Fiscal consolidation to ensure resumption of IMF SBA: World Bank report

Satisfactory expenditure containment and revenue collection from recent measures for fiscal consolidation, and a solid Finance Bill 2011 could pave the way for resumption of SBA or opening talks for a new IMF programme in the next fiscal year. The budget support from the World Bank remains dependent on setting up a satisfactory framework for economic stabilisation and recovery, a World Bank report revealed here on Wednesday.
The report titled,' Pakistan Economic Update 2011' says that the major concern of the economy remains the large fiscal deficit. A shortfall in fiscal revenues and an overrun on electricity subsidies and security spending led to the budget deficit widening in the first half of the fiscal year to 2.9 percent of GDP (more than 70 percent of the full-year target). Last January, the government estimated that unless urgent measures were taken, the consolidated fiscal deficit could go beyond 8 percent of GDP.
Then, last March, in an attempt to contain the deficit below 6 percent of GDP, the government announced some one-off tax measures (through presidential ordinances), removal of tax exemptions and zero ratings, measures to cut expenditure and also raised power tariffs and export growth and strong inflows of workers' remittances. As a result, the current account deficit fell from $3.9 billion (2 percent of GDP) in FY2009/10, to $748 million for the first 10 months of FY2010/11. Foreign exchange reserves increased to $14.1 billion by end-February 2011, from $13.0 billion at end-June 2010.
According to the report, progress on critical structural reforms, especially in tax administration and the energy sector, has been steadily progressing. Pending consensus on the proposed broad-based value added tax, the government decided to improve the existing General Sales Tax. , It recently removed several tax exemptions and launched several measures to improve tax administration, especially addressing large tax payers and tax evaders.
The government has increased power tariffs and registered circular inter-agency debt; and it aims to reduce inefficiencies by an ongoing process of appointment of new management boards in all electricity companies. However, power subsidies remain high due to delays in implementing these tariff adjustments and rising input costs, like fuel.
Together with other difficulties encountered by the sector, such as reduced allocations of the low-cost natural gas feedstock, these factors discourage investment by the private sector in electricity generation so that load shedding continues to be a critical constraint on growth.
The World Bank report reveals that the macroeconomic management in FY2010/11 has featured multiple weaknesses and policy slippage. Devastating floods during July-August 2010 added considerable strains to fragile economic conditions. The IMF-supported Stand-By Arrangement (SBA) went off track during this period due to a large fiscal expansion that, according to the Authorities, threatened to cause a budget deficit of 8.4 percent of GDP by end-FY2010/11. However, continued implementation of recently announced measures aimed at fiscal consolidation could pave the way for resumption of the SBA or talks for a new IMF program in the next fiscal year.
The report says that the agriculture sector of Pakistan, which provides 25 percent of the growth impetus, suffered a serious setback as floods damaged about one-fourth of the standing Kharif crops. Hence, it is unlikely that the agricultural sector will be able to achieve its targeted growth of 3.8 percent this year. Its recovery depends largely on the performance of the Rabi crops, particularly wheat.
Similarly, the large-scale manufacturing sector contracted by 1.8 percent during July-December 2010 compared to 1.6 percent growth in the same period last year, but turned positive in December 2010. This contraction was not unexpected as it was primarily driven by flood damage to agro-based industries, petroleum refining, and damage to the infrastructure.
The current account has shown substantial and unexpected improvement in first seven months of FY2010/11. The report shows that the total revenue collection during the first half of the fiscal year was only 5.9 percent of GDP (compared to 6.1 percent of GDP in the first half of FY2009/10). Federal tax collection continued to underperform during the first eight months of FY2010/11 compared with the government's reform programme and budget, growing by 10.3 percent instead of the 26 percent increase required to meet the budget target. All taxes performed below target.
Collection from direct taxes, sales tax, excises and customs duties grew by 5.8 percent, 13.6 percent, 14.9 percent, and 3.8 percent, compared to the required increases of 24.4 percent, 30.8 percent, 27.1 percent and 12.1 percent. According to the report, Pakistan's tax structure suffers from low buoyancy levels across the tax structure, which reveals the existence of narrow tax bases and a skewed tax structure.
