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Global Economic Outlook
Pakistan Outlook: The Politics of Fiscal Austerity
By Arpitha Bykere and Ayoti Mittra
- The IMF will continue to back Pakistan but will seek stronger fiscal tightening, which will boost inflation and reduce government popularity and political support.
- Remittances, portfolio inflows and foreign loans are critical for the current account to weather higher oil prices and falling FDI.
- U.S.-Pakistan relations are at a critical point, and there is little hope for a breakthrough in the India-Pakistan negotiations; meanwhile, extremists may continue to suppress the reformists.
Macroeconomic Dynamics: No Light at the End of the Tunnel
Pakistan’s GDP growth is on track to slow from 4.1% y/y in FY2009 to 2.5-2.6% in FY2010 (ending in June 2011), according to consensus estimates. After the 2010 floods caused US$11 billion worth of damage, Pakistan is coping with strained fiscal resources, handicapped infrastructure, insufficient agricultural and textile output and subpar textile exports. Biting inflation, elevated defense spending, reduced subsidies and acute power shortages will affect rural and urban wages, private demand, manufacturing activity and development spending. Meanwhile, the assassination of liberal political leaders in early 2011 has reignited security concerns, highlighting the government’s continued struggle in curbing extremist groups. According to consensus estimates, growth is likely to pick up to 3.5-4% y/y in FY2011, but several downside risks loom. In the coming years, Pakistan’s growth will remain below the average rate of 7.0% y/y recorded in 2004-07.
Pakistan’s current account and FX reserve position improved in 2010, and remittances—mostly coming from the less politically volatile United Arab Emirates and Saudi Arabia—may stay robust. However, stronger-than-expected global oil prices and an increase in domestic economic activity are likely to raise the import bill in 2011. This will increase Pakistan’s reliance on hot money inflows and IMF loan funding as FDI continues to decline owing to security and sovereign risks.
Policy Implications: IMF Loan a Necessary Evil
Inflation, despite easing since Q4 2010, will remain above 10% y/y in FY2011 due to Pakistan’s high oil import dependence, infrastructure shortages, government borrowings from the central bank and weak currency. Facing opposition challenges, falling popularity and rising inflation, the government has kept fiscal reforms gradual, with measures including electricity and fuel subsidy reductions, a GST tax hike and increases in income surcharges and excise duties. Moreover, weak growth has slowed revenues to a trickle, while spending on security, post-flood reconstruction and support for ailing state enterprises remains high. The fiscal deficit in FY2010 will reach 6-7% of GDP, breaching the IMF-mandated target of 4.7% and thereby delaying the disbursement of the remaining US$3 billion of the 2008 Stand-By Arrangement.
But given risks of economic crisis fueling political and social instability in a geostrategically important country, the IMF is unlikely to exit the loan program and will instead extend it beyond September 2011 (when it is scheduled to expire). The IMF loan is vital for Pakistan to attract foreign portfolio inflows and loans from the ADB and the World Bank. However, the IMF is likely to disburse additional funds only when Pakistan undertakes or promises to initiate necessary fiscal tightening measures, such as reducing subsidies and government borrowings and implementing tax reforms. Such reforms also could help Pakistan obtain a second loan from the IMF if growth prospects fail to improve in 2011-12.
- The Middle-Eastern countries allow Pakistan to delay oil import payments.
- Remittances, farm exports and portfolio inflows help finance a higher oil import bill.
- Political opposition to fiscal reforms delays IMF loan disbursement, while higher oil prices increase the current account deficit, posing risk to FX reserves and the external debt of oil companies.
- Rising food and oil prices and subsidy withdrawal increase public anger against the government and reduce the support of coalition parties, increasing political instability.
- Relations with the U.S. deteriorate.
- The security situation worsens, and extremists gain ground against reformists.
Figure 1: Fiscal Reforms and High Commodity Prices to Exacerbate Inflation in the Near Term
Figure 2: Current Account Deficit Financing (USD, millions)