pakistan development update - world bank€¦ · islamic finance institutions mp market price adb...

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Pakistan: Actual and Trend Economic Growth, 1961-2015

PAKISTAN DEVELOPMENT UPDATE

October 2015

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Standard Disclaimer:

This volume is a product of the staff of the International Bank for Reconstruction and Development/ The World Bank. The findings, interpretations, and conclusions expressed in this paper do not necessarily reflect the views of the Executive Directors of The World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries

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Pak is tan Dev e lo pment Upd a te

Octob er 2015 THE WORLD BAN K

Table of Content

EXECUTIVE SUMMARY ......................................................................................................................................................... I

A. RECENT ECONOMIC DEVELOPMENTS ................................................................................................................ 2

I. Real Sector ......................................................................................................................................................................................................... 2

II. Fiscal Policy ....................................................................................................................................................................................................... 4

III. Debt Dynamics ................................................................................................................................................................................................. 8

IV. External Sector .................................................................................................................................................................................................. 9

V. Monetary Policy And Aggregates ................................................................................................................................................................. 13

VI. Inflation ............................................................................................................................................................................................................ 16

VII. Financial Sector Developments .................................................................................................................................................................... 18

B. OUTLOOK AND PROJECTIONS .............................................................................................................................. 21

I. Near-Term Outlook is Positive on Continuation of the Reform Momentum ..................................................................................... 21

II. There are Substantial External as well as Domestic Risks to the Outlook ............................................................................................ 23

C. PROGRESS ON STRUCTURAL REFORMS ............................................................................................................. 25

D. SPECIAL SECTIONS .................................................................................................................................................. 27

I. Why Investment is Low in Pakistan? ........................................................................................................................................................... 27

II. Fiscal Decentralization in Pakistan: Progress and Challenges ................................................................................................................. 33

III. Some Stylized Facts of Pakistan Economic Growth ................................................................................................................................ 39

IV. Federal Budget 2015/16 – Sectoral Analysis of Spending Priorities ...................................................................................................... 45

V. Fiscal Disaster Risk Assessment Report ..................................................................................................................................................... 51

VI. National Financial Inclusion Strategy .......................................................................................................................................................... 55



List of Acronyms

AAOIFI Accounting And Auditing Organization For Islamic Finance Institutions

MP Market Price

ADB Asian Development Bank MPC Marginal Propensity To Consume

AFI Alliance For Financial Inclusion MSME Ministry Of Micro Small And Medium Enterprises

AJK Azad Jammu And Kashmir MTBs Market Treasury Bill BE Budget Estimates NATO North Atlantic Treaty Organization BISP Benazir Income Support Programme NDA Net Domestic Asset CCI Council Of Common Interest NDM National Disaster Management CIB Credit Information Bureau NDMA National Disaster Management Authority CLL Concurrent List Of Legislation NEC National Economic Council CNG Compressed Natural Gas NER Nominal Exchange Rate CPCE China Pakistan Economic Corridor NFA Nat Foreign Asset CPI Consumer Price Index NFC National Finance Commission CRR Cash Reserve Requirement NFIS National Financial Inclusion Strategy CSF Coalition Support Fund NFNE Non-Food Non-Energy DFID Department For International Development NPLs Non-Performing Loan DNA Damage And Need Assessment NPS National Payment System DTA Digital Transaction Accounts OMO Open Market Operation EOBI Employment Old Age Benefit Institution PARC Pakistan Agriculture Research Council

ERRA Earthquake Reconstruction And Rehabilitation PASSCO Pakistan Agricultural Supplies And Shortage Corporation

ETPB Evacuee Trust Property Board PBA Pakistan Broadcasters Association EU European Union PDF Pakistan Development Fund FATA Federally Administrated Tribal Areas PDMA Provincial Disaster Management Authority FBR Federal Board Of Revenue PIB Pakistan Investment Bond FDI Foreign Direct Investment PKR Pakistan Rupee FDRA Fiscal Disaster Risk Assessment POL Petroleum, Oil, & Lubricants FIs Financial Institutions POS Point Of Sale FLL Federal Legislative List PPP Public-Private Partnership FPI Foreign Portfolio Investment PRA Punjab Revenue Authority FY Fiscal Year PRI Pakistan Remittances Initiative GB Gilgit Baltistan PSC Private Sector Credit GCR Global Competiveness Report PSDP Public Sector Development Program GDP Gross Domestic Product PSE Public Sector Enterprises GIDC Gas Infrastructure Development Cess PSO Pakistan State Oil GSP Generalized System Of Preferences PTA Pakistan Telecommunication Authority GST General Sales Tax Q1 First Quarter (Of The Fiscal Year) H1 First Half (Of The Fiscal Year) Q2 Second Quarter (Of The Fiscal Year) H2 Second Half (Of The Fiscal Year) Q3 Third Quarter (Of The Fiscal Year) HEC Higher Education Commission RE Revised Estimates HP Hodrick-Prescott REER Real Effective Exchange Rate IAP Insurance Association Pakistan RM Reserve Money IBA Institute of Business Administration ROA Return On Asset IC Implementation Committee ROE Return On Equity ICT Information And Communication Technology SBP State Bank Of Pakistan

IDB Inter-American Development Bank SECP Security And Exchange Commission Of Pakistan

IFI International Financial Institutions SME Small And Medium Enterprises IFS Internal Financial Statistics SOEs State Owned Enterprises IMF International Monetary Fund SPDC Social Policy And Development Center IPP-BNU

Institute Of Public Policy – Beaconhouse National University

SRB Sindh Revenue Board

IRC Interest Rate Corridor SRO Statutory Regulatory Order IT Information Technology TDP Temporary Displaced Persons



KIBOR Karachi Inter Bank Offer Rate TFP Total Factor Productivity KP Khyber Pakhtunkhwa UAE United Arab Emirates KSE Karachi Stock Exchange UBL United Bank Limited KYC Know-Your Customer UK United Kingdom LNG Liquefied Natural Gas USA United States Of America LSM Large Scale Manufacturing USD United States Dollar M2 Broad Money WA Weighted Average MDGs Millennium Development Goals WAONR Weighted Average Overnight Repo Rate MFB Micro Finance Banking Y-o-Y Year-On-Year MLT Medium And Long Term



Acknowledgement This Update was prepared by Macroeconomic and Fiscal Management Global Practice under the guidance of Shubham Chaudhuri (Practice Manager, GMFDR), Rachid Benmessaoud (SACPK) and Illango Patchamuthu (Country Director, Pakistan). Sector analyses were contributed by: Enrique Blanco Armas (Executive Summary and Progress on Structural Reforms), Saadia Refaqat and Mohsina Atiq (Real Sector), Mehwish Ashraf (Fiscal and Public Debt), Amna Sehar (Inflation), Muhammad Waheed (Balance of Payments, Monetary Aggregates, and Medium-term Outlook), and Sarmad Sheikh (Financial Sector Development). Special sections were contributed by: Muhammad Waheed (Why Investment is Low in Pakistan? And, Some Stylized Facts of Pakistan Economic Growth), Saadia Refaqat (Fiscal Decentralization in Pakistan: Progress and Challenges), Mehwish Ashraf (Federal Budget 2015/16 – Sectoral Analysis of Spending Priorities). Team would like to acknowledge the contributions from other Global Practices; A brief on Fiscal Disaster Risk Assessment Report by Haris Khan (GSURR) and, a section on National Financial Inclusion Strategy by Sarmad Sheikh (GFMDR) and Gabi George Afram (SACPK). This report has benefited from very useful comments from Deepak Mishra (GMFDR), Anthony Cholst (SACPK), and Shahzad Sharjeel (SAREC). Special thanks to Shabnam Naz (SACPK) and Anwer Ali (GMFDR) for their administrative support during the process. The overall effort was led by Muhammad Waheed (GMFDR).

I

Executive summary

A mild growth recovery is underway.

Pakistan’s economy posted GDP growth of 4.2 percent in FY2014/15 compared to 4.0 percent in the previous year, but below the 5.1 percent targeted growth envisaged for FY2014/15 in the Annual Plan. On the demand side, investment and government consumption posted strong growth. Private consumption was supported by record high remittances in the order of US$18.7 billion in FY2014/15. The share of investment in GDP remains relatively small, at 15.1 percent of GDP, about half of the South Asian average at 30 percent. More worryingly, private investment as a share of GDP has been declining and stood at 9.7 percent of GDP in FY2014/15. This low investment has implications for Pakistan’s long term growth potential that has been on a clear declining long run trend as discussed in special section III in this issue.

Lack of complementary public investments and a weak investment climate are constraining private sector investment.

Several factors are contributing to this low investment normal. Constrained fiscal space limits the government’s ability to make the necessary complementary public investments. In addition, inconsistent trade and industrial policies create disincentives for investors and contributes to weak business environment, as evidenced by Pakistan’s ranking in most international surveys dealing with this issue, like the Global Competitiveness Ranking. Another reason for the very low investment levels has to do with the low domestic savings rate in Pakistan at below 10 percent of GDP, which compares unfavorably with an average of around 25 percent in South Asia. Limited access to financial markets, high dependency ratio and low returns on financial instruments all contribute to this low rate of savings.

The services sector continues to be the main contributor to growth.

More than two-thirds of the economy’s growth came from the services sector, while industry and agriculture jointly contributed about one-third. In the agricultural sector, crop performance remained weak owing to prolonged adverse weather and two years of relatively low prices. In the industrial sector, the poor performance was primarily the result of weak growth in the large-scale manufacturing sector, which achieved growth of 2.4 percent against a target of 7 percent. Ongoing energy shortages, limited external demand and structural bottlenecks all constrained industry growth. The weak growth in the industrial sector also acted as a drag on related services sectors such as trade and communications, which also posted relatively slow growth. On the positive side, transport, finance and insurance and government services all posted strong growth.

Government efforts for fiscal consolidation continue, but progress is slower than anticipated.

The overall deficit for FY2014/15 was 5.3 percent of GDP, 0.3 percentage points higher than the revised estimates. The declining trend represents a break from the recent past, with deficits between 6 and 9 percent of GDP between FY2009-10 and FY2012/13. The reduction in the deficit was achieved through curtailing the federal development budget and above target non-tax revenues, while tax revenues continued to fall short of targets. Energy subsidies remain large, although lower oil prices have contributed to limiting the energy subsidy bill. Spending grew fastest at the provincial level due to post 7th NFC award availability of higher resources, and devolution of increased responsibilities (see special section II for a detailed discussion of Pakistan’s current Fiscal Decentralization Framework). Total public debt stood at 64.6 percent of GDP at the end of FY2014/15, a slight decline from the previous year. Domestic debt continues to dominate the debt stock, despite healthy disbursements by the IFIs, the continuation of the IMF program and the

I I

successful issuance of international bonds.

A narrowing current account deficit and large external financial inflows suggest a significant turnaround in the external sector, a key concern a few years ago.

The current account deficit narrowed to US$2.6 billion (from US$3.1 billion in the previous year), a result of record high remittances in the order of US$18.7 billion and inflows in the services account of Coalition Support Fund (CSF). Remittances are concentrated in oil producing countries (Saudi Arabia, UAE), the US and the UK. Remittances from oil producing countries may be negatively affected by low oil prices, but there are no sign of it yet. External financial inflows continued strong, although lower than in the previous year. This is despite very weak Foreign Direct Investment (FDI) inflows of 0.3 percent of GDP, the lowest in the last decade. As a result, the balance of payments was positive for the second year in a row and international reserves increased by US$4.4 billion to US$13.5 billion by end of FY2014/15 or more than three months of next year’s imports (goods and services). The turnaround on the external front has been quite impressive, which has also led international rating agencies to upgrade the country’s sovereign credit ratings in recent months.

The trade deficit widened, as non-oil imports increased due to improved economic activity.

Exports declined in FY2014/15 and this decline was broad based, a result of both low international prices of some of Pakistan’s export products as well as weak external demand. Textiles, which account for about half of all exports, posted a significant decline. Imports also declined, mainly due to lower international oil and commodity prices, although to a lesser extent than exports. Non-oil imports increased significantly, in particular metals, food, machinery and wood and paper products. As a result, the trade deficit widened in absolute terms.

Reserves buildup contributed to stability in foreign exchange markets, which contributed to low inflation.

As a result of the positive developments in the external sector, the Pakistan Rupee (PKR) remained largely stable with a small depreciation of about 3.0 percent against the US$ during FY2014/15. A relatively stable nominal exchange rate against the US$ and sharply falling inflation resulted in the REER appreciating by about 8.0 percent during the period under review, which affected the competitiveness of the tradable sector. Average inflation declined by around 4 percentage points to 4.5 percent in FY2014/15, its lowest level in a decade, the result of declining oil prices being passed on to consumers and a stable exchange rate. The decline in inflation was broad based, with both food and non-food items contributing to the deceleration in inflation.

Improved macroeconomic conditions allowed SBP to ease its policy stance during FY2014/15 while the government borrowed heavily from the banking sector.

The stability in PKR and the government decision to pass-on the benefit of falling international oil prices eased inflation considerably. All this allowed State Bank of Pakistan (SBP) to ease monetary policy through a cumulatively cut of its policy rate by 350 bps in FY2014/15. While reserve money grew by 9.9 percent in FY2014/15, broad money supply grew by 13.2 percent. Reserve money growth was influenced by government efforts to limit borrowing from the SBP. At the same time, broad money growth was driven by the government’s borrowing from the commercial banks to finance the deficit and reduce financing from the SBP. As a result, government borrowing from commercial banks expanded by PKR 1.3 trillion in FY2014/15, compared to PKR 0.1 trillion in the previous year.

Credit to the private sector remains sluggish – a combination of both supply and demand side conditions.

The private sector borrowed PKR 209 billion in FY2014/15, a decline from PKR 371 billion in the previous year. Structural bottlenecks as well as weak external demand constrained business activity and credit demand by the private sector. A relatively high real cost of borrowing as inflation declined at a much faster pace than lending rates also played a role in subdued private sector credit demand. The fast increase in borrowing by the government also tightened financing conditions –

I I I

which may have led to crowding out of private sector credit. The government has recently approved a National Financial Inclusion Strategy and started its implementation, which may help in reversing this trend. For a more detailed discussion please see section VI in this volume.

The financial sector remains strong with improving banking indicators and an upward trend in equity markets.

The banking sector achieved strong growth, driven primarily by increased government borrowing. Risk indicators such as the capital adequacy ratio have improved over the past year while profitability indicators also remain high. The equity market saw considerable investor interest in FY2014/15, despite both domestic and external turbulences, but the bond market continues to be dominated by government bonds. As in most of the world, capital markets have seen some volatility over the past few months.

Real GDP growth (at factor cost) is projected to register 4.5 percent in FY2015/16, reaching 4.8 percent in FY2016/17.

GDP growth is projected to accelerate to 4.5 percent in FY2015/16 and 4.8 percent in FY2016/17, supported by strong services growth and a slight improvement in the industry sector. This assumes that some of the constraints affecting the industry sector, like power outages, will be addressed in the forecast period. Investment is forecast to increase, given both greater fiscal space as well as an increase in private sector investment as the government’s reform agenda begins to bear fruit. Investments foreseen in the China Pakistan Economic Corridor will also contribute to an increase in investment.

