Success of SOEs’ divestments: WB for addressing political economy implications first

ISLAMABAD: The World Bank has linked the success of divestments and restructuring of State Owned-Enterprises (SOEs) with the resolution of political economy implications, maintaining that fiscal risks from SOEs and civil service compensation and pensions continue to be significant.

The World Bank report ‘Pakistan Development Update’ released on Tuesday stated the federal government is in the process of implementing SOE reform plans including preparing an SOE law, an SOE policy, as well as undertaking possible divestments and restructuring of certain SOEs. However, these reforms have not been finalized, and have considerable political economy implications, which must first be addressed. SOEs therefore continue to be a source of fiscal risk, especially as they account for significant extra budgetary transactions of the federal government.

In addition, civil service and pensions continue to be a growing source of fiscal risk for the government. Federal and provincial employee compensation accounted for at least 23 percent of national expenditures in 2019, while pensions in 2019 were an additional 10 percent of the total national expenditure. Reforms are being planned for civil service at the federal government, while all governments are planning pensions’ reforms, with an aim to have partially funded pension programs in place to ease the fiscal burden off the budget in medium-long term.

The report further stated that Pakistan’s economic growth is expected to recover slowly, given heightened uncertainty surrounding the COVID-19 pandemic, besides economic activity is projected to be dampened in the short-term by fiscal consolidation measures associated with the resumption of the International Monetary Fund (IMF) stabilization program, says the World Bank.

Economic growth is expected to remain below potential, reaching 1.3 percent in fiscal year 2021 and strengthening to 2 percent in fiscal year 2022 and 3.4 percent in 2023.

Real GDP growth at factor cost is estimated to have declined from 1.9 percent y-o-y in fiscal year 2019 to -1.5 percent in fiscal year 2020, the first contraction in decades. This reflected the effects of the COVID-19 pandemic-related containment measures that followed the monetary and fiscal tightening associated with the IMF Extended Fund Facility (EFF).

Pakistan’s near-term economic prospects are subdued. There are also considerable downside risks to the outlook, especially with the ongoing third wave of the infection that could trigger more protracted and extensive lockdowns, stifling the fragile recovery, it added.

Unanticipated policy unwinding among advanced economies could trigger safe-haven effects, leading to a sudden tightening of international financing conditions, which in turn could contribute to financial volatility, higher external financing risks, and increase debt servicing costs. Such risks would be further compounded if Pakistan faces difficulties in rolling-over bilateral debt from non-traditional donors, the report noted.

The government is attempting to meet a fiscal deficit (excluding grants) target of 7.1 percent of GDP, which is contingent on a robust revenue performance, an almost 14 percent increase in revenues, including a 26.2 percent increase in taxes.

With rigid expenditures and low revenues due to the economic slowdown, there is limited fiscal space to address any additional shocks, including those from the pandemic. An additional COVID-related expenditure, at either the federal or provincial government levels, including any expenditure on purchasing vaccines, can derail efforts to meet the fiscal deficit target, the Fund added.

The current account deficit is projected to gradually widen as domestic demand picks up and international trade recovers. Export values are projected to decline in fiscal year 2021 amid weak global demand, whereas import values are projected to grow in line with the recovery in domestic economic activity. However, the current account deficit is projected to narrow to 0.8 percent of GDP, as a wider trade deficit is more than offset by stronger remittance inflows. The current account deficit is projected to gradually widen to 1.7 percent of GDP in 2023, with import values growing alongside domestic demand and higher projected oil prices.

The report further noted that the fiscal deficit (excluding grants) is projected to reach 8.4 percent of GDP in fiscal year 2021, partly due to subdued economic activity and the settlement of arrears in the power sector. As critical revenue-enhancing reforms gain pace, the fiscal deficit (excluding grants) is projected to gradually narrow to 7 percent of GDP by 2023. Under the baseline scenario, revenue collection is expected to increase over the medium term as growth recovers and the government implements structural reforms related to GST harmonization; rolls back tax expenditures, streamline tax rates and improve the withholding tax regime.

The fiscal deficit targets in the 2021 budget were also planned to be achieved by having lower federal subsidy payments, as the government had plans to undertake significant reforms to manage the ballooning circular debt and its fiscal implications. By end December 2020, the government had already incurred 61.7 percent of the budgeted subsidies expenditure, and any delay in the reforms could result in the government overshooting its budgeted target for subsidies.

