Pakistan's economic momentum ahead of 2007 elections
KARACHI (September 12 2006): As President Musharraf enters the final year of his, current presidential term, he can point to a robust economic picture, with growth exceeding six percent for the third year in a row, healthy external accounts, and much improved macroeconomic indicators (table).
J.P. Morgan Chase Bank in its Research note said that the economic turnaround has been accompanied by a significant acceleration in the implementation of economic reforms, progress in privatisation and an attendant sharp increase in foreign direct investment (FDI) inflow. Moreover, the country has been able to access international financial markets on favourable terms, the latest issue being two Eurobonds totalling $800 million with tenors of up to 30 years.
Pakistan's subindex in the composite EMBIG has widened relative to the over all EMBIG since last April after consistently out performing the index since June 2002.
Going forward, the main underlying factors that sustained the post 2001 performance-the imprimatur of an IMF programme, major debt forgiveness, and the surge in remittances will not be repeated and Pakistan will face a tougher international environment, as well as difficult domestic economic challenges. In particular, it will need to overcome internal and external macroeconomic imbalances-economic overheating, negative fiscal trends, and a widening external account gap in order to sustain good economic performance over the longer term.
Surging exports, an expansionary fiscal stance, and abundant liquidity have underwritten rapid output growth over the last three years. Real GDP growth reached 8.6 percent in FY2004/05 and 6.6 percent in FY2005/06 (fiscal years running to June 30, 2005). However, in combination with the rapid rise in energy costs, these factors have made for persistently high levels of inflation (first chart). Indeed, inflation has picked up again just in the past three months to around eight percent oya, after hitting a two-year low of 6.2 percent in April.
Monetary policy has been tightening in the past year, with a gradual removal of liquidity through open market operations. Consequently, growth in base money slowed to around 10 percent oya in May 2006 from a high of 23 percent in September 2004. Rates on 90-day T-bills have risen by about 50bp to 8.80 percent since March, and the State Bank of Pakistan (SBP) raised the discount rate by 50bp, to 9.5 percent at the end of July this year. As a result, real interest rates have moved into positive territory. Nevertheless, the SBP still maintains a pro-growth bias.
KEY ECONOMIC INDICATORS AND FORECASTS FISCAL YEARS BEGINNING JULY 1
========================================================================== 2002/03 2003/04 2004/05 2005/06 2006/07GDP (US$ billion) 85.0 98.3 113.1 131 5 146.5GDP/capita (USD) 579.0 669.0 742.0 847.0 900.0Real GDP growth (%) 4.7 7.5 8.6 6.6 7.0Fiscal balance (% of GDP) -3.7 -2.4 -3.3 -4.2 -4.2CRI (%oya) 3.1 4.6 9.3 7.9 6.5Exports of goods ($ billion)10.89 12.40 14.40 16.80 19.50(%oya) - 13.8 16.2 17.1 16.1 -Imports of goods ($ billion)11.33 13.60 18.75 27.90 34.10(%oya) - 20.0 37.8 48.8 22.2 -Trade balance ($ billion)-0.44 -1.21 -4.35 -11.10 -14.60Current account ($ billion)3.16 1.31 -1.75 -5.80 -6.30(% of GDP) 3.7 1.3 -1 5 -4.4 -4.3Net FDI ($ billion) 0.82 0.92 1.68 3.53 5.00Fx reserves ($ billion) 10.72 12.33 12.62 13.02 13.02Total ext debt ($ billion) 35.47 35.26 35.83 36.56 38.00(% of GDP) 43.1 36.7 32.6 28.3 25.9Total public debt (% of GDP)76.9 69.7 82.5 53.3 50.8Exchange rate(Rs/$) 58.50 57.57 59.36 59.81 80.00==========================================================================
Sources: State Bank of Pakistan, IMF, J.P. Morgan.
EUROBOND ISSUANCE AND TRADING Pakistan's March 2006 Eurobond issue-the third in six years-substantially extended the country's external debt curve, but faced moderately weaker investor appetite than did earlier issues, due to broader emerging market trend at the time.
This latest issue went beyond the maximum five year maturity previously achieved by including a $500 million 10-years tranche A at 7.125 percent (240bp over Treasures) and a $300 million 30-year trance B at 7.875 percent (a spread of 302bp).
The term were marginally less favourable than for recent similarly rated recent sovereign issues, but in line with prevailing market conditions. There are currently three Eurobonds outstanding. On September 5, the 16s and the 36s were trading at spreads of 250bp and 311bp, respectively, an increase of 8-10bp since the date of issue but down from peaks of 304bp and 334bp, respectively on July 17.
A QUESTION OF FISCAL SUSTAINABILITY Under the Fiscal Responsibility and Debt Limitation Law (FRDL) of 2005, the government is committed to balancing the budget by FY2008 and reducing public debt to 60 percent of GDP by 2013.
The debt stabilisation target was achieved in this past fiscal year despite the surge in government spending, which rose an average of 12 percent p.a. in the five years ended FY2005/06 as a result of big increase in security, infrastructure, and social spending.