External risks have increased – and despite recent reforms Pakistan has limited buffers to absorb major shocks.

External and internal balances are projected to improve. The current account will reach around 1 percent of GDP during the forecast period – as it will be supported by robust remittances and a continuation of external financial flows. Fiscal consolidation is projected to continue, and the Government has an ambitious target of reducing the deficit to 3.5 percent of GDP by FY2016/17. Debt levels are projected to remain in a slowly declining trend while reserves have already achieved more comfortable levels. But downside risks remains as a more volatile external environment going forward may result in lower financial inflows. The slowdown of the Chinese economy and slow recovery in the Euro zone will weaken external demand, affecting both trade and investment. Low energy prices benefit Pakistan in the form of lower energy subsidies and fuel imports – but it may eventually affect remittances, which have been crucial in financing Pakistan’s persistent trade deficit and supporting consumption.

Consistent implementation of the government’s reform agenda will be crucial to maintain macroeconomic stability and accelerate and maintain growth.

Fiscal consolidation will require strong tax revenue efforts by the government as well as gradual phasing-out of energy-related subsidies and of reduced support to loss-making SOEs. Efforts to tighten fiscal policy will also need closer coordination with the provinces, and ensuring that progress in the country’s decentralization effort better aligns the province’s responsibilities with the increased resource envelop that resulted from the 7th NFC award. Efforts to prevent major shocks to the government’s fiscal stance should also include reducing the fiscal risks of the frequent natural disasters affecting Pakistan – an issue discussed in detail in special section V. On the external side, it will be important to increase efforts to attract more FDI from the current low levels, by improving the overall business climate and address regulatory weaknesses at the sectoral level that may be affecting the country’s ability to attract investment. Continued implementation of the government’s reform agenda to address structural bottlenecks, in particular in the energy sector, will also be crucial to be able to attract more investment.

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A. Recent Economic Developments

I. Real Sector

Growth remained below Target, as Investment Lags

A mild recovery is underway.

Following a steady path of recovery, Pakistan’s economy registered a GDP growth rate of 4.24 percent in FY2014/15 compared to 4.03 percent in last year. Nevertheless, this performance was below the 5.1 percent targeted growth rate envisaged for FY2014/15 in the Annual Plan.

On the aggregate demand side, consumption remained the largest contributor to growth despite low growth in FY2014/15.

It is quite typical for consumption to be the largest component of aggregate demand, however, in the case of Pakistan, it constitutes a very large share of GDP at 90 percent1 and contributes 3 percentage points towards GDP growth (see Figure 1) 2,3. This high level has been driven by private consumption primarily on the back of sustained growth in home remittances over the years – which increased to a record high US$ 18.7 billion in FY2014/15 (discussed in detail under the External Outlook section). In the outgoing fiscal year, government consumption’s contribution to growth has also been strong (see Figure 2).

Figure 1: Contribution to GDP Growth – Aggregate Demand (percent change, y-o-y)

Figure 2: Consumption as Driving Force for Growth (Percent)

Source: Economic Survey of Pakistan 2014/15

Investment posted above average growth in FY2014/15 but investment levels remain among the lowest in South Asia.

The share of investment in GDP is relatively small, increasing from 15.0 percent of GDP in FY2013/14 to 15.1 percent of GDP in FY2014/15, driven by an increase in public investment. Private investment declined from 10.0 percent of GDP in FY2013/14 to 9.7 percent of GDP in FY2014/15 – the lowest level in the last three years. Pakistan has very low investment rates when compared with its peers in South Asia, with an average of 30 percent of GDP. A number of factors are responsible for this including (a) volatile security situation in the country which has only recently started to improve; (b) slow-down in the global economy, which is affecting foreign

1 Average for ten years (2005-2015) 2 Average for eight years (2008-2015) 3 A significant behavioral shift at the consumer level seems to be developing, as marginal propensity to consume has increased sharply overtime. In 2000s, the private MPC was almost 71 percent, and this increased to 97 percent by FY2010/11.

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Agriculture IndustryServices GDP Growth

direct investment and limiting domestic demand; and (c) energy shortages that limit full capacity utilization. Low investment level is one of the main challenges facing Pakistan’s economy today (also see special section I).

Low investment levels are also a result of a very low savings rate.

Pakistan’s savings rate, at 13 percent, compares with an average savings rate in South Asia of 23 percent (average for the past decade). Multiple factors account for this low level of savings in Pakistan, including limited access to financial markets, high propensity to consume, high dependency ratio and low real returns on financial instruments.

On the supply side, services sector continued to lead GDP growth followed by industry and agriculture.

More than half (2.91 percentage points out of 4.24) of the GDP growth came from services while industry and agriculture contributed 0.73 and 0.6 percentage points respectively (see Figure 3). Within agriculture, the overall crop performance remained weak (see Table 1), growing by only 1.0 percent4 owing to prolonged adverse weather and two years of relatively low prices. Agriculture was supported, however, by the livestock, forestry and fishing subsectors which grew at 4.1 percent, 3.1 percent and 5.8 percent respectively.

Figure 3: Sectoral Contribution to GDP Growth (percent) - Aggregate Supply

Table 1: Performance of Agriculture – Growth Rate (percent)

2011/12 2012/13 2013/14R 2014/15P

Cotton 18.6 -4.1 -2.0 9.5

Rice 27.7 -10.1 22.8 3.0

Sugarcane 5.6 9.2 5.8 -7.1

Wheat -6.9 3.1 7.3 -1.9

Maize 17 -2.7 17.2 -5.0

Source: Economic Survey of Pakistan 2014/15 Source: Pakistan Bureau of Statistics; P: Provisional; R: Revised

Performance in the industrial sector, which was targeted to grow at 6.8 percent, was disappointing as it only grew at 3.6 percent in FY2014/155.

The poor performance of industrial sector was solely on account of the Large-Scale Manufacturing (LSM) sector which achieved a growth rate of only 2.4 percent against an ambitious target of 7 percent. This target was based on expectations of an improvement in energy supplies and export demand from EU markets under the GSP Plus arrangement. The strong growth in automobiles sector (at 20 percent) and construction subsectors (at 19 percent) remained an exception. Lower than expected performance in other sectors dragged overall LSM growth down. A number of reasons explain this outcome: (i) continued energy constraints, (ii) limited external demand for textiles, (iii) decline in sugar crop production due to price disputes between sugar crop growers and sugar mills, and (iv) extraordinary growth in some subsectors like edible oil, Petroleum, Oil, & Lubricants (POL), and fertilizers in FY2013/14 meant that some form of growth slowdown was expected in FY2014/15. Within LSM, textile posted a cumulative growth rate of 0.5 percent in FY2014/15 compared to 1.5 percent in previous year and food posted a growth rate

4 Annual target was 3.3 percent while last year’s growth was registered at 3.2 percent 5 Compared to 4.5 percent in FY2013/14

4

of -1.0 percent compared to a healthy 8.4 percent last year.

Services sector grew by 5 percent in FY2014/15, compensating for the low growth in agriculture and industry.

With an 18 percent share in GDP, wholesale and retail trade subsector posted growth of 3.4 percent vis-à-vis 4 percent in FY2013/14 (see Table 2). This low growth was mostly due to a direct spillover effect of weak LSM and crop performance in the outgoing fiscal year. Similarly, transport, storage and communication grew by 4.2 percent in FY2014/15 compared to 4.6 percent in previous year mostly due to slowdown in communications while air transport and railways continued to grow steadily6. Growth in the services sector came from finance and insurance (6.2 percent, compared to 4.2 percent in the previous year) and general government services (9.4 percent compared to 2.9 percent in FY2013/14), on account of an increase in infrastructure spending and wages.

Table 2: Performance of Services – Growth Rate (percent)

Growth

Share within Services

Contribution to Growth

2011/12 2012/13 2013/14 2014/15P 2014/15P 2014/15P

Wholesale & Retail Trade 1.7 3.5 4.0 3.4 31.0 18.3

Transport, Storage & Communication

4.6 4.0 4.6 4.2 22.7 13.4

Finance & Insurance 1.6 8.3 4.2 6.2 5.3 3.1

General Govt. Services 11.1 11.3 2.9 9.4 12.7 7

Housing Services 4.0 4.0 4.0 4.0 11.5 6.8

Other Private Services 6.4 5.3 6.3 5.9 16.8 9.9

Source: Pakistan Bureau of Statistics; P: Provisional; R: Revised

II. Fiscal Policy

Fiscal Consolidation Remains on Track for the Second Consecutive Year

Fiscal consolidation continues, albeit at a slower pace than anticipated.

The overall deficit for FY2014/15 turned out to be 5.3 percent of GDP, 0.3 percentage points higher than the revised estimates, owing to provincial increased spending as well as tax revenue shortfalls. Nonetheless, the budget deficit declined slightly from 5.6 percent of GDP observed in the previous fiscal year. The past two years have been a break from the past four years (FY2009/10-FY2012/13) when the fiscal deficit has hovered above 6 percent of GDP7 (see Figure 4). This break has been a result of government efforts in tightening fiscal policy.

6 Railways posted a growth of 121 percent due to reduction in delays of passenger trains and increase in freight trains. Air transport grew by 27 percent as fuel prices plunged and operational efficiency was improved. 7 For FY2011/12, the deficit was a high as 8.8 percent of GDP.

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Figure 4: Fiscal Deficit ( percent of GDP)

Source: Ministry of Finance

FBR taxes continue to experience shortfall.

The budget target for tax revenues – 86 percent of total revenues – for FY2014/15 was set at PKR 2,810 billion, which was revised downward during the year. Provisional data points to a collection of PKR 2,594 billion – PKR 11 billion lower than the last revised estimate of PKR 2,605 billion – on account of FBR revenues, recording an annual growth of 14.2 percent viz.-a-viz. collection in the previous year8. Weak performance of sales tax (with 42 percent share in FBR taxes) as well as direct taxes (40 percent share) appears to be the reason behind this moderate growth (see Table 3). The underlying factors have been the decline in oil prices, historical low inflation, sluggish LSM sector activity as well as non-implementation of some revenue measures introduced at the time of budget that were challenged in court9. Consequently, in order to compensate for the shortfall resulting from these developments, the government implemented a number of additional tax measures10 during the course of the year. These additional measures have been able to only partially compensate for the shortfall in tax revenue. Despite these headwinds, the tax-to-GDP ratio increased from 10.5 percent in FY2013/14 to 11.0 percent in FY2014/15 – the increase coming from the federal government only. This has been possible due to some progress towards improving the efficiency and effectiveness of tax administration as well as phasing out of Statuary Regulatory Order (SRO) related exemptions.

8 Last year, the growth was 17.4 percent. 9 These measures included 5 percent income tax on bonus shares and Gas Infrastructure Development Cess (GIDC). The GIDC bill was only approved by the end of fiscal year, on May 22, 2015. The bill will not only authorize the government to continue collecting the GIDC, but will also provide retroactive legalization to the GIDC the government has been collecting since 2011. 10 These included raising GST rate on petroleum products from 17 percent to 22 percent and then to 27 percent, levying regulatory duties of 10 percent on imports of more than 300 items and imposing a 2 percent withholding tax on non-filer service providers & importers.

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Table 3: FBR Tax Collection

percent growth

PKR Billions (unless mentioned otherwise) 2012/13 2013/14 2014/15 2013/14 2014/15

Direct 736 884 1,029 20.2 16.4

Indirect 1,200 1,388 1,565 15.6 12.7

Customs 240 241 306 0.6 27.0

Sales Tax 841 1,002 1,089 19.1 8.7

Federal Excises 119 145 170 21.4 17.2

Total Taxes 1,936 2,272 2,594 17.4 14.2

Source: Federal Board of Revenue

Non-tax revenues declined compared to FY2013/14. They were nonetheless higher than budgeted, on account of healthy central bank profits as well as CSF monies.

Normalization of interest receipts from SOEs as well as lower energy-related proceeds contributed to a 7.7 percent decline in non-tax revenues in FY2014/15, recorded at PKR 913 billion (see Table 4). Last year, the circular debt settlement increased the revenues generated by SOEs considerably and thus, this year – without any such development – the revenues from SOEs reverted to its past normal trend. Moreover, collection in FY2013/14 was unusually high due to another one-off inflow from Universal Access Fund of the Telecommunication Ministry. In the outgoing fiscal year, the highlight has been the SBP profits that were to the tune of almost PKR 400 billion, 22 percent higher than those booked the previous year, mainly on account of successful divestment of government shares in commercial banks11. Moreover, defense receipts due to CSF12 proceeds were impressive and amounted to PKR 157 billion. Additionally, provinces showed notable effort towards non-tax revenue and collected PKR 76 billion in aggregate, higher than PKR 49 billion collected in the previous year.

Table 4: Non-Tax Revenues

percent growth

PKR billions (unless mentioned otherwise) 2012/13 2013/14 2014/15 2013/14 2014/15

Federal

Profits Post Office Deptt./PTA - 95 4

(96.1)

Interest (PSEs & Others) 12 66 14 468.3 (78.4)

Dividends 63 66 74 3.7 12.5

SBP Profits 220 326 399 48.3 22.3

Defense 180 117 157 (35.0) 34.0

Passport Fee 16 19 19 16.8 (1.2)

Development Surcharge on Gas 32 39 - 19.8 (100.0)

Discount Retained on Crude Price 15 41 10 163.0 (76.2)

Royalties on Oil/Gas 65 76 74 17.3 (3.1)

Others 41 96 87 133.8 (9.2)

Provincial 71 49 76 (30.7) 53.1

Total 717 990 913 38.1 (7.7)


Weak revenue Limited growth of expenditure as a share of GDP is solely due to curtailment of

11 In FY2014/15, three capital market transactions were completed: United Bank Limited, Allied Bank Limited and Habib Bank Limited; that were on the books of the central bank. 12 Coalition Support Fund (CSF) is reimbursement for logistic support provided by Pakistan to North Atlantic Treaty Organization (NATO) troops in Afghanistan.

7

performance compelled the government to rein in expenditure in order to reduce the fiscal deficit.

development expenditure. In absolute terms, total expenditure amounted to PKR 5,392 billion in FY2014/15, 7.3 percent higher than in FY2013/14. Recurrent expenditures were PKR 4,416 billion, 14.7 percent higher than those in FY2013/14, while development spending was 2 percent lower (see Table 5).

Recurrent expenditures exceeded budgeted amounts due to SOEs-related spending and interest payments.