For the period 1980-2010, tax buoyancy in Pakistan turns out to be about 0.93. This means that given an overall low response of tax revenues to economic growth there is continuous need for the government to introduce short-term discretionary measures (as the government did recently in a bid to narrow the growing revenue gap). Revenue collection during the current fiscal year was also harmed by floods directly in a slowing of economic activity and indirectly through federal and provincial governments' decisions to exempt flood-affected areas from collection of all taxes.
Power tariff increases and efforts to reduce sector inefficiencies were not enough to lower power-sector subsidies significantly. Monetary expansion has contributed to inflation. Increasing demand for credit by the government resulted in substantial monetary expansion of Rs 445 billion between July 1, 2010 and February 26, 2011 compared with Rs 295 in the same period last year Net Foreign Assets (NFA) of the banking system in that period increased by Rs 146 billion, in step with foreign exchange reserve build-up.
Overall government borrowing from the banking system for budgetary support in this time was high: Rs 325 billion. Due to a shortfall in domestic revenues and external financing, and over-shooting of budgeted expenditures, the government borrowed substantially from the State Bank. However, from December 2010 a clear downward trend in its cumulative borrowing is apparent while the inflationary pressures, already high at the beginning of FY2010/11, remained elevated.
According to the report, the government made persistent efforts to build consensus on introducing VAT. The economic team of the government engaged in intense dialogue with all parliamentary parties spanning over a month. However, the requisite support was not forthcoming.. However, the government promised to revisit the program next fiscal year and showed its commitment to broadening the tax base by eliminating major exemptions of recent years, except in the health sector.
The government has proposed amendments of the State Bank of Pakistan act 1956 (SBP Act) to assure monetary and financial stability by enhancing autonomy of SBP. The amendments were approved by the cabinet, and are scheduled to be tabled before the National Assembly.
Electricity subsidies continued to remain high during the first three quarters of 2010/11. In the 2010/11 budget, the government allocated Rs 134 billion (or 0.8 percent of GDP) for all types of budgetary subsidies, with almost two-thirds of this amount allocated to power sector subsidies. On the assumption of timely and full implementation of government's power sector action plan, the budget allocated only Rs 32 billion for tariff differential subsidy.
The report points out that the government has increased its estimate of power sector subsidies (for 2010/11) to around Rs 190 billion, of which Rs 143 billion is for tariff differential subsidy. Although later than expected, on March 15, 2011 the Government notified tariff increases of two percent for most household consumers, increased the fixed charges to industrial and commercial consumers and introduced a two percent surcharge on all consumers other than households using up to 300kWh per month.
Government liabilities to the power sector accumulated up to the end of 2008/09 (commonly called as the "circular debt"), amounting to Rs 301 billion were transferred to Power Holding Company, a government owned entity. The transfer of functions that were being performed by Pepco to the utility companies is expected to be completed by June 30, 2011.
Pakistan's public-debt-to-GDP ratio in FY2009/10 (excluding obligations to the IMF) stood at 56.8 percent, lower than 57.3 percent of GDP in FY2008/09, and within the limit of 60 percent specified by the Fiscal Responsibility and Debt Limitation Law. In 2009/10, 48 percent of the debt was external while 52 percent was held domestically. In FY2010/11, total public debt (excluding obligations to the IMF) is further expected to decline by about 2.5 percent to 54.3 percent. Including IMF obligations, total public debt-to-GDP ratio is also projected to decrease from the peak of 61.5 percent of GDP in FY2009/10 to around 58.6 percent in FY2010/11.
The report says that the devolution process after the 18th Amendment has been somewhat slow mainly on account of reluctance of provincial governments to accept federal employees of the devolved ministries. The provinces feel that they can discharge the devolved functions and deliver these services using their own staff. Given the weak provincial capacity, this reluctance has created concerns whether the provinces will be able to do justice with the devolved functions.