The federal budget estimates a provincial surplus of Rs 242 billion (0.5 percent of estimated GDP) for 2021 to reach the national fiscal deficit (excluding grants) of 7.1 percent of GDP. Thus far during the year, despite lower levels of federal transfers and higher provincial current expenditure, provincial governments have still managed to post a consolidated fiscal surplus of Rs 170 billion. However, the surplus is 29.3 percent narrower than in H1 2020. Given the provincial budgetary projections, it is estimated that provincial expenditure will accelerate in the second half of 2021, putting pressure on the consolidated provincial balance, and possibly affecting the efforts to achieve the national fiscal deficit target.

Pakistan’s Public and Publicly Guaranteed Debt (PPGD)-to-GDP ratio is projected to peak at 94.4 percent of GDP by end-2022 on account of elevated fiscal deficits, before easing to 94.1 percent of GDP by 2023. The decline in the PPGD-to-GDP ratio will be mainly due to moderately higher economic growth and declining primary deficits. The public debt-to-GDP ratio is expected to remain elevated over the medium-term, increasing Pakistan’s exposure to debt-related shocks. In addition, fiscal risks from debt servicing remain high.

The report noted that government consumption growth is expected to initially weaken as fiscal consolidation resumes after COVID-19 mitigation measures wind down and the government attempts to rein in the fiscal deficit. Gross fixed capital formation is also expected to be weak and continue shrinking for the third consecutive year in 2021, amid the uncertainty regarding the medium-term impact of the COVID-19 crisis and tepid global growth. Net exports are expected to decline this fiscal year as export volumes are projected to contract, while import volumes grow in line with the domestic demand recovery.

Headline consumer price inflation is expected to average 9 percent in 2021, as the recent hike in energy prices is likely to maintain an upward pressure on prices for the remainder of the year.

Food price inflation was recorded at 13 percent in urban areas and 15.7 percent in rural areas during H1 2021, compared to 13.7 percent and 15.1 percent, respectively, in H1 2020. The considerable increase in food prices was in part due to crop damage from the locust attacks that began in February 2020, as well as from the exceptionally heavy monsoon rainfall in August and September 2020. The COVID19 lockdown also disrupted supply chains, impacting the availability of inputs such as seed, fertilizer, pesticides, and fuel for farmers, along with timely availability of labor for the harvest. Further the higher wheat prices were also due to lower-than-targeted procurement by government agencies and its timely release to the market, and the subsequent delay in wheat imports to mitigate shortages.

The sizeable labor market shock brought about by the COVID-19 containment measures and economic slowdown is expected to have translated into an increase in poverty. Simulation results indicate that poverty in 2020, as measured at the official national poverty line, might have increased by 2.3 percentage points, which translates into 5.8 million additional people falling into poverty as a result of the pandemic. After two decades of uninterrupted decline in poverty, the COVID-19 pandemic is expected to have reversed the progress of more recent years. The COVID-19 pandemic is expected to not only increase poverty, but also worsen the depth and severity of poverty among the already poor, as indirectly demonstrated by the increase in the share of the severely food insecure population, which stood at 10 percent during the lockdown phase, compared to 3 percent at the baseline. The construction sector, whose expansion had contributed to lifting millions of households out of poverty over the previous decades, suffered the heaviest toll. Some 80 percent of its workers lost their jobs or had reductions in income.

While the percentage of the working population facing job loss or income decline is higher in urban areas, rural areas are likely to have seen the largest increases in poverty incidence. Results of the simulation exercise indicate that the absolute increase in poverty in rural areas is expected to be similar in magnitude, if not even larger, than the one predicted in urban areas.

Poverty trends in Balochistan have been traditionally characterized by a high degree of volatility, which indicates a relatively higher vulnerability to welfare shocks. Given Balochistan’s relatively higher concentration of population just above the poverty line, the COVID-19 shock is expected to have the largest increase in poverty incidence in this province.

With disruptions to schooling and the associated learning losses, the pandemic poses significant risks to long-term prospects of poverty reduction, equity, and social mobility.

The report stated that increasing competitiveness and stimulating private investment will require continued macroeconomic stability and maintenance of a market-determined exchange rate, improving the business environment, and supporting competition to promote exports.

It further stated that uncertainty remains high amid the current third wave of the infection with the re-imposition of some social restrictions. Consequently, economic conditions facing businesses can quickly become adverse with significant implications. There is therefore a case for further policy support to buttress the nascent recovery. Policy measures that prevent permanent firm closures and the consequent layoff of workers will contribute significantly to sustaining the recovery.