Grants (other than provinces) grew by 11 percent due to realization of contingent liabilities and to support loss-making SOEs. Interest payments amounted to PKR 1,304 billion – a growth of 13.6 percent over FY2013/14 – and comprised 30 percent of current expenditures. This increase has largely been on account of changes in the domestic debt servicing schedule13. Moreover, defense spending was up by PKR 75 billion in view of increased requirements under the National Action Plan to combat terrorism and improve security situation in the country. Energy subsidies remain large, although lower oil prices have contributed to limiting the subsidy bill and a significant reduction from the past year

Table 5: Summary of Pakistan Fiscal Operations

percent growth

PKR billion (unless mentioned otherwise) 2012/13 2013/14 2014/15 2013/14 2014/15

Total Revenue 2,949 3,630 3,937 23.1 8.5

Tax Revenue 2,232 2,640 3,024 18.3 14.5

Federal 2,081 2,450 2,818 17.7 15.0

Provincial 151 190 206 25.8 8.3

Non-Tax 717 990 913 38.1 (7.7)

Federal 646 941 838 45.7 (11.0)

Provincial 71 49 76 (31.0) 54.3

Expenditures 4,816 5,027 5,392 4.4 7.3

Current of which: 3,660 3,852 4,416 5.2 14.7

Interest 991 1,148 1,304 15.8 13.6

Subsidy 305 336 265 10.2 (21.1)

Defense 541 623 698 15.3 12.0

Development Expenditure 777 1,136 1,113 46.2 (2.0)

Net lending 363 101 27 (72.2) (72.9)

Statistical Discrepancy 16 (62) (165)

Fiscal Balance (1,867) (1,397) (1,455) (25.2) 4.2

percent of GDP (8.3) (5.6) (5.3)

Memorandum items

GDP (nominal) 22,379 25,068 27,384


This time, unlike the previous year, provinces did not contribute to fiscal consolidation efforts of the federal government.

An increased spending role after the 18th Constitutional Amendment (see special section II for further details) is manifested in a growth of 18.2 percent for FY2014/15 for provincial recurrent spending, significantly higher than the 7.1 percent growth witnessed the previous year. Similarly, provincial development expenditures increased to PKR 499 billion from PKR 431 billion in the previous year, growing by almost 16 percent. As a result, provinces posted a small combined deficit of PKR 9.8 billion (or 0.04 percent of GDP) for FY2014/15 contrary to revised estimates that projected a surplus to the order of 0.5 percent of GDP. During the 7th NFC Award, this is the second time when provinces have posted a

13 PIBs, with 34 percent share, dominate the domestic debt. New issuance is typically launched at the start of a fiscal year and then the same issue is re-opened during all auctions of that year. As a result, the bi-annual coupon payments appear in January and July, eventually increasing the interest cost on domestic debt.

8

combined deficit.

To meet fiscal targets, the government had to significantly curtail federal development spending.

Federal PSDP was reduced to PKR 489 billion from a higher-than-budgeted revised allocation of PKR 542 billion. Nonetheless, the category underwent a moderate growth of 12.4 percent in FY2014/15. The non-PSDP development spending was cut to half (PKR 125 billion from PKR 270 billion spent in FY2013/14 due to phasing-out of one-off items14.

III. Debt Dynamics

As a Result of Continued Fiscal Consolidation, Public Debt Dynamics Continue to Improve

Total public debt marginally declined over the course of the year.

As of end-June 2015, total public debt stood at 64.6 percent of GDP15 as compared to the June 30, 2014 stock position of 64.9 percent (see Figure 5). In terms of its composition, domestic debt dominated the stock in line with the past trend. In fact, foreign currency public debt declined by 1.3 percentage points during the year and closed FY2014/15 at 19.1 percent of GDP despite healthy IFI disbursements, continued IMF program and successful launch of international Sukuk. This is primarily due to translational gain16 observed during most of the fiscal year.

Figure 5: Trends in Public Debt Figure 6: Government Auction Profile, FY2014/15

Source: State Bank of Pakistan and staff calculations Source: State Bank of Pakistan and staff calculations

Domestic debt was created using both long-term and short-term funding

Resultantly, government was able to retire some of its central bank borrowings thereby complying with the zero quarterly borrowing limit17. Domestic debt recorded an increase of PKR 1.3 trillion in the portfolio, thereby closing FY2014/15 at PKR 12.3 trillion (or 44.8 percent of GDP). The year started with a continued 14 The major being the Pakistan Development Fund receipts amounting to PKR 157 billion that were booked under this head. These proceeds were in fact bilateral grant monies. 15 The total public debt is still above the threshold of 60 percent stipulated under the Fiscal Responsibility & Debt Limitation Act 2005. 16 Translational gain observed during FY2014/15 implies the appreciation of US dollar against major currencies. In Pakistan, external loans are contracted in various currencies but disbursements are effectively converted into PKR. As PKR is not an internationally traded currency, other currencies are bought and sold via selling and buying of USD. Hence, the currency exposure of foreign debt originates from two sources: USD/other foreign currencies and PKR/USD. This two pronged exchange rate risk is called translational gain/loss. 17 Specified in the SBP (Amendment) Act, 1956.

58%

60%

62%

64%

66%

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

FY11 FY12 FY13 FY14 FY15

PK

R b

illi

on

External Domestic Public Debt to GDP (RHS)

FRDLA Threshold

-

500

1,000

1,500

2,000

2,500

3,000

Q1 Q2 Q3 Q4

PK

R b

illi

on

MTBs MTBs MTBs Target PIBs PIBs PIBs Target

9

avenues.

interest in PIBs18 facilitating the government to mop up proceeds comfortably above the pre-auction targets in the first half19. Market sentiments during the second half of FY2014/15 seemed to shift towards Market Treasury Bills (MTBs)20 in view of policy rate cuts and resultantly, the government started accepting offers over and above the targeted amount in these short-term papers; the main thrust of the market being in the 6-month and 12-month T-bills21. Nevertheless, scheduled banks’ interest in Pakistan Investment Bonds (PIBs), on top of MTBs, was intact in these last two quarters of FY2014/15 and the government was equally receptive (see Figure 6). This interest of the banking industry points toward the financial sector’s preference in risk-free sovereign instruments rather than investing in riskier ventures such as the private sector (also discussed in the Monetary Developments section).

There have been limited efforts to tap into savings in Islamic banks.

Despite huge deposits of idle liquidity parked in the books of Islamic banks22, efforts to capitalize on it have been diminishing over time. The last auction of the 3-year Government Ijarah Sukuk was held in June 2014 and a whole year has passed by without any new instrument coming to surface. Implementation of the plans to introduce short and medium-term Shariah-compliant papers will provide a level-playing field to the Islamic financial sector and diversify the existing financing mix of the government on domestic debt.

IV. External Sector

Foreign Exchange Reserves Position Continued to Improve

A narrowing current account deficit and healthy financial inflows are key contributing factors to an overall positive external outlook.

Notwithstanding lower capital and financial inflows compared to the previous year, a relatively modest current account deficit contributed to a positive overall balance of US$2.6 billion for FY2014/15 against US$3.9 billion in the previous year. Pakistan foreign exchange reserves build up continued, supporting stability in foreign exchange market (see Table 6).

Table 6: Balance of Payments Summary

(US$ billion) 2013/14 2014/15

i. Current account (A+B+C+D) -3.1 -2.6

A. Trade balance -16.7 -17.3

Export 25.1 24.1

Import 41.8 41.4

B. Services net -2.6 -2.8

of which: CSF 1.1 1.5

C. Income net -3.9 -4.6

D. Current transfers net 20.1 22.1

of which Remittances 15.8 18.7

ii. Capital and Financial A/c 7.4 5.4

of which: 18 Pakistan Investment Bonds – the MLT market debt instrument – with maturity points of 3, 5, 7, 10, 15, 20 and 30-years. 19 During Q2, on aggregate, acceptance of bids for PIBs was more than two times the auction target. 20 Market Treasury Bills – the short-term financing instrument – available in three tenors: 3-months, 6-months & 12-months. 21 Out of total acceptance in H2-FY2014/15, both constituted 41 percent share. 22 The Financing to Deposits ratio (Liquidity indicator of Islamic banking) went down from 54.3 percent in December 2009 to 40 percent by end-June 2015, exhibiting a build-up of liquidity in the Islamic banking institutions in recent years.

1 0

Direct investment 1.5 0.8

Portfolio investment 2.8 1.9

Other Investment Assets 0.2 0.1

Other Investment Liabilities 1.0 2.2

iii. Errors and omissions -0.4 -0.1

Overall balance 3.9 2.6

SBP reserves (excl. CRR, sinking fund) 9.2 13.5

Memorandum Items Current A/c Balance ( percent of GDP) -1.3 -1.0

Trade Account ( percent of GDP) -6.8 -6.4

Export growth percent 1.1 -3.9

Import growth percent 3.8 -0.9

Remittance growth percent 13.8 18.2

Financial & Capital A/c ( percent of GDP) 3.0 2.0

Source: State Bank of Pakistan

Several factors such as strong workers’ remittances and CSF inflows and on track IMF program contributed to this benign outcome.

The main factors contributing to an overall positive external outlook are (i) resilient growth in workers’ remittances — which more than offset the trade deficit; (ii) improved inflows in services account of Coalition Support Fund (CSF); and (iii) substantial capital and financial flows through successful issuance of Sukuk and new loans from IFIs. Official reserves reached US $13.5 billion at end-June 2015, covering about three months of imports of goods and services. Pakistani rupee slightly depreciated by 3.3 percent in FY2014/15. These positive developments have led the international rating agencies to upgrade the country’s sovereign credit ratings in recent months23.

External Current Account

The current account narrowed to 1.0 percent of GDP in FY2014/15 compared to 1.3 percent of GDP in FY2013/14.

Export performance was weak as it registered a decline of 3.9 percent in FY2014/15 over the previous year, compared to an anemic, albeit, positive growth of 1.1 percent in FY2013/14. Imports also declined mainly due to lower international oil and commodity prices (see Table 6). Nevertheless, trade deficit widened in absolute terms. As has been the case for five few years, workers’ remittances grew strongly, by average 16.2 percent, and reached an all-time high of US $18.7 billion—more than off-setting the trade deficit. This and strong inflows in services account of Collation Support Fund (CSF) resulted in overall current account deficit of US $2.6 billion—lower by about US $ 0.5 billion compared to FY2013/14.

The demand for non-oil imports in response to relatively improved economic activities has somewhat offset the favorable oil prices effect on overall import bill.

Imports witnessed a decline of 0.9 percent during FY2014/15 against 3.8 percent growth in previous year. This contraction was primarily due to declining petroleum group import bill – which declined by 17.8 percent (US $ 2.6 billion) during FY2014/15 compared to FY2013/14. Although the volume of petroleum imports also declined marginally, it was the price impact which caused the overall petroleum group’s import bill to fall. Nevertheless, the decline in oil imports was nearly neutralized by a significant rise in non-oil imports especially in metals, transport, food group and machinery24. Disaggregated analysis of prices and quantity effects reveals that volume impact outweighs the price effect for imported good except for soyabean oil.25

23 Moody’s and S&P have improved Pakistan’s outlook from ‘stable’ to ‘positive’ on 25th March and 5th May, respectively. 24 Rise in domestic construction activities particularly in the public sector projects, LNG terminal at Port Qasim, Faisalabad-Multan Motorway etc. were the main reasons behind a surge in metal group imports. 25 The exceptional rise in price of soyabean oil reflecting the increase in tariffs on soyabean oil import.

1 1

Slowing global economy and drop in international prices resulted in the exports contraction which more than offset the reduction in the import bill.

The decline in exports was broad based and all the exports groups experienced a decline with the exception of food group which posted growth of 3.6 percent on account of higher exports of fruits, vegetables, spices and meat. Rice is an important export for Pakistan which contributed around 46 percent in total food exports but suffered because of drop in international rice price. Despite a healthy growth of 24.3 percent in volume, value of rice exports declined by 3.4 percent.

The decline in exports is broad based.

The main contributors to the decline in export growth is the textile sector which accounts for about 56 percent in total exports; petroleum (naphtha and petroleum products); jewelry, leather products, engineering goods, furniture, cement and guar products. Overall decline in value of textile exports (by 1.0 percent) is mainly on account of decrease in low value added exports which declined by 9.8 percent due to structural bottlenecks and lower demand from China and Bangladesh26 – major buyers of Pakistani cotton yarn and fabric. The Generalized Schemes of Preference (GSP) plus status continued to infuse a positive impact on textile exports as high value added textile exports grew by 5.4 percent and somewhat diluted the negative impact of declining low value added textile exports (see Figure 7).

Figure 7: Growth in Value of Textile Export in FY2014/15


Current transfers (mainly workers’ remittances) continued to support current account.

During FY2014/15, current transfers increased to US $ 22.1 billion from US $20.1 billion in FY2013/14. This was mainly supported by increased workers’ remittances which posted a notable growth27 of 18.2 percent and reached US $ 18.7 billion. The significance of these workers’ remittances cannot be over emphasized as these finance almost 45 percent of the import bill (see Figure 8). Country wise data

26 China is faced with lower exports of its high value added products due to lower demand and recession in EU, therefore suppressing exports from Pakistan. Similarly Bangladesh is also faced with lower exports to US and supply chain issues which resultantly led to lower imports of fabric from Pakistan. 27 The key factors behind this growth are (i) increased numbers of workers going abroad, particularly skilled and qualified workers, (ii) enforcement of anti-money laundering legislation and (iii) implementation of Pakistan remittance initiatives (PRI) by the banking sector.

-30.0

-20.0

-10.0

0.0

10.0

20.0

30.0

Raw

Co

tto

n

Co

tto

n Y

arn

Co

tto

n C

loth

Co

tto

n C

arded

Oth

er Y

arn

Oth

er T

exti

le M

ater

ial

Kn

itw

ear

Bed

Wea

r

To

wel

s

Ten

ts,C

anvas

etc

.

Rea

dym

ade

Gar

men

ts

Syn

thet

ic T

exti

le

Mad

eup

Art

icle

s

Low Value-added High Value-added

1 2

shows that remittances from all major countries increased except the non–UK EU countries, which contributes only 2 percent in total remittance and hence have a negligible impact on overall volume and growth of remittances. The share of Saudi Arabia in overall remittances was the largest (31 percent); with the United Arab Emirates (23 percent), the United States (14 percent) and United Kingdom (12 percent) together contributing 80 percent in total remittances28. Further declines in oil prices could affect remittances by affecting economic growth in oil producing countries—which are the source of 65 percent of total remittance.

Figure 8: Worker's Remittances, a Main Stay for the Current Account


Capital and Financial Account

In FY2014/15, capital and financial account was in surplus, albeit US$ 2.0 billion lower than in FY2013/14.

The capital and financial account posted a surplus of US$ 5.4 billion against US$ 7.4 billion last year, mainly on account of few healthy inflows including issuance of US$ 1 billion worth of Sukuk bond in international market, loans from IFIs (including US$ 987 from IDB and US$ 364 million from ADB) and privatization proceeds — albeit relatively lower as compared to FY2013/1429. The surplus was 27 percent (0.7 percent of GDP) lower compared to FY2013/14 and continued to be driven by debt creating flows. FDI declined to 0.3 percent of GDP30 (US$ 0.8 billion) against 0.6 percent last year — reaching its lowest level over last few years (see Figure 9). Overall, official reserves reached US$ 13.5 billion by end-June FY2014/15 posting a significant increase of US$ 4.4 billion from FY2013/14 (see Figure 10).

