a priority. They commended the authorities for their firm commitment to boosting targeted income support programs, and encouraged a gradual expansion of coverage and benefits as savings from energy tariff adjustments and fiscal space are realized.

Directors recognized the risks to the program from a delicate security situation, a further deterioration in the external environment, and potential constraints in legal, administrative, or technical capacity and resistance from vested interests to the reforms. They welcomed the authorities’ considerable efforts in undertaking prior actions, signaling their commitment to the program’s objectives and their willingness to take additional measures if necessary. They emphasized the importance of close collaboration with development partners, including through technical assistance, and continued strong political will and ownership for the program’s success.