In line with State Bank of Pakistan (SBP) forward guidance, monetary policy is expected to remain accommodative in the near term, with future adjustments in the policy rate targeting a gradual return of mildly positive real interest rates.

In March 2020, longer-term expectations signaled lower interest rates, resulting in a largely downward sloping yield curve. However, these expectations have recently changed, leading to the reversion to a normal upward sloping yield curve in January 2021. This indicates that interest rates are expected to increase over time, making borrowing for longer-term investments potentially more expensive. As upward-sloping yield curves are typically associated with periods of positive economic growth, this reversion to a normal yield curve is consistent with the ongoing economic recovery.

The Real Effective Exchange Rate (REER) appreciated by 3.5 percent in H1 2021, partly due to higher domestic inflation relative to the inflation in Pakistan’s major trading partners.

While Non-Performing Loan (NPLs) ratios have moderated from recent highs, the quantum of NPLs is forecast to climb with the expected expiration of SBP relief measures in March 2021.

Findings from two waves of the Business Pulse Surveys (BPS) administered across Pakistan suggest that a nascent recovery is underway in the private sector. Businesses that had highlighted the steep impact of the COVID-19 crisis and a dismal outlook in the first-wave of the survey, administered over June-July 2020, reported improving conditions in the second-wave of the survey, administered in January 2021. While the general trend is reassuring, there is a case for cautious optimism, as many businesses are still in a vulnerable state and have low cash buffers to navigate further shocks.

Moreover, sales performance remains muted, having not recovered to pre-pandemic levels. The case for caution is given impetus by the fact that the country is now firmly in the midst of a third COVID wave. While the outlook was favorable at the time of survey administration, uncertainty remains high and the economic conditions facing businesses can quickly become adverse with significant implications, particularly for vulnerable firms. This uncertainty and choppy economic conditions have manifested themselves in recent weeks with the government re-imposing some of the restrictions it had lifted earlier.

The report noted that Pakistan’s missing merchandise exports are estimated at $61 billion. This results from comparing actual merchandise export levels with the potential that emerges from the estimation of a gravity model of trade. Given Pakistan’s observable characteristics in terms of economic size, level of development, remoteness, and factor endowments, it is estimated that Pakistan’s potential exports are at $88.1 billion, about 4 times the actual current level. This large gap between actual and potential exports, or “missing exports,” places Pakistan among the top quartile of the distribution of countries with missing exports. While this figure is striking, were Pakistan’s exporters to tap into that potential, the resulting export-to-GDP ratio would place the country at around the middle of the distribution of countries according to export orientation. To reach that point, Pakistan’s exports would need to grow at the same rate as Vietnam’s for 10 years, or 13 years at Bangladesh’s.

The opportunity cost of Pakistan’s “missing exports” is estimated at 893,000 jobs and $1.74 billion in foregone taxes. Of these, 152,000 jobs could be created in the agriculture export sector, and 741,000 jobs could be created in the manufacturing export sector.

To tap into the export potential, Pakistan needs to upgrade its trade policy framework. Specifically, it needs to: First, reduce the anti-export bias of tariff policy. Second, reorient trade enhancement schemes and third, negotiate market access with high potential destinations.

Increasing competitiveness and stimulating private investment will require: (i) further enhancing macroeconomic stability through fiscal and debt management reforms, and the maintenance of a market-determined exchange rate; (ii) improving the business environment through regulatory reform, implementing a harmonized GST regime, and reducing distortionary exemptions; improving energy sector performance, as well as providing transport and logistics infrastructure to support private sector growth and investments, and supporting the development of an efficient and transparent market for land to unleash efficiency gains from urbanization; and (iii) supporting competition by reducing the anti-export bias of trade policy.

“It is crucial to sustain the positive reform momentum to continue to boost the competitiveness of Pakistan’s economy and lay a strong foundation for a more robust, inclusive and sustainable recovery,” said Najy Benhassine, World Bank Country Director for Pakistan.

“Despite some recovery in the private sector, many firms remain vulnerable and require support to prevent closures and further job losses. Policy measures that prevent permanent firm closures and further job losses will contribute significantly to sustaining the recovery,” said Derek H. C. Chen, World Bank Senior Economist for Pakistan.

The policy measures that can be considered include enhancing private sector access to formal finance, in particular for Micro, Small & Medium Enterprises, streamlining regulatory and administrative requirements to ease compliance costs, and providing support to firms in digitizing and establishing an online presence.

Copyright Business Recorder, 2021