28Remittances from Saudi Arabia, UAE, USA and UK grew by 19.1 percent, 35.3 percent, 4.93 percent and 4.92 percent respectively in FY2014/15. 29 During FY2013/14, there was a notable increase in financial inflows from Euro and Sukuk bonds sale proceeds, new loans from IFIs, spectrum auction fee, UBL divesture proceeds and grant receipt under PDF. 30 Apart from China’s direct investment in telecom sector and motorcycle industry, no significant contribution has been witnessed under direct investment in Pakistan.

15.0

20.0

25.0

30.0

35.0

40.0

45.0

3.0

6.0

9.0

12.0

15.0

18.0

21.0

FY

06

FY

07

FY

08

FY

09

FY

10

FY

11

FY

12

FY

13

FY

14

FY

15

perc

en

t

US

$ b

illi

on

Remittances As % of Imports (RHS)

1 3

Figure 9: Capital & Financial Account ( percent of GDP

Figure 10: SBP's Foreign Exchange Reserves - Month End Position (Billion US $)

Source: State Bank of Pakistan Source: State Bank of Pakistan

Reserves buildup continued to ease forex market expectation.

The PKR remained largely stable with a small depreciation of about 3.0 percent against the US$ during FY2014/15. A stable nominal exchange rate and sharply falling inflation resulted in REER appreciating by 7.9 percent during the period under review (see Figure 11).

Figure 11: Movement on Exchange Rate


V. Monetary Policy and Aggregates

Higher Budgetary Borrowing remains a Leading Factor behind Monetary Expansion

Improved macroeconomic indicators allowed SBP to ease its monetary policy stance aggressively during FY2014/15.

Strong workers’ remittance and CSF flows, and declining international oil prices helped contain current account deficit to 0.8 percent of GDP. This coupled with substantial inflows in capital and financial accounts resulted in a buildup in SBP’s reserves thereby infusing stability in the foreign exchange market. As a result, the PKR remained stable with a small depreciation of 3.3 percent against the US$ during the year. The stability in PKR and the government decision to pass-on the benefit of falling international oil prices eased inflation considerably. All this allowed SBP to ease monetary policy through a cumulatively cut of its policy rate by 350 bps

-0.7%

0.3%

1.3%

2.3%

3.3%

4.3%

5.3%

6.3%

7.3%F

Y05

FY

06

FY

07

FY

08

FY

09

FY

10

FY

11

FY

12

FY

13

FY

14

FY

15

FDI FPI Capital & Financial A/c

85.0

90.0

95.0

100.0

105.0

110.0

115.0

120.0

125.0

Jan

-14

Feb

-14

Mar

-14

Ap

r-14

May

-14

Jun

-14

Jul-

14

Aug-

14

Sep

-14

Oct

-14

No

v-1

4

Dec

-14

Jan

-15

Feb

-15

Mar

-15

Ap

r-15

May

-15

Jun

-15

NER REER

5.0

6.0

7.0

8.0

9.0

10.0

11.0

12.0

13.0

14.0

Jul-

14

Aug-

14

Sep

-14

Oct

-14

No

v-1

4

Dec

-14

Jan

-15

Feb

-15

Mar

-15

Ap

r-15

May

-15

Jun

-15

2.3 months of import coverage

3.3 months of import coverage

1 4

in FY2014/15.31

Movement in monetary aggregates were largely dictated by targets set in the government’s reform program agreed with the IMF.

While reserve money growth decelerated for the third year in a row to 9.9 percent in FY2014/15, broad money supply grew by 13.2 percent in FY2014/15, compared with 12.5 percent in FY2013/14. The behavior of reserve money was primarily influenced by measures to limit government borrowing from SBP. This, along with the outright sale of government securities to commercial banks, allowed the SBP to limit growth of net domestic assets (NDA) for all quarters of the year. While these measures have constrained growth in NDA, overall positive external balance allowed net foreign assets (NFA) of central bank to expand, albeit slower than in FY2013/14 (see Table 7). The current account balance narrowed slightly during FY2014/15; but limited FDI and capital and financial inflows led to a deceleration of NFA growth during the year, particularly with regards to the central bank.

Broad money growth was fundamentally driven by the government sector borrowing for budgetary support and commodity operations.

This is reflected in strong expansion in NDA of banking system which grew by 11.7 percent as compared to 9.1 percent in FY2013/14 (see Table 7). Although expansion in NDA is in line with the monetary easing during the year, a significant part of this growth came from the government sector instead of private sector. In absolute term, the government borrowed PKR 861.0 billion for budgetary finance from the banking system in FY2014/15, compared with PKR 303.0 billion in FY2013/14. Within the banking system, the government heavily relied on commercial banks not only to finance its budget deficit, but also to retire some of its borrowing from SBP. In addition, in a declining interest rate environment, banks were also keen to lock-in their funds in high yielding assets. As a result of this demand-supply dynamics, net government borrowing from commercial banks expanded by PKR 1,335 billion in FY2014/15 compared with only PKR 106.1 billion in FY2013/14.32

Table 7: Monetary Aggregates (Flow since end-June)

Flow

(PKR billion) 2013/14 2014/15

Net Foreign Assets 332 218

of which: SBP 357 239

Net Domestic Assets 778 1097

Government borrowing: 327 933

Budgetary borrowing 303 861

from SBP 197 -474

from Scheduled banks 106 1335

Commodity operations 25 72

Non-govt sector borrowing: 438 288

Private sector 371 209

Public Sector Enterprises 67 80

Other Items 13 -124

M2 1110 1316

Growth (YoY) 12.5 13.2

RM 326 282

Growth (YoY) 12.8 9.9

Currency in circulation 239.7 376.9

31 The newly introduced SBP target rate was set at 50 bps lower than the ceiling of the Interest Rate Corridor (IRC). This implies that main policy rate has declined to 6.5 percent. 32 The substitution of borrowing from central bank to commercial banks would entail higher “actual” debt servicing cost. Borrowings from central bank are virtually free as any interest earned by central bank is eventually passed on to Government as transfer of profits and becomes part of non-tax receipts.

1 5

Demand and Time Deposits 868.0 936.6

Source: State Bank of Pakistan,

Despite this easing, overall market liquidity conditions remained tight as indicated by overnight repo rates.

The government, as part of its economic reform program with the IMF, limited borrowing from the central bank, and instead resorted to increased borrowing from commercial banks. To ease these liquidity issues, SBP stepped up its liquidity injections through open market operations (OMOs). The volume of OMOs increased sharply with a continuous rollover of OMOs throughout the year (see Figure 12).33 This relatively tight liquidity conditions resulted in overnight rates close to Interest rate Corridor ceiling throughout the year (see Figure 13)

Fig 12: Liquidity Injections through OMOs (Billion PKR)

Fig 13: IRC and WA Overnight Repo Rate ( percent)


In addition to supply side constraints, there were several demand side factors that contributed to low off take of private sector credit.

The sharp fall in commodity prices and consequent reduced demand for working capital and trade financing loans during the year coupled with energy constraints remained key reasons behind this low demand for credit from the private sector. A relatively high real cost of borrowing as inflation declined at a much faster pace than lending rates also played a role in subdued private sector credit.34 Furthermore, constraints arising from structural weaknesses of the economy like power shortages, law & order, and weak external demand also played their role in curtailing overall credit demand.

Slow credit off-take in manufacturing sector dragged overall credit growth in private sector.

Out of overall private sector credit, private businesses borrowed PKR 180 billion during FY2014/15 compared to PKR 298 billion in FY2013/14. Sectoral analysis in Table 8 indicates that overall slowdown in credit offtake was most pronounced in manufacturing sector where it grew by only 4 percent in FY2014/1535 compared to 13 percent in FY2013/14. On the other hand, construction and ship breaking sectors registered an uptake in credit.

33 For H1-FY2014/15, SBP injected on average PKR 161 billion through OMOs. This increased on average to PKR 450 billion in H2-FY2014/15. 34 By end-June 2015, real weighted average lending rates in incremental credit was 5.44 percent. 35 This lower growth was fundamentally due to net retirement or slow off-take in textile, food and Beverage sectors.

-400

-200

0

200

400

600

800

1000

1200

2-J

ul-

14

21-J

ul-

14

29-A

ug-

14

1-O

ct-1

4

28-O

ct-1

4

28-N

ov-1

4

22-D

ec-1

4

19-J

an-1

5

9-F

eb-1

5

20-F

eb-1

5

6-M

ar-1

5

20-M

ar-1

5

1-A

pr-

15

20-A

pr-

15

7-M

ay-1

5

25-M

ay-1

5

22-J

un

-15

10-J

ul-

15

31-J

ul-

15

Mop-ups Injections

4.0

5.0

6.0

7.0

8.0

9.0

10.0

11.0

2-J

ul-

14

22-J

ul-

14

18-A

ug-

14

5-S

ep-1

4

25-S

ep-1

4

20-O

ct-1

4

12-N

ov-1

4

2-D

ec-1

4

22-D

ec-1

4

13-J

an-1

5

2-F

eb-1

5

23-F

eb-1

5

13-M

ar-1

5

3-A

pr-

15

23-A

pr-

15

14-M

ay-1

5

3-J

un

-15

24-J

un

-15

15-J

ul-

15

WAONR Ceiling of IRC

Floor of IRC SBP Target Rate

1 6

Table 8: Monetary Aggregates (Flow in PKR billion)

(PKR billion) 2013/14 2014/15

Loans to private sector businesses (a…+...h) 298.0 179.5

By sectors:

a. Agriculture 30.7 32.7

b. Manufacturing 187.2 68.4

Textile 43.2 -8.4

Wearing apparel, readymade garments -0.6 -0.3

Food products and beverages 97.5 15.3

Chemicals 20.2 17.9

Non-metallic mineral products -13.2 19.7

Leather -0.8 6.9

Others 40.9 17.2

c. Electricity, gas and water 49.8 -11.4

d. Ship Breaking 0.1 11.0

e. Construction -1.1 13.6

f. Commerce and trade 16.4 13.7

g. Transport, storage and communication 27.3 29.5

h. Others businesses -12.4 22.0


VI. Inflation

Inflationary Pressure Softened, supported by Falling Global Commodity Prices and Fiscal Consolidation

Inflationary pressure substantially eased during FY2014/15.

The average Consumer Price Index (CPI) inflation steadily declined by around 4 percentage points and reached 4.5 percent, its lowest level in a decade and well below its previous level of 8.6 percent in preceding year and annual target of 8.0 percent (see Figure 14). Similarly, year-on-year inflation exhibited a sharp fall particular from October 2014 onward mainly due to fall in global oil price, which was duly passed on to domestic consumers, and lower food prices (see Figure 15). Specifically, during Q1-FY2014/15, year-on-year inflation declined only marginally from the 8.2 percent to 7.7 percent by September 2014; after that it decelerated sharply in subsequent months and reached 2.1 percent in April 2014. Since then, it inched up slightly to 3.2 till June 2015.36

Fig 14: Average Inflation Trends (12-m moving average)

Figure 15: Y-o-Y Inflation in FY2014/15

36 This moderate trend continues to the first two months of FY2015/16 with y-o-y inflation falling to 1.7 percent in August 2015.

0.0

2.0

4.0

6.0

8.0

10.0

Trimmed Inflation

NFNE Inflation

Headline Inflation

0.0

2.0

4.0

6.0

8.0

10.0

NFNE Inflation

Trimmed Inflation

Headline Inflation

1 7

Source: Pakistan Bureau of Statistics Source: Pakistan Bureau of Statistics

The decline in inflation was broad-based with both food and non-food segments contributed to this easing.

During FY2014/15, year-on-year food inflation decelerated from 7.4 percent to 3.2 percent, whereas non-food inflation decelerated from 8.9 percent to 3.2 percent in June 2015. The decline in international oil prices, which was regularly passed on to domestic consumers, led to lower transportation cost, capping of piped gas tariffs and only minor increase in electricity tariffs37 that kept energy prices low38. Whereas, improved supply of commodities, particularly wheat and rice due to depressed exports, coupled with timely imports of certain food items, contributed to low food inflation during FY2014/15. Consequently contribution of food segment in Y-o-Y inflation fell drastically from Nov 2014 onwards (see Figure 16). Within the food group, the prices of perishable food items declined significantly as is evident from its current year index reduction to 2.2 percent against 11 percent last year owing to improved supply management of onion and tomato crops (see Figure 17).

Figure 16: Weighted Contribution in Y-o-Y Inflation Figure 17: Weighted Contribution in Y-o-Y Food Inflation

Source: Pakistan Bureau of Statistics Source: Pakistan Bureau of Statistics

Both measures of core inflation, non-food non-energy (NFNE) and 20 percent trimmed, gradually softened during the period.

Lower raw material prices, particularly cotton and steel, and restrained aggregate demand were the main reasons behind softening core inflationary pressure (Figure 14). Government’s fiscal consolidation and improved external accounts that kept exchange rate stable also helped in containing the underlying inflationary pressure during the year. Similarly, with the reduction in food and fuel prices, the growth in prices of majority of commodities included in core inflation, particularly in second half of the year, which has put downward pressure on core inflation.

The inflation outlook is benign with several factors contributing to easing of expectations.

Average headline inflation could pick up modestly in FY2015/16 to 5.0 percent due to base effects. Continuation of low crude oil prices also supports this trend. A possible adverse impact of prevailing low food prices on next year crops production, pick-up in aggregate demand on the back of historic low interest rates and weak performance of commodity producing sectors represent upside risks for inflation. Any upward adjustment in electricity and gas tariffs in the ongoing reform process also poses upside risks to inflation.

37 Electricity tariffs were increased by 1.79 percent in November 2014. 38 Contribution of energy sector in Y-o-Y inflation turned negative from December 2014 onward.

-2.0-1.00.01.02.03.04.05.06.07.08.09.0

Jul-

14

Aug-

14

Sep

-14

Oct

-14

No

v-1

4

Dec

-14

Jan

-15

Feb

-15

Mar

-15

Ap

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Jun

-15

Food Non-Food-Non-Energy Energy

-3.0-2.0-1.00.01.02.03.04.05.06.07.08.0

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1 8

VII. Financial Sector Developments

Heavy Government Borrowing continues to Drive Financial Sector Indicators and Crowd-Out Private Sector Credit

The banking system remains robust based on standard solvency indicators, with the capital adequacy ratio well over regulatory

requirements.

The key driver of this robustness has been a shift in risk behavior of banks from private sector loans to risk free government securities. The banking sector has achieved sizable growth, which is driven primarily by increased government borrowing. Commercial banks hold about PKR 4.99 trillion of government domestic debt as of May 2015, which is about 38 percent of total assets (see Figure 18). Furthermore, investments in government securities constitute approximately 90 percent of total banking system investments. As a result of zero risk rating of government debt for capital adequacy purposes, this significantly reduces risk weighted assets of the banking system. For purposes of comparison, the capital to total assets ratio has declined from 8.8 percent to 8.3 percent during FY2014/15, while the capital adequacy ratio has increased from 15.1 percent to 17.2 percent during the same period.

Profitability remains high with return on assets and return on equity of 2.7 percent and 27.5 percent respectively for the quarter ending in June 2015.