Outlays are expected to increase 9.7 percent in FY2006/07. After narrowing in FY2002/03 and FY2003/04, the fiscal gap has widened in the past three years, and is expected to reach 4.2 percent of GDP in each of FY2005/06 and FY2006/07.
In addition to privatisation revenues, which cover about 25 percent of the fiscal gap, about one-third of the deficit is financed by bilateral and multilateral loans and grants. (Pakistan's low per capita income and strong diplomatic support from the US should ensure the continuation of official monies as a long-term financing source.)
The government has completed its financing in the past four years by means of bond issuance-in the form of Eurobonds, as well as "sukuks" (Islamic bonds). The FY2006/07 budget plans for issues totalling $500 million. Expansionary fiscal policies and a narrow tax base will complicate fulfilment of the FRDL, but the fiscal gap should remain manageable in the medium term.
Nevertheless, both the State Bank of Pakistan and the IMF have been pressing for fiscal reform. As a result of under-taxation or tax exemption for major sectors, Pakistan has one of the lowest tax takes among emerging markets, with tax revenues the equivalent of only about 10 percent of GDP.
Without fiscal reform (which could prove difficult, considering the powerful vested interests of the tax-exempt sectors, particularly agriculture), the financing of much-needed social and infrastructure spending will prove challenging in the longer term. Privatisation is moving ahead, with the sale of strategic stakes in state-owned companies and listings on the KSE.
NET FOREIGN INVESTMENT BY SOURCE $ MILLION, FISCAL YEARS BEGINNING JULY 1
==================================================== 2001/02 2002/03 2003/05 2004/05UAE 17.3 120.4 146.5 417.3USA 324.7 226.6 259.8 373.0UK 2.1 184.4 41.9 199.1 -Switzerland 30.6 5.7 211.3 127.5Saudi Arabia 1.4 43.6 5.3 18.2Others 102.7 239.4 256.9 541.5Total 474.6 820.1 921.7 1,676.6====================================================
Source: State Bank of Pakistan
Privatization proceeds for 2005 totalled about $3 billion. Currently, 63 companies are on the sale list of which 26 are slated to be sold by the end of FY2006/07. As shown by the experience of other major emerging markets such as Brazil, Mexico, and Turkey, privatisation often acts as a catalyst for private greenfield investment.
Recent data seem to support the emergence of this dynamic for Pakistan, as private sector inflows quadrupled between FY2001/02 and FY2004/05 (the last year for which we have full data) to $1.7 billion, with the UAE, Saudi Arabia, the United States, and the UK as the major investors (table).
FINANCING A WIDENING CURRENT ACCOUNT GAP The turnaround of the external accounts has been one of the major achievements of the past six years, after Pakistan narrowly averted an external default in 1999. Three successive years of current account surpluses, debt relief, and large capital inflows allowed stabilisation of the external debt and accumulation of foreign exchange reserves.
Over the past five years, exports rose 60 percent and worker remittances quadrupled Foreign exchange reserves stood at $13.0 billion (8.7 months of imports) at the end of FY2005/06, while the external debt has stabilised at around $36.6 billion (or 28.3 percent of GDP, down from 49.5 percent in FY2000/01).
However, rapid economic growth and the surge in both oil import costs and capital goods imports have reversed the previously improving current account trends, pushing the current account back to deficits of US$1.8 billion in FY2004/05 and an estimated $5.8 billion in FY2005/06 (table). Oil import costs jumped 67 percent in FY2005/06 to $6.6 billion, accounting for about two-thirds of the deterioration in the current account balance.
CURRENT ACCOUNT BALANCE $ MILLION, FISCAL YEARS BEGINNING JULY 1
================================================================== 2002/03 2003/05 2004/05 2005/06Exports 10,889 12,398 14,401 16,800o/w: Textiles 5,810 8,073 8,465 9,787Imports 11,333 13,604 18,753 27,900Petroleum products 2,807 3,166 4,080 6,600 Capital goods 2,175 4,200 5,918 7,500Trade balance -444 -1,206 -4,352 -11,100Remittances 4,237 3,871 4,166 5,000Current account balance 3,165 1,314 -1,753 -5,800==================================================================
Source: State Bank of Pakistan and J.P. Morgan.
Patterns of external financing have shifted in the past two years from official assistance to greater reliance on private flows. While Pakistan continues to be the recipient of large official disbursements, it is increasingly dependent on foreign direct and portfolio investments, which totalled $4.5 billion in FY2005/06, a tenfold increase in five years financing almost 80 percent of the past fiscal year's current account deficit (chart).
While privatisation and a booming stock exchange gave a major boost to these flows, a large portion of the FDI comes from Pakistan's oil-rich neighbours of the Gulf Co-operation Council, reflecting close economic and political ties-according to published data, the UAE and Saudi Arabia accounted for about 25 percent of total private investment, both FDI and FPI, in FY2005/06.