This positive trend has persisted but is expected to weaken on the back of an accommodative monetary policy stance which has reduced the policy rate by over 300 basis points in less than a year. As a result, the benchmark interest rate (6-month KIBOR39) dropped to 7 percent while the policy rate is at 6.5 percent at the end of June 2015.

Figure 18: Commercial Banks’ Exposure to Government Debt

Table 9: Selected Key Indicators of the Banking Sector

(PKR billion) June-14 June -15

Profit Before Tax ytd 113 171

Credit to Private Sector 3,729 3,937

(In percent)

ROA Before Tax 2.1 2.7

ROE Before Tax 23.5 27.5

Advances to Deposits Ratio 47.7 45.7

Liquid Assets/Deposits 60.6 69.5

Capital Adequacy Ratio 15.1 17.2

Gross NPLs to Loans 12.8 12.4

Net NPLs to Loans 2.9 2.7

6 month KIBOR 10.2 7.0


39 Karachi Inter-bank Offer Rate (KIBOR) serves as the bench mark for commercial lending.

2.0 2.7

3.6 3.9

5.0

26%

31%

36% 35% 38%

0%

5%

10%

15%

20%

25%

30%

35%

40%

0.0

1.0

2.0

3.0

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6.0

FY11 FY12 FY13 FY14 FY15

% o

f T

ota

l A

ssets

Go

vern

men

t D

eb

t (P

KR

tln

)

1 9

Compared to FY2013/14 when private sector credit grew by PKR 357 billion, the uptake of private sector credit has slowed down considerably in FY2014/15, growing by only PKR 195 billion.

One key highlight of FY2014/15 has been the increase in credit for long term investment purposes of PKR 127 billion compared to PKR 71 billion in FY2013/14. Non-performing loans (NPLs) remained stable at 12.4 percent of the overall loan portfolio. Given adequate provisioning, net NPLs continued to decline, reaching 2.7 percent in June 2015. Year on Year, NPLs in Small and Medium Enterprises (SMEs) decreased from 33.9 percent to 32.2 percent of all loans and NPLs in the consumer sector decreased from 12.4 percent to 10.6 percent (see Table 9).

Equity Market has seen Considerable Investor Interest, but the Bond Market is Still Dominated by the Government

The equity market has maintained an upward trend.

Despite reeling from multiple political shocks, Pakistan’s equity market retained its upward momentum during FY2014/15 (see Figure 19). The KSE-100 Index grew by 16 percent during FY2014/15 compared to 41 percent in FY2013/14, on the back of improving macroeconomic fundamentals and general investor confidence. Market capitalization grew to PKR 7.2 trillion out of which foreign investors represent 10 percent. The upward trend in turnover volumes and the KSE-100 index has primarily been driven by foreign portfolio investment, resilient corporate profitability, increasing forex reserve levels and increased confidence shown by international agencies. However, despite strong performance overall, the market is marred by high volatility which has manifested itself most recently during July-August 2015 when the market rose 3.9 percent in July but fell 5.9 percent in August.

Figure 19: KSE-100 Index and Volumes

Source: Karachi Stock Exchange

The bond market consists mainly of government debt, while the corporate bond market is looking towards local and international Islamic debt capital markets.

Since the introduction of Pakistan Investment Bonds in 2000, there has been an active interest in medium- to long-term government debt. The yield curve has shifted significantly over the past year due to a lower interest rate environment as well as expectations over the long term (see Figure 20). The yield curve also reflects expectations about the persistence of lower interest rates for up to 3-year tenors. Last year, these expectations only spanned a 1-year period. During FY2014/15, the sovereign bond market saw the issuance of US$ 2 billion worth of international bonds. In addition, US$ 1 billion was raised from the Islamic capital markets through Sukuk bonds. The Islamic bond market has shown promising signs in the

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nd

ex

Volume (millions) KSE-100 Index

20

domestic corporate debt market as well. The capital market regulator issued Sukuk Rules in February 2015 which are aligned with the Accounting and Auditing Organization for Islamic Finance Institutions (AAOIFI), thus aiming for better governance and larger appeal for international investors. Following the issuance of the rules, Karachi-based utility K-Electric sold US$ 216 million worth of seven-year Islamic bonds, the largest listed corporate Sukuk in the country.

Figure 20: Yield Curve


4.0

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July-14 September-15

21

B. Outlook and Projections

I. Near-Term Outlook

Economic growth is expected to accelerate slightly over the next two years as macroeconomic indicators improve and the reform momentum continues.

The outlook for Pakistan’s economy is supported by relatively low inflation, particularly low oil prices, and continuous fiscal consolidation. Reforms are expected to continue and support easing of energy constraints and improvements in the economy’s competitiveness. Nonetheless, this outlook is subject to substantial external and domestic risks. Investment levels remain low given weak investors’ confidence. Removing infrastructure bottlenecks, especially in energy, will be crucial to accelerate growth and its long-term sustainability. Security situation, though improved, still affects growth prospects negatively.

Figure 21: GDP Growth Forecast—Gradual Increase to Continue amid Improving Fundamentals and Limited Increase in Investment

Source: Data from Pakistan Economic Survey and World Bank staff estimates


Real GDP growth (at factor cost) is projected to register 4.5 percent in FY2015/16, reaching 4.8 percent in FY2016/17.

GDP growth during FY2015/16 is projected at 4.5 percent of GDP (compared to 4.2 percent in 2014/15), below the authorities’ estimate of 5.5 percent (see Figure 21). On the supply side, economic growth would be driven largely by services sector which comprises more than half of the economy. Agriculture sector, which is one-fifth of the economy, is expected to grow at about 3 percent in FY2015/16 (see Figure 22). Given forward linkages of the agricultural sector, improved performance would support growth in the industry and services sectors also. Agricultural income also provides critical support for domestic demand. The industrial sector is expected to grow at 4.4 percent, lower than the official target of 6.4 percent. Services, which has been a main stay for growth in the last few years, is expected to grow at about 5.2 percent in FY2015/16.

3.6

3.8 3.7

4.0 4.2

4.5

4.8

3.0

3.5

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5.0

FY11 FY12 FY13 FY14 FY15 FY16P FY17P

Real GDP growth, at constant factor prices

14.1

15.1 15.0 15.0

15.1 15.1

15.4

13.5

13.8

14.1

14.4

14.7

15.0

15.3

15.6

FY11 FY12 FY13 FY14 FY15 FY16P FY17P

Total Investment (in percent of GDP)

22

Figure 22: GDP Growth Forecast is underpinned by Slow Growth in Investment, Aided by Consumption Growth; Consistent Services Sector Growth will be Crucial for Overall Growth



Several factors are constraining industrial growth.

Dampened international demand, and falling output prices have been some of the key constraints for major industries such as textiles. Power sector has remained under pressure due to lower capacity utilization amid build-up of inter-corporate circular debt.40 The outlook assumes that some of these issues will be resolved in the medium term, given government efforts in that respect.

Household consumption growth is expected to expand along with economic activity.

Low inflation environment due to low commodity prices will support higher household consumption. Nevertheless, for households in the agriculture sector, the impact is not clear given that many will be net food sellers. State Bank of Pakistan Consumer Confidence survey indicate an improved sentiments about the future during FY2015/16. In addition, recent aggressive monetary policy easing may have a positive lagged effect on overall consumption through higher spending on durables in the medium term.

Increase in investments is predicated on the implementation of (CPEC) and other infrastructure projects.

Investment to GDP ratio is expected to grow from 15.1 percent in FY2014/15 to 15.4 percent in FY2016/17 (see Figure 21). Despite constrained fiscal space, government is allocating significant resources for the public sector development program. The public sector development program will be supported by investments in energy and transport infrastructure foreseen in the China Pakistan Economic Corridor (CPEC). Materialization of the planned government investment in energy and infrastructure and improvement in security conditions are expected to encourage private sector investment going forward.

Current account deficit is projected to register 1.0 percent of GDP by FY2016/17 and will be supported by robust

The trade deficit will widen in the near term but continued remittance inflows are expected to finance much of it. Exports are projected to contract by half a percent in the first year owing to tapered global demand and then grow marginally the following year. Imports, however, are projected to post moderate growth due to CPEC-related investments and higher domestic demand. The slowdown of the Chinese economy and slow recovery in Euro zone will weaken external demand,

40 Essentially, the term refers to cash-flow problems in the power sector that arise due to the factors like non-payment of electricity bills by consumers (public and private), transmission losses, and delays in subsidy payments.

0.0

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20.0

Private Consumption

Government Consumption

Gross Fixed Capital Investment

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Agriculture Industry Services

23

remittances in the near term.

more than compensating for the potential positive impact of an acceleration of growth in the US. A stable exchange rate and weak commodity prices will also limit the import bill. The impact of low oil price will remain a dominant factor on the overall import bill. The circular debt in the energy sector, which will limit PSO’s (largest oil market company) liquidity, and new regulatory duties are also among the factors restricting imports growth.

Fiscal consolidation is expected to continue.

Fiscal consolidation is projected to continue over the medium term on the assumption of strong tax revenue efforts by the government as well as gradual phasing-out of energy-related subsidies and of contingent liabilities on loss-making SOEs. Resultantly, the fiscal deficit (including grants) is expected to decline to 4.2 percent of GDP in FY2015/16 and to 3.5 percent in the subsequent fiscal year. Accordingly, reduced deficit financing will facilitate provision of bank credit to the private sector, leading to increased economic activity.

Under the baseline scenario, inflationary pressures are likely to remain contained.

In the short to medium run, inflationary pressures are expected to remain subdued. It is expected that inflation would remain around 4-5 percent as international commodity prices (especially of crude oil) are expected to stabilize at a new lower normal. A stable PKR against US$ positively influence expectation of businesses (since movements in the US$-PKR parity directly influence price setting by private sector businesses). The recent IBA-SBP’s Consumer Confidence Survey trends indicates lower inflationary expectations for the months ahead). The 1.8 percent YoY monthly inflation in July, 2015 (the lowest since August, 2003) is the continuation of the declining trend in CPI inflation in FY2015/16 as well. However, the supply disruption of perishable food items due to seasonal floods and a possible hike in the electricity and gas tariffs by the government pose up-side risks. In addition, recent monetary easing may result in higher aggregate demand which may also result in inflation uptick.

II. Risks to the Outlook

Recent slowdown in China and weak recovery in the EU represent to have some downside risks for external side.

Recent slowdown in China and a weak recovery in the EU may have direct and indirect impact on Pakistan’s exports. First is the direct impact on trade, stemming from both demand effects and exchange rate effects. China constitutes 10 percent of Pakistan’s exports (roughly US $2.2 billion). Competitiveness of the textiles sector, accounting for more than half of all exports, may be affected by recent appreciation of the real effective exchange rate and compensate for slight improvements in competitiveness otherwise. Remittances are expected to remain at current high levels, but a further weakening of prices may negatively oil-producing countries where a large share of the remittances originate.

Underperformance in revenue collection may pose downside risk to fiscal consolidation.

On the fiscal side, realization of tax revenue targets largely hinges upon the steady implementation of the tax reform agenda. Fiscal consolidation may also be negatively affected by delayed implementation of the government’s privatization agenda. Public sector investment is expected to increase as a result of official Chinese government support to the CPEC. Should the slowdown in China affect the level of this support, public investment may be negatively affected. Deviation from targeted budget deficits may force government to increase its financing from commercial banks which may continue to crowd out private sector credit.

Structural Investment seems to be recovering only slowly, despite improvements in the

24

bottlenecks continue to pose downside risks.

economy’s macroeconomic fundamentals. For economic growth to accelerate and be sustained, key growth constraints like electricity shortages, cumbersome business climate, complex trade regime, low access to finance and security situation need to be addressed.

Any adverse shock in overall economic performance can affect vulnerable

population.

High degree of vulnerability to poverty remains a substantial challenge. A very large share of households are clustered around the poverty line and are a shock away from falling back into poverty. Reliance on remittances and low commodity prices to improve the lives of the poor and vulnerable is therefore a risky strategy. Sustainable poverty reduction requires investment and job creation within the economy, as well as efforts to substantially raise agricultural productivity, by building value chains, improving technology adoption and reducing exposure to uninsured climate risks.

25

C. Progress on Structural Reforms

After a strong focus on macroeconomic stability over the past two years – Pakistan needs to continue making progress in the structural reforms agenda.

Over the past two years, Pakistan has successfully implemented an economic reform agenda with a strong focus on achieving external and internal balance. Aided by a narrowing current account and strong external financial inflows, the external balance has been positive over the past two years and international reserves have steadily increased to reach over 3 months of imports. The fiscal deficits have also declined – although by less than programmed, and debt levels are now in a downward trajectory. Growth has also accelerated, but it remains well below potential at 4.2 percent in FY2014/15. Investment remains low, and more worryingly private sector investment has declined as a share of GDP over the past few years. It will be important for the country to now focus on a reform agenda that accelerates growth and investment and ensures its sustainability.

The government continues with its ambitious reform agenda in the energy sector.

Reforming the energy sector continues to be a top priority as the private sector continues to be plagued by power outages. The poor performance of the energy sector also inhibits much needed private sector investment in the sector and generates significant fiscal outlays, in the form of energy subsidies and the accumulation of circular debt that will ultimately have to be financed through the budget. The reform program is laid out in the new energy policy approved in July 2013. The policy foresees (i) adoption of a new tariff pricing formula, (ii) improved operating efficiency and reduced losses within power distribution companies, (iii) increased efforts to attract private sector investment to the sector, including the privatization of a number of companies (both distribution and generation). In the past year, the Government has implemented surcharges and adjusted prices with the objective of achieving full cost recovery from consumers. The Government has also developed a mechanism to monitor the accumulation of arrears in the sector (circular debt) and adopted a plan for reducing the accumulation of arrears. This plan includes the improvement of collections and reduction of operation costs and losses (through revenue-based load management) and adoption of performance contracts to improve management of the distribution companies. The Government is also implementing a number of demand-side measures with regards to pricing, metering-infrastructure and adoption of equipment standards for improved energy efficiency and conservation. On the supply-side, the Government is improving the fuel-mix in electricity generation, continues to invest and attract investment in generation, transmission and distribution infrastructure. There are a number of large investments planned in the energy sector over the next few years (including through the CPEC) that will add significant generation capacity.

Increasing tax revenues remains high on the government’s reform agenda – and despite significant revenue growth performance continues to be below targets.

Pakistan has one of the lowest tax to GDP ratios in the world. The Government adopted relatively ambitious targets to increase revenues from below 10 percent to 14 percent in only five years. The reform is laid out in the tax reform strategy adopted in February 2014 and a 3-year plan for phasing out SRO-based tax exemptions in July 2014. The Government has started to implement this ambitious reform agenda, including the elimination of a large number of SRO-based exemptions and the authority to grant tax concessions or exemptions has now been transferred to parliament. The Government is also implementing a series of measures to automatize and streamline business processes, enhance tax administration through broadening the tax base and improving compliance, enforcement and market analysis. At the same time as broadening the tax base, the Government is also increasing efforts to improve governance and reduce corruption in tax administration. With the devolution of authority over a number of taxes to

26

the provincial level, it is becoming increasingly important to enhance capacity at the provincial level. Provinces have now authority over services sales taxes, property taxes and agricultural income taxes, all taxes with significant revenue potential which is currently not being exploited. Despite these efforts – tax collection continues to be below targets, suggesting the need to maintain the focus on this reform area and to accelerate efforts as appropriate.

Private investment continues to be very low – and more worryingly seems to be on a declining trend.

Despite a more stable macroeconomic environment and government broader efforts to attract investment, private investment is now on a declining trend, falling below 10 percent of GDP in FY2014/15. FDI is also on a declining trend, and at 0.3 percent of GDP is the lowest in a decade and among the lowest in South Asia (for a discussion on the reasons for such low levels of FDI and investment more broadly see special section I). To reverse this trend, the Government of Pakistan adopted in October 2014 a plan to improve the investment climate. The reform plan covers a broad range of issues to improve the investment climate, including measures to improve (i) business start-up and registration, (ii) dealing with construction permits, (iii) accessing credits, (iv) tax administration, (v) trade facilitation, and (vi) contract enforcement. The Government has implemented a series of reforms over the past few years, including the establishment of one-stop-shops, started the implementation of a comprehensive tariff reform to improve trade competitiveness and the preparation and adoption of a financial inclusion strategy in early 2015, which includes the preparation and passing of a number of key laws including the Credit Bureau Act, the Secured Transactions Law and the Deposit Protection Fund. A number of reforms are under the responsibility of provincial authorities. To improve the business environment at the subnational level, the Federal Government is enhancing coordination with provinces and developing province-level implementation plans to improve the business environment.

27

D. Special Section

I. Why Investment is Low in Pakistan?

Pakistan’s investment to GDP ratio is low and declining.

Pakistan has immense potential for profitable investments, considering its strategic location and prospective market size. Despite this potential, the investment-to-GDP ratio has consistently remained lower than other economies in the region; more troubling is the declining trend of this ratio in recent years that reached a 35-year low by end FY2013/14 (See Figures 23). Persistently low level of investments has constrained growth potential. Hence, whenever the economy experienced demand-driven boosts, macro-economic imbalances emerged in the form of inflation, higher imports and current account deficits. This section discusses some of the reasons behind chronically low investment rates in Pakistan.

Figure 23: Investment Trends in Pakistan (in percent)

Source: Pakistan Bureau of Statistics

Low public investments have been unable to remove infrastructure bottlenecks.

The empirical literature does not provide a clear evidence of the impact of public investment vis-à-vis private investment in Pakistan—the crowding-in phenomenon. However, less-than-desired public investment in important sectors like infrastructure, energy, human capital and transport, has clearly been weighing heavily on the country’s growth prospects, as suggested by the latest Investment Climate Analysis prepared by the World Bank in 2009, which, among other constraints for private sector development, highlighted the quality and availability of infrastructure, particularly energy. Gas and power shortages have become the norm, and the country’s performance in logistics lags behind most developing countries (see Table 10).

0.0

5.0

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25.0

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1991

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Investment to GDP ratio 10 Year Average

28

Table 10: Logistics Performance Index (ranking among 160 countries)

Overall Customs Infrastructure

International shipments

Logistics quality and competence

Tracking and tracing

Timeliness

Singapore 5 3 2 6 8 11 9

Malaysia 25 27 26 10 32 23 31

China 28 38 23 22 35 29 36

South Africa 34 42 38 25 24 41 33

Indonesia 53 55 56 74 41 58 50

India 54 65 58 44 52 57 51

Pakistan 72 58 69 56 75 86 123

Source: Haver Analytics,

Pakistan’s low investment will place it at a disadvantaged position among peer countries going forward.

Emerging economies typically focus on better infrastructure—road,

transportation, energy—to attract and facilitate private investment. As shown in

Figure 24, investment-to-GDP ratio in Sri Lanka, Bangladesh, Thailand

Cambodia, and India has remained higher than in Pakistan in the last 10 years.

More worrying is the fact that during the last 5 years, this ratio has declined to

even lower levels despite huge infrastructure needs. Pakistan’s domestic savings

rate, which hovers around 10 percent of GDP for the last decade, limits the scope

to increase investment.

Figure 24: Investment to GDP ratio


Limited fiscal space is partly to blame for the low public investment level.

One of the major reasons for low public investment in Pakistan has been the limited

fiscal space due to low tax revenues—a legacy of suboptimal tax structure—and

high current expenditures, leaving limited space for public investments. Current

expenditures exhibit structural rigidities due to large debt servicing cost and

significant amount of subsidies, e.g. in FY2014 public investment to resolve the

energy crisis amounted to PKR 115 billion, while energy subsidies amounted to

PKR 309 billion on the same year. Another implication of high fiscal deficit is its

financing through borrowing from commercial banks. This has effectively crowded

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Bhutan China Nepal India Sri Lanka Bangladesh Pakistan

1980s 1990s 2000s 2010s

29

out private sector from the credit market (see Figure 25). 41 In fact, commercial

banks overall deposit increased by PKR 1,100 billion during FY2014/15 while

government borrowing from commercial banks increased by PKR 1,335 billion,

effectively squeezing private sector from credit markets. Pakistan’s long-term debt

market is not developed, and lack of depth in financial markets is a constraint to

undertake large-scale projects.

Figure 25: Government vs Private Sector Credit (PSC) as % of GDP—Crowding Out


A relatively shallow financial market is unable to fulfill long term investment needs.

Banking sector deposit to GDP is about 32 percent at end June 2014. Most of these deposits are of shorter maturity (Table 11) creating a mismatch between commercial banks assets and liabilities. This clearly hampers the ability of banks to advance longer term advance which are generally required to make capital investment. In addition, private corporate debt market is in its early stages with very few companies able to issue long term certificates to finance new investments or expansions. Out of total 122 listed term finance certificates up till end February 2015, only 20 are outstanding so far. A total of PKR 135 billion were raised of which PKR 30 billion is outstanding. With this limited success, investors have limited options to finance long term investments.

Table11: Banking Sector Deposits by Term of Maturity (percent)

Fixed

Current/Call Saving < 6 months

>6 & <1 years

1 to 2 years 2 to 3 years 3 to 4 years

4 to 5 years >

5years

Jun-08 27 41 14 5 7 1 2 1 3

Jun-09 29 39 14 4 9 1 1 1 2

Jun-10 29 39 14 3 10 1 1 0 2

Jun-11 31 38 13 4 10 0 1 0 3

Jun-12 31 39 12 3 11 0 1 0 2

Jun-13 32 41 11 3 9 0 1 0 2

Jun-14 37 39 10 3 8 0 1 0 2


The Public-Private Where governments cannot directly finance infrastructure projects, these collaborate

41 Overall deposit of commercial Banks increase by PKR1100 billion while government borrowing from commercial banks increased by PKR1335 billion during FY2014/15.

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Government Borrowing (Stock) PSC (Stock)

30

Partnerships (PPP) framework needs to be strengthened.

with the private sector. All over the world, the private sector goes hand in hand in financing the requirements for strategically important sectors like energy, transport, telecom and water & sewerage. The private sector can also bring improved management skills to the operation of infrastructure services. Table 12 below shows that Pakistan has a relatively small number of projects where it successfully reached financial closure. In terms of amount, Pakistan attracted about US$ 35 billion in PPP compared to US$ 338 billion by India and about US$ 500 billion in Brazil over the past 25 years. Not only is Pakistan quite behind other emerging economies in terms of number of projects; but more importantly, the distribution is skewed towards one sector. A major reason for low private participation in Pakistan has been due to a weak legal framework, which outlines the modus operandi of private sector involvement in financing and operating infrastructure facilities.42 The provinces are seeking to fill this void, with Sindh and Baluchistan provincial assemblies passing a public-private partnership bill in 2010 and Punjab and Khyber Pakhtunkhwa passing such a bill in March 2014.43

Table 12: Sector-wise Number of Projects reaching Financial Closure in Public Private Partnership (1990-2014)

Total Projects

Airport Electricity Natural Gas Railroads Roads Seaports Telecom Water and Sewerage

Pakistan 83 1 63 2 0 0 8 9 0

India 847 7 356 5 8 387 38 37 14

Brazil 748 17 407 17 19 72 53 36 128

Russia 337 8 102 3 2 3 11 186 23

China 1204 17 323 199 15 139 74 4 433

Mexico 240 6 46 31 8 70 28 15 37

Source: http://ppi.worldbank.org/

Lack of coherent and consistent industrial and trade policies are impeding investors’ confidence.

Inconsistencies in policies for different sectors over time have dented investors’ confidence. Incidents like the Independent Power Producers-Government stand-off in the late 1990s; litigation over Reko Diq mining lease; contract enforcement issues with Engro Fertilizer; and, frequent changes in Compressed Natural Gas (CNG) policy have affected the interest of potential investors in Pakistan. Government capacity in terms of designing and analyzing investment agreements, including in terms of forecasting demand and supply, needs strengthening. Investments that need uninterrupted gas supplies (e.g. fertilizer) are now facing operational constraints given gas shortages. The lack of coherence in the country’s trade and industrial policies has also played a key role in reducing industrial investments. More specifically, tariff policies have not been supplemented by a comprehensive industrial strategy to improve the competitiveness of local firms. Entry in some sectors is difficult. Burki (2008) observed that industrial policies were made either as part of medium-term development plans or in response to some crisis the country was facing. He states that, “the frequent changes in industrial policy have kept the industrial sector relatively backward compared to the developments in other large Asian economies”.

42 Financing infrastructure and development projects in Pakistan has over the years been made directly from budget allocations; therefore there is a lack of institutional and regulatory capacity, which is necessary to facilitate private participation in infrastructure provision. 43 Source: Provincial Assembly of Sindh (http://www.pas.gov.pk/index.php/acts/details/en/19/127); Provincial Assembly of KP (http://www.pakp.gov.pk/2013/acts/the-khyber-pakhtunkhwa-public-private-partnership-act2014/);

http://ppi.worldbank.org/

http://www.pas.gov.pk/index.php/acts/details/en/19/127

http://www.pakp.gov.pk/2013/acts/the-khyber-pakhtunkhwa-public-private-partnership-act2014/

http://www.pakp.gov.pk/2013/acts/the-khyber-pakhtunkhwa-public-private-partnership-act2014/

31

Foreign investors have better options available elsewhere.

Foreign Direct Investment (FDI) has been declining over a number of years and compared to other countries’ performance is a point of concern.44 (see Figure 26) FDI is also highly concentrated in a small number of sectors and countries of origin. In the last 15 years almost 60 percent of FDI went to three sectors: oil and gas exploration, communications and financial business. Such high concentration means that negative developments in these sectors can have a disproportionate impact on overall FDI, e.g. the law and order situation in the exploration areas has deterred FDI in oil and gas exploration45 which has dragged down overall FDI in the country. In terms of sources of FDI, the US, UK and UAE jointly contribute on average 60 percent of total FDI making Pakistan highly vulnerable to economic conditions or changing perceptions of investors in these countries.

Figure 26: FDI as percentage of GDP


Pakistan’s share in overall global investment flow is low and falling.

The Inward FDI Performance Index46 measures the amount of FDI that countries receive relative to the size of their economy (GDP). A value greater than 1 suggests that the economy has received more FDI relative to its economic size, while a value below 1 suggests that it has received less FDI. The inward FDI performance index for Pakistan suggests that over the years, the country has lost momentum in attracting FDI. In contrast, some other countries in the group have either stabilized or improved (see Table 13). Initially, the fall in FDI flows to Pakistan was considered to be in line with global trends as most of the countries in the region were facing similar declines. However, while the FDI flows to a number of peer countries have stabilized or resumed recently, they continued to fall for Pakistan.

Table 13: Inward FDI Performance Index

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Pakistan 0.62 0.87 1.07 1.04 1.23 0.7 0.52 0.26 0.22 0.3

India 0.47 0.42 0.73 0.59 1.24 1.29 0.73 0.79 0.71 0.75

Bangladesh 0.42 0.61 0.4 0.24 0.41 0.34 0.37 0.39 0.56 0.54

Bhutan 0.73 0.35 2.73 0.07 0.54 2.73 0.88 0.59 0.64 0.55

Sri Lanka 0.66 0.52 0.58 0.53 0.63 0.46 0.44 0.69 0.87 0.71

Nepal 0 0.01 -0.03 0.02 0 0.15 0.24 0.22 0.28 0.21

44 FDI in FY2014/15 stood at US$ 642 million against US$ 1,541 million in FY2013/14. 45 Many of exploration blocks are adjacent to FATA and in Baluchistan province) 46 It is the ratio of a country´s share in global FDI flows to its share in global GDP.

1.3

2.5

3.3 3.1

2.2

1.2

0.7

0.3 0.5 0.6

0.2

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15

32

Indonesia 0.43 1.36 0.46 0.45 0.62 0.44 0.88 0.95 1.19 1.09

China 1.82 1.48 0.89 0.67 0.81 0.9 0.87 0.71 0.79 0.68

South Asia 0.58 0.52 0.67 0.54 0.99 1 0.63 0.64 0.62 0.63

Developing Economies

1.78 1.45 1.15 1.1 1.28 1.46 1.39 1.24 1.53 1.45

Source: Data from IFS and staff calculations

Business environment needs improvement.

Pakistan’s poor global ranking in business environment remains one of the key

reasons that the country has not been able to attract sufficient investment. Almost

all global indicators regarding governance and competitiveness show that Pakistan is

far below compared to its regional peers (see Table 14). Efforts to improve the

governance and the country’s investment climate should improve Pakistan’s ability

to attract investment.

Table 14: Comparison of Global Competitiveness Ranking and Governance Index

Global Competitiveness Rankings (2013/14)* Governance Indicators (2014)**

Overall

Ranking Institut

ions Infrastruc

ture Macro

Environment Political Stability

Govt. Effective

ness

Regulatory Quality

Rule of Law

Control of Corruption

Pakistan 133 123 121 145 0.95 23.44 24.88 20.85 17.7

India 60 72 85 110 12.32 47.37 33.97 52.61 35.89

Bangladesh 110 131 132 79 7.58 22.49 20.57 22.75 20.57

Bhutan 109 44 87 109 70.14 64.59 13.88 59.24 77.99

Sri Lanka 65 54 73 120 26.07 45.93 47.85 46.45 51.67

Nepal 117 127 144 41 14.22 18.18 22.01 26.07 29.19

China 29 47 48 10 27.01 54.07 42.58 39.81 46.89

Source: Data from IFS and authors’ calculations

How to exit from low investment horizon?

There is an immediate need to bolster investors’ confidence on the economy.

Government reform efforts in privatization, removal of energy bottle necks, and

simplifying and making tax laws more transparent are all steps in the right direction.

But perhaps more needs to be done to revive overall investment activity especially

FDI. Just facilitating foreign investors without making efforts to revive domestic

investment may not yield the desired results. It will be unrealistic to expect foreign

businesses to invest in Pakistan when its own private sector is not investing. This

regime should ideally be designed in such a manner that motivates and induces

industries to invest, innovate and reinvest. Improvements in the investment climate

will also need public investments in infrastructure and improved logistics.