MEDIUM-TERM OUTLOOK The IMF completed its annual Article IV review this week. Its preliminary assessment of Pakistan's recent economic performance and medium-term economic prospects is very positive, although it points to the vulnerabilities associated with the widening current account gap.
The economic expansion maintains considerable momentum, and the government's projection of 7 percent growth for FY2006/07 seems on track. Strong export performance, the recent stabilisation of oil prices, and continued growth in remittances are expected to stabilise the current account deficit at about 4.3 percent of GDP, with strong FDI flows and official finance providing the bulk of the financing. In the longer term, though the widening.
SOCIOECONOMIC DEVELOPMENT Building on several years of rapid economic growth, Pakistan now needs to translate that growth into tangible benefits for the population at large. With per capita income of under $1,000, Pakistan is classified as a Low Income country by the World Bank.
Moreover, income distribution is highly skewed, with the poorest 20 percent of the population receiving only about 6.6 percent of total income, versus almost 50 percent going to the top 20 percent. Also, almost 40 percent of the rural population and 23 percent of the urban population are classified as poor.
While pro-poor public spending has gone up significantly as a percentage of GDP (from 3.6 percent to about 4.6 percent in the past two years), it remains inadequate. Spending on external gap remains a major threat to economic stability.
Under J.P. Morgan's base case for oil prices and economic growth, we estimate that the trade deficit could double between FY2005/06 and FY2009/10 to $20 billion, leading to a current account deficit of $10-12 billion (5.5-6 6 percent of GDP). Extrapolating from the medium-term projections done by the IMF in its 2005 review of the Pakistani economy, the current account would have to remain at about education as a share of GDP is estimated at about 7.8 percent significantly below the 13-16 percent average for East Asian emerging market countries.
Pakistan has committed itself to the UN's Millennium Development Goals (MDG), which aim to improve sharply the socio-economic conditions of the world's poorest citizens by halving the incidence of poverty by 2015.
As seen in the fiscal discussion of the main text, Pakistan's social and infrastructure spending has increased significantly in the past few years, but will need to grow even faster to make the Millennium goals achievable.
Five percent of GDP for the external debt to stabilise at current levels (relative to GDP). However, this would require FDI/FPI flows to double from today's levels by FY2009/2010, as well as additional private external financing of $2-3 billion per annum experience in other major emerging markets over the past few years shows that such a scenario can he achievable but will require and acceleration of economic reforms, in particular on the fiscal and privatisation side.
Politics: Musharraf to be reelected despite a more robust opposition
President Musharraf has brought considerable stability to Pakistan's fractious politics. He also has proven to be a key ally of the West in the global war on terror. The President, who is also the head of the armed forces, has consolidated his power and remains unchallenged.
Nevertheless, the deterioration in the domestic and regional political climate in the past few months has increased the pressure on Musharraf from several directions.
Both presidential and legislative elections are scheduled for the fall of 2007-on dates still to he determined. Musharraf his likely to be reelected. The president is chosen by an Electoral College composed of the national and regional legislatures. By moving his own reelection ahead of the legislative ones, Musharraf will face an Electoral College where he has a majority.
Potential gains by a more unified opposition in the next legislative elections may force Musharraf to broaden his coalition. Currently, his coalition controls 200 seats in the 342 member National Assembly (centered around 126 seats for the MQM-Q), against 100 for the two major secular parties PPP and PML-N, which have formed an electoral alliance, the Alliance for the Restoration of Democracy (ARD).
Moreover, the ARD joined hands with the largest Islamic party the MMA, to present a motion of no confidence against Prime Minister Shaukat Aziz on August 23. This no-confidence vote, which failed, under-scored the potential for a broader anti-Musharraf coalition, which could gain control of parliament with a shift of 30 seats next October.
Musharraf's efforts to walk a fine line between co-operating ailing with the West (and in particular the United States) and appeasing the powerful domestic Islamic parties have been complicated by the current rising tide of anti Americanism in popular opinion.
The security situation has deteriorated with a spike in Islamic militant and Taliban activity in the provinces bordering Afghanistan, as well as a rise in violence in Balochistan. Pakistan has deployed 40,000 troops in the border provinces in the past few months, and casualties on both sides are reported to the heavy.
However, the just-announced "peace agreement" between the government and tribal leaders in the North-western provinces is a first step toward restoring some measures of calm and policing the frontier more effectively. Balochistan, a gas rich province occupying a key strategic position between Afghanistan and Pakistan's access to the Persian Gulf, has been the scene of rising separatist activities.
The recent killing of the head of Balochistan's largest tribe and key separatist leader by the Pakistan armed forced can only worsen tensions between the separatist and the government.
Relations with India have deteriorated in the wake of Indian allegation of Pakistani involvement in the recent Mumbai bombings. Earlier, Pakistan and India made little progress with regard to Kashmir and establishing economic links.
While these challenges are contained for the time being, they serve as a reminder that the significant economic achievements of the past five years could be eroded by the risk of discontinuity in the political scene in the medium term, Musharraf's ability to play an effective role will depend on broadening his political base.