33

II. Fiscal Decentralization in Pakistan: Progress and Challenges

The 18th Amendment promulgated in 2010 is viewed as the most comprehensive attempt at constitutional reform since the 1973 Constitution was adopted by Pakistan.

Amongst other political reforms, the amendment sought to increase provincial autonomy and restore the fiscal relationship between the center and provinces. It abolished the Concurrent List of Legislation (CLL)47 and reassigned the functions to provincial governments (except electricity) and also made changes in the Federal Legislative List (FLL)48 with a view to increase provincial influence. Resultantly, the provinces gained complete control over all public services within their jurisdiction and control over all local government institutions. The center mostly retained functions relating to natural resources, electricity, communications, and regulatory frameworks and cross border relationships of trade and finance.

The Amendment and the 7th NFC Award that preceded it also sought to expand the resource envelope of the provinces in order to respond to the larger service delivery mandate.

For one, provinces were given authority over sales tax on services, considered to be a dynamic and buoyant tax (estimates for Pakistan suggest it could yield revenues of 0.5 percent to 1.0 percent of the GDP). In addition other taxes such as those on immovable property, estate and inheritance, and zakat and usher (religious taxes) were reverted back to the provinces. The NFC Award of 2009 was also considered a significant milestone in terms of altering the distribution of resources between the center and the provinces. It broke from the past and introduced a multifactor formula that included not just population share but also poverty, inverse population density and provincial tax effort. Overall share of the provinces was also increased from 47.5 percent to 56 percent in the first year of NFC Award (2010/11) and 57.5 percent in the remaining years of the Award (see Table 15).

Table 15: The 7th NFC Award (2009) for Federal Divisible Pool Transfers to Provinces

Total Pool 56%-57.5% of the following sources of Federal revenues: Personal and corporate income taxes, wealth tax, sales tax, excise duties on tea, tobacco, sugar, betel nut and other excises.

Formula for provincial allocation

Population – 82% weight Poverty – 10.3% weight Provincial tax effort – 5% Inverse of Provincial Population density – 2.7% weight

Provincial shares In Population Punjab: 57.4% Sindh: 23.7% KPK: 13.8% Baluchistan: 5.1%

Provincial Shares in NFC Allocation: Punjab: 51.7% Sindh: 24.6 KPK: 14.6% Baluchistan: 9.1%

Source: Retrieved from Devolution in Pakistan-Fourth Annual Report by IPP-BNU, 2011

The reform process augmented the influence of

The 18th Amendment strengthened the Council of Common Interests (CCI), a Constitutional body entrusted with decision making, monitoring, supervision and control over matters included in the Federal Legislative List Part II49, by including

47 The CLL was introduced as part of the 1973 Constitutional Amendment that listed responsibilities shared by the federal and provincial governments to allow an interim period before these responsibilities are fully entrusted upon the provinces. 48 The FLL consists of two lists – Part I and II. The former contains functions allocated exclusively to the Federal government while the latter consists of subjects which are a joint provincial and Federal responsibility under the Council of Common Interests (CCI). 49 This list was expanded through the 18th Amendment and now includes the following: railways, minerals, oil and natural gas, hazardous materials, industrial policy, electricity, major ports, Federal regulatory authorities, national planning and economic coordination, supervision and management of public debt, census, provincial police powers beyond

34

provinces in the fiscal institutional framework.

the Prime Minister as the Chairperson and requiring the Council to meet at least once every ninety days (see Table 16). In addition to the CCI, the composition of the National Economic Council (NEC) was altered to increase representation of the provinces and remove discretionary powers of the President in terms of its composition (see Table 17).

Table 16: Changes in the Composition of CCI due to 18th Amendment

Table 17: Changes in the Composition of NEC after the 18th Amendment

Before After

Chief Ministers of the Provinces

Equal number of members from Federal government (Prime Minister will be the Chair if he/she is a member; otherwise a Federal minister nominated by the President)

Prime Minister (Chair)


Three members from Federal government

Before After


One member from each province nominated by the President on recommendation of provincial government



One member from each province nominated by Chief Minister

Four other members as the Prime Minister may nominate from time to time

Source: The Constitution of the Islamic Republic of Pakistan 1973, The Ideal Publishers, Karachi, 2011

Source: Retrieved from Devolution and Social Development-SPDC Annual Review 2011/12

Roadmap of Devolution

The reform process was steered by an Implementation Committee (IC) set up at the Federal level comprising of members of Parliament representing the leading political parties of Pakistan.

The IC expired on 30 June, 2011 and the role of resolving outstanding issues has now been passed on to the Council of Common Interests (CCI). A 2014 report by Jinnah Institute estimates that a total of 201 functions, institutions and organizations were to be devolved to the provinces, re-allocated within the Federal government, or abolished as a result of this process. Of these, 103 functions ended up being devolved, while other were abolished or retained at the Federal level. Seventeen Federal ministries/divisions, mostly relating to social sectors were abolished while eight new ministries/divisions were created to manage retained functions in devolved subjects (SPDC 2012).50 The reforms affected functions of 61,000 Federal employees of which approximately 15,000 were transferred to the provinces whereas the remaining were placed either in the surplus pool or temporarily deputed under Section 10 of the Civil Servants Act.

A key area of contention was the various vertical programs51 in devolved social sectors.

Provinces were reluctant to take ownership of these initiatives thus the CCI directed the Federal government to continue supporting several such programs till 2014/15. The budgets of top three programs during 2014/14 were PKR 11 billion for National Program for Family Planning and Primary Health Care, PKR 3.6 billion for the Population Welfare Program Punjab, and PKR 2.8 billion for Expanded Program on Immunization. The Federal government also retained several autonomous bodies and attached departments where mandates overlapped between the center and the provinces, such as the Higher Education Commission (HEC), Pakistan Agriculture Research Council (PARC), Pakistan Agricultural Supplies and

provincial boundaries, legal, regulation of legal, medical and other professions, standards in education and research, interprovincial coordination and conflict resolution. 50 Social Policy and Development Centre. (2011). Social Development in Pakistan Annual Review 2011/12. Karachi: Social Policy and Development Centre. 51 In Pakistan, Federal financing of provincial projects has been an important instrument of fiscal equalization, Vertical programs refers to such programs.

35

Storage Corporation (PASSCO), and the Planning Commission.

Fiscal Implications for Federal and Provincial Governments

The 7th NFC Award and 18th Constitutional Amendment aimed to strengthen the federation through increasing fiscal autonomy of the provinces, increasing their share in revenues, and expanding their role in public service delivery.

The goal of fiscal decentralization is to improve the efficiency of public service delivery by increasing the agency of provincial governments in determining development priorities and raising revenues. A review of fiscal trends at the provincial level reveals that some progress is being made towards realizing the goals of decentralization. However issues of political economy and capacity continue to create challenges.

Fiscal Trends at Provincial Level in Post 18th Amendment Period.

During 2010/11 to 2014/15 – as a result of changes introduced by 7th NFC Award in terms of divisible pool of taxes52 – almost PKR 865 billion additional resources have been shared with the provinces (see Figure 27) when compared to a continuation of the 6th NFC Award. To understand whether this increase in resources translated into achieving decentralization objectives, it needs to be looked into where these additional funds went.

Analysis of provincial finances shows that the additional resource transfer to the provinces has largely been directed towards higher recurrent spending rather than development.

In the period 2010/11 to 2014/15, growth in recurrent expenditure was 27 percent whereas development expenditure grew at 15 percent in real terms. While there is need to increase the proportion of budget for development projects, it is encouraging to see a shift towards service delivery in development priorities of the provinces in the post reform period.53 Social services now has the largest share in provinces’ overall development budget at 29 percent (see Figure 28) in contrast to pre-NFC period when infrastructure related subjects received the highest budgets (such as transportation/construction and agriculture/irrigation). Moreover, provincial social service spending over the four years of 7th NFC Award have risen by 45 percent.

On the revenue side, provincial revenue collection indicators

This increase is largely driven by the reversion of GST on services to the provinces and thus does not translate into increasing the national resource pie. Provinces need to focus on strengthening own revenue collection effort to contribute to expanding

52 Which included increasing the vertical share of the province, increasing the divisible pool pie, etc. (see section 1.4 of full policy note for details). 53 According to Global Competitiveness Report (GCR) 2014/15, quality of road infrastructure in Pakistan is ranked at 75 out of 144 countries, while India is and Bangladesh are ranked at 76 and 117 respectively. Similarly for quality of port infrastructure indicator, Pakistan is ranked at 59 while India and Bangladesh are ranked at 76 and 93 respectively. However, Pakistan ranking in social sector indicators drops in comparison to the regional peers. For example, infant mortality indicators of GCR ranks Pakistan at 137 out of 144 countries compared to 115 and 104 ranking for India and Bangladesh respectively. On quality of education indicator, Pakistan is ranked at 119 out of 144 countries compared to 88 and 108 ranking for India and Bangladesh. For infant mortality indicators, Pakistan is ranked at 137 out of 144 countries compared to 115 and 104 ranking for India and Bangladesh.

36

0

300

600

900

1200

1500

2009/10 2010/11 2011/12 2012/13 2013/14

Divisible pool transfers (6th NFC proj. post2009/10)

Divisible pool transfers (7th NFC actual)

PK

R

0% 20% 40% 60% 80% 100%

2009/10

2010/11

2011/12

2012/13

2013/14

Shares

Interest Subsidies General Admin.

Law & Order Social Services Others

have improved significantly during the period, increasing from 0.23 percent of GDP to 0.32 percent of GDP.

the country’s small revenue base. Effectively tapping tax bases such as agricultural income and immovable property could help raise provincial revenues equivalent to nearly one percent of the GDP.

Figure 27: Enhanced Divisible Pool Transfers as a result of Change in the Award

Figure 28: Provincial Current Expenditures : Shares of Major Expense Categories (2009/10- 2013/14)

Source: 6th NFC estimates are based on staff calculations Source: Based on staff estimates

Weak capacity at the provincial level made spending these additional resources challenging.

As a result, provinces generated sizeable surpluses during 2010/11 (first year of the Award), and recent two years. While this has helped alleviate the federal deficit at the national level, which has been under pressure during this period (discussed below), improving absorption capacity of provinces is important if objectives of decentralization are to be fully realized.

Table 18: Provincial Own-Tax Revenues (real terms)

(PKR billions) 2009/10 2010/11 2011/12 2012/13 2013/14 2014/15

Actual

Budget Estimate

Up to Q3

Punjab 18.4 16.8 20.6 35.3 41.2 64.8 28.9

Sindh 13.3 14.2 29.5 31.1 33.8 42.1 27.1

K-PK 1.4 1.8 1.8 1.9 5.0 7.6 3.1

Baluchistan 0.6 0.5 0.5 0.5 1.2 1.4 0.8

Pakistan 33.9 33.4 52.4 68.8 81.2 115.9 59.9

% of GDP 0.23 0.18 0.26 0.31 0.32 0.40 0.22

Memo: GDP (mp) 14,867 18,276 20,047 22,379 25,068 29,078 27,384

Note1: * Collection responsibility taken over by SRB of Sales Tax on Services in 2011/12. ** Collection responsibility taken over by PRA of Sales Tax on Services in 2012/13. *** Collection responsibility taken over by KPK of Sales Tax on Services in 2013/14. Note2: The premise of 7th NFC Award was to increase the overall tax-to-GDP ratio to 15 percent while increasing the provincial taxes to 1.15 percent.

Source: Ministry of Finance (Fiscal Operations)

Fiscal Implication for the Federal Government

The post 18th Amendment period has been particularly

Not only have the reforms created a significant squeeze on the Federal government’s resources, they have also coincided with a period of higher pressure on spending due to higher security related operations, energy crisis and the

37

challenging for the Federal government.

accumulation of circular debt, and other unforeseen events such as the floods in 2010, 2011 and 2014. Fiscal deficit of the consolidated government remained high for four years subsequent to the 7th NFC Award and 18th Amendment, before finally declining to 5.3 percent of GDP in FY2014/15.54

The fiscal imbalance was partially exacerbated by a decrease in Federal resources due to lowering of its share in Federal tax revenues (at a ceiling of 42.5 percent)55 without a corresponding decrease in its responsibilities.

Best practice in devolution recommends “finances follow function” i.e. functional decentralization should precede redistribution of resources. The sequencing of reforms in Pakistan has led to fiscal challenge since the 7th NFC Award (higher resource transfers) preceded the 18th Amendment (transfers of responsibilities). As a result, provinces disassociated the link between the two reforms. They had already committed additional resources to increase current expenditures before the Amendment was promulgated, leaving little room for assuming responsibilities in devolved areas. The Federal government’s budget during 2010/11 for current expenditure in devolved subjects (ministries/divisions) stood at PKR 22 billion (excluding the HEC) and should have converted into savings for the Federal government. However, no savings materialized as:

66 percent of anticipated savings went towards the 8 new ministries created to manage retained functions and inter-provincial coordination;

Most of the staff in devolved ministries/divisions remained on the federal government’s payroll;

Nearly 16 vertical programs in health and population continued to be funded by the Federal government with a fiscal implication of almost PKR 18 billion per annum.

The fiscal challenge at Federal level are likely to continue as the current vertical sharing arrangement i.e. the 7th NFC Award has been extended for another year by the President.

Unresolved Issues

There are numerous issues which remain unresolved as a result of the decentralization process.

This include, the fate of several state institutions such as the Higher Education Commission, Employment Old Age Benefit Institution (EOBI), Workers Welfare Fund, and Evacuee Trust Property Board (ETPB), amongst others, remains undecided and are being contested in the Supreme Court by provincial and federal governments. Issues of ownership and revenue sharing in oil and natural gas sectors also remain outstanding. These pending issues need immediate attention and focus.

Conclusion and Way Forward

The 18th Constitutional Amendment must be seen as an important first step in a broad based agenda for reforms in the multi-order governance system in Pakistan.

Countries which have successfully integrated it within their governance systems have done so over decades of consistent effort. Moreover, Pakistan also needs to correct its mistake in sequencing of the devolution process i.e. for finances to follow functions. Currently the process in Pakistan appears to be evolving organically instead of strategically. To ensure Pakistan makes progress on the agenda, there is a need to chart a clear roadmap and identify ‘champions’ at the provincial and federal level who not only lead the process but also help strengthen inter-provincial coordination. The CCI would appear to be a natural candidate to take the lead. It is important to define its leadership role in not just resolving inter government

54 This decline has been attributed not to any structural improvements in the government’s finances but rather due to higher revenues from one off inflows and non-settlement of the circular debt during the year (SBP Annual Report 2014). 55 Since over 90 percent of all tax revenues are raised by the Federal government, the fiscal envelope for both the Federal and provincial governments is defined (mostly) by the NFC Awards.

38

Devolution however is a dynamic process and much works remains to be done.

disputes arising from the devolution process but also shaping the decentralization roadmap. The Inter-Provincial Coordination Division can provide a coordinating platform as well to help address regional disparities and enable equitable inter government relations.

39

III. Some Stylized Facts of Pakistan Economic Growth

Pakistan low investment will place it at a disadvantaged position among peer countries going forward.

This section explores stylized facts of Pakistan’ growth patterns. The analysis suggests that Pakistan’s economic growth has been a story of scarce growth spurts and declining long run trend in growth potential. Using a growth accounting framework, it also analyzes the role factor accumulation and technological progress over the long term.

An economy which is unable to sustain longer period of high growth.

Since independence Pakistan economy has been characterized by both high growth episodes as well as economic downturns. The 1960s, 1980s and the period of 1999-2005 are characterized as high growth episodes while 1970s, 1990s and the period of 2006-2011 experienced low growth. The average growth rate during high growth episodes was 6.7 percent while it remained around 3 percent during low growth periods56 (see Table 19). Over the past few years, the economy has shown some recovery but still growing below 5 percent. Generally the periods of relatively strong growth tend to be associated with increased investment and trade, real exchange rate depreciations, and with political stability57. Moreover, high levels of external aid and ability to push through reforms also contributed to growth spurts. As the economy has a very low domestic saving rate (as percentage to GDP)58, Pakistan has remained dependent on foreign saving inflows to sustain its investments.

The economy’s growth pattern is full of short cycles of rapid growth followed by stagnation.

On average, the economy grew at an average annual rate of slightly above 5 percent59 during the last six decades and few impressive high growth episodes with an average of around 7 percent. However, these episodes tends not to be sustained (see Table 19). For instance, since 1962, there have been only two periods where growth consistently remained above 5 percent per annum for more than 4 years. Hence, episodes of robust growth are frequent, but not sustained. This is not the case in many comparable countries in the region such as India, China, Malaysia and South Korea, which have all managed to grow at relatively high rates for a considerable period of time. In contrast, Pakistan’s economic growth is characterized as less volatile. Over the last five decades, the volatility of its GDP growth, as measured by the standard deviation of the growth rate of real GDP, was 2.1 percent; near about the average in South East Asia60. However, this has been increasing in recent times, rising from 1.4 in the 1980s to 2.5 in the 2000s.

56 High growth is assumed to be greater than 5 percent per annum. 57 Haussmann, Pritchett and Rodrik (2004) define growth accelerations as periods with an increase of GDP per-capita growth of 2 percentage points or more for at least 8 years. Accounting for population dynamics, in Pakistan such a figure would be roughly equivalent to GDP growth of at least 5 percent. 58 For last several year National Saving to GDP ratio is below 15 percent. 59 This rate is much lower than the 7.0 percent, the government estimates is needed to absorb youth employment (Pakistan: Framework for Economic Growth, Planning Commission 2011). 60 World Bank, 2010, “Pakistan Country Partnership Strategy, Report No.53553-PK.”

40

Table 19: Growth Pattern

High Growth > 5% Low Growth < 5% Total

Periods

Episodes of Growth

(Consecutive Years)

Average Growth

Periods

Episodes of Growth

(Consecutive Years)

Average Growth

Years Average Growth

FY62-FY66 5 7.10% FY67 1 3.70% 55 5.20%

FY68-FY70 3 7.40% FY71-FY72 2 1.60%

FY73-FY74 2 6.90% FY75-FY77 3 3.30%

FY78-FY83 6 6.90% FY84 1 3.90%

FY85-FY88 4 6.80% FY89-FY90 2 4.60%

FY91-FY92 2 6.60% FY93-FY94 2 3.40%

FY95-FY96 2 5.40% FY97-FY03 7 3.30%

FY04-FY08 5 6.60% FY09 1 0.40%

FY10-FY15 6 3.70%

Total 29 6.70% Total 25 3.10%


Agriculture sector has strong influence on overall growth performance due to its strong forward linkages with industry and services sectors.

Although agriculture contribution to GDP has gradually halved its share of GDP from 47 percent in 1960 to 21 percent in 2015, Figure 29 shows the existence of a high correlation between real GDP and real agricultural GDP—even though such correlation weakens in the 2000s from 80 percent to 35 percent till 2015, whereas such correlations with services and industrial sector GDPs strengthen overtime (with 95 percent and 87 percent respectively in 2000s)— as share of services and industrial sector increased and services sector has the largest share in the economy61. Political uncertainty and natural disasters have also contributed to growth slowdown. Looking closely at Pakistan’s economic history, above average growth rates in the 1960s and 1980s coincided with episodes of reform and economic and political stability along with high levels of external aid. In contrast, during the 1970s and 1990s, political disruption, economic uncertainty and regional tensions were accompanied by few or incomplete reforms and, toward the end of the 1990s, macroeconomic instability and the resulting inability of policymakers to implement and sustain policies necessary for growth and poverty reduction. In addition, natural disasters have taken their toll and explain a few episodes of growth deceleration. This is certainly the case of the late 2000s—a period that witnessed four natural disasters. See section V for a more detailed discussion about disaster risk reduction financing.

61 On average agriculture sector has around 47 percent share in total employment followed by services sector with 33 percent and industry sector with 20 percent in employment.

41

Figure 29: Correlation between Agricultural & Real GDP Growth Rates (%)


Low saving-low investment trap has reduced the growth potential.

Pakistan’s economy is on a declining long run trend both in potential and actual growth. Perhaps more concerning than the inability to sustain growth spurts over long periods of time, is the steady fall in the economy’s potential62, which would suggest the country has gradually eroded its wealth over time. Low national savings has resulted in low investments.63 Results suggests that potential growth has been falling over the past 55 years and actual growth is below trend, i.e. the economy is underperforming (Figures 30).

Figure 30: Pakistan: Actual and Trend Economic Growth, 1961-2015


Long term declining growth can be associated to falling investment in physical infrastructure and labor productivity.

The findings of a growth accounting model often provide useful insights about the reasons underlying such decline. This framework is used following Bosworth and Collins (2007). GDP growth in Pakistan decelerated from 6.1 percent in 1980s to 4.4 percent in the 1990s, before mildly recovering to 4.5 percent in the 2000s and remained around 4 percent till 2015 (see Table 20). Sectoral analysis show that all three sectors (agriculture, industry and services) exhibited similar trends. For instance, the industry and services sector were more dynamic with growth rate of

62 Hodrick-Prescott (HP) filtering technique is used to estimate potential growth trend. 63 On average, over last four decades, investment to GDP ratio remained below 20 percent. In last 5 years, this ratio is hovering around 15 percent.

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

1960-6

1

1962-6

3

1964-6

5

1966-6

7

1968-6

9

1970-7

1

1972-7

3

1974-7

5

1976-7

7

1978-7

9

1980-8

1

1982-8

3

1984-8

5

1986-8

7

1988-8

9

1990-9

1

1992-9

3

1994-9

5

1996-9

7

1998-9

9

2000-0

1

2002-0

3

2004-0

5

2006-0

7

2008-0

9

2010-1

1

2012-1

3

2014-1

5

Real GDP Agriculture

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

10.0

1959-6

0

1961-6

2

1963-6

4

1965-6

6

1967-6

8

1969-7

0

1971-7

2

1973-7

4

1975-7

6

1977-7

8

1979-8

0

1981-8

2

1983-8

4

1985-8

6

1987-8

8

1989-9

0

1991-9

2

1993-9

4

1995-9

6

1997-9

8

1999-0

0

2001-0

2

2003-0

4

2005-0

6

2007-0

8

2009-1

0

2011-1

2

2013-1

4

Real GDP growth Trend growth

42

7.7 percent and 6.6 percent in 1980s, which sharply decelerated to average 2.8 percent and 4.7 percent during last five year till 2015. Whereas agriculture sector showed steady decline with average growth of 3.6 percent during last 35 years.

Decomposition of the output per worker growth into its contributing factors shows that growth in Pakistan has been mainly driven by capital accumulation and productivity growth, with human capital contributing relatively less.

Labor productivity—measured by output per worker—has been steadily declining from 4.3 percent in 1980s to 1.2 percent in 2000s and then slightly increased on average in last 5 years. Among its regional peers, Pakistani labor is the least productive and the gap has increased in the last two decades64. It appears that labor productivity in recent years is increasing due to better human capital contribution.65 The contribution of physical capital to labor productivity has decreased over time. This deceleration is accompanied by steady decline in investment (as a ratio to GDP) from average 20 percent in 1980 to 14 percent since 2011 onwards. Private investment which picked up and reached 15 percent in 2005-06, led by the private telecommunication sector, has now declined to less than 10 percent of GDP in 2015 due low investor confidence and challenging structural bottlenecks.

Table 20: Pakistan Sources of Growth, Total Economy and Major Sectors, 1980-2015 (Average annual percentage rate of change)

Period

Real Output Growth

Investment as % of GDP

(constant prices 2005)

Employment Growth

Output Per

Worker Growth

Output per worker: % Contribution of

Physical Capital

Human Capital

Arable Land

TFP

Total Economy

FY81-FY90 6.1 19.86 1.8 4.3 2.3 0.9 -0.2 1.3

FY91-FY00 4.4 20.44 2.4 1.9 1.1 -0.2 -0.3 1.2

FY01-FY10 4.5 17.68 3.3 1.2 0.3 0.4 -0.3 0.8

FY11-FY15 3.9 13.79 1.6 2.3 0.1 0.9 0.0 1.3

FY81-FY15 4.8 18.53 2.5 2.3 1.0 0.5 -0.2 1.0

Agriculture

FY81-FY90 4.0 4.45 1.8 2.2 4.1 0.4 -0.7 -1.4

FY91-FY00 4.4 4.79 1.6 2.8 1.5 -0.1 -0.6 2.0

FY01-FY10 2.6 3.48 2.5 0.1 0.2 0.1 -1.4 1.2

FY11-FY15 3.0 3.02 0.7 2.2 0.5 0.4 0.1 1.3

FY81-FY15 3.6 4.07 2.0 1.5 1.7 0.2 -0.8 0.6

Industry

FY81-FY90 7.7 5.82 2.0 5.6 3.6 0.7 0.0 1.3

FY91-FY00 4.2 6.91 1.0 3.2 3.3 -0.1 0.0 0.1

FY01-FY10 5.7 5.09 4.8 0.8 -0.9 0.4 0.0 1.3

FY11-FY15 2.8 2.51 3.4 -0.6 -1.9 0.6 0.0 0.7

FY81-FY15 5.5 5.45 2.9 2.5 1.3 0.3 0.0 0.9

Services

FY81-FY90 6.6 10.17 2.8 3.6 1.2 1.2 0.0 1.2

FY91-FY00 4.5 9.50 3.7 0.8 0.4 -0.3 0.0 0.7

FY01-FY10 4.9 9.32 3.4 1.4 0.3 0.9 0.0 0.2

FY11-FY15 4.7 8.25 1.7 3.0 0.3 1.1 0.0 1.5

FY81-FY15 5.2 9.46 3.2 1.9 0.6 0.7 0.0 0.7

Source: Pakistan Bureau of Statistics and World Bank Staff calculations

Contribution of human capital in

The contribution of human capital66 was somewhat significant in the 1980s and turned negative in 1990s, but rose again in the 2000s. However, with fast growing

64 Government of Pakistan. 2011. “Pakistan: Framework for Economic Growth.” Planning Commission, Islamabad. 65 As measured by average school years which are increasing over time. 66 Following Bosworth and Collins (2007), human capital has been measured by adjusting number of workers for their average years of schooling by assuming that each additional year

43

labor productivity has enhanced in recent years.

labor supply and very low enrollment in primary education rate, Pakistan appears to be evolving toward an economy intensive in unskilled labor, which limits its potential for raising its labor productivity. More recently, contribution of human capital’s contribution in output per worker has improved. TFP contribution has also been relevant, but dramatically declining to about half from 1980s to 2000s. However, these have recovered in last 5 years to 1.3 percent on average still below medium-term average of 2.0 in East Asia67. Productivity has increased the most in the services sector, led by a significant improvement in productivity in the past five years (Table 20).

Contribution of total factor productivity in overall labor productivity is low, compared to peer countries.

Literature identified several factors contributed to the low TFP in Pakistan compared to many of its peer countries. The underlying factor have been the overall macroeconomic environment, financial developments, limited FDI and human capital and technological developments. Evidence indicates that TFP growth in Pakistan was particularly strong in periods where the macroeconomic environment improved and political stability ensued68. Low levels of science and technological growth also appeared to be closely correlated with low TFP growth69. There is also evidence from literature that the TFP decline in 1990s was a result of macroeconomic factors70 whereby the need to curtail the fiscal deficit was mainly done through cutting development expenditure and social sector expenditures, which negatively affected human capital. The above mentioned results are consistent with literature, which highlighting that high TFP growth is associated with macroeconomic stability, high level of investments, low inflation and external inflows.71 During 1980, a period of relatively high productivity growth, all sectors benefitted from price stability, significant external inflows and the impact of large investment made by public sector in 1970s72.

More recently, lack of investment has held back labor productivity growth, with improved human capital in services sector contributing

The recent low contribution of capital to productivity is in line with the overall low investment levels in the economy in the last 5 years. Labor productivity growth in recent years can also be associated with demographic transitions effects. Pakistan is passing demographic transition as working age population (15-64) has been increasing73 and which in turn can yield a demographic dividend — an opportunity provided by the changing age structure when the growth rate of labor force is higher than the growth rate of the total population. This has been the result of declining fertility rates, and thus lower dependency ratio has implications for economic raises workers’ productivity by a given percentage. In this analysis this is assumed to be 7 percent. 67 International Monetary Fund (IMF). 2004. Pakistan: Selected Issues and Statistical Economy.” 68 World Bank. 2006. “Pakistan Growth and Competitiveness, Report No. 35499-PK.” Washington D.C. 69 Mahmood, Zafar, and Rehana Siddiqui. 2000. “State of Technology and Productivity in Pakistan’s Manufacturing Industries: Some Strategic Directions to Build Technological Competence.” The Pakistan Development Review. 39(1):1-21 70 Sabir, M. and Qazi M. Ahmed. 2003, “Macroeconomic reforms and Total factor productivity growth in Pakistan: an empirical analysis”, Conference Paper International Atlantic Economic Conference. 71 Khan, S.U, 2006, “Macroeconomic Determinants of Total Factor Productivity in Pakistan”, SBP Research Bulletin. 72 1970s large public sector investment projects were Tarbela Dam projects that increased irrigation water availability, the hydel power projects and other in fertilizers and cement sector. 73 Planning Commission of Pakistan, 2011, “Pakistan: New Growth Framework”, Government of Pakistan.

44

strongly. growth. In addition, last 5 years also saw a rise in utilization of telecommunication services, and an enhanced focus on technical and vocational education. This better connectivity and easy transfer of information, and improved skills may have resulted in higher human capital contribution in labor productivity. More specifically, looking at services sector, human capital contributed the most in last 5 years.

45

IV. Federal Budget 2015/16 – Sectoral Analysis of Spending Priorities74

Federal Budget 2015/16 envisages a reduction of 1.0 percent of GDP in total expenditures of the Federal government from 14.1 percent in FY2014/1575 to 13.1 percent in FY2015/16.

This curtailment relies solely on 1.3 percent of GDP decline in recurrent spending while development spending is expected to increase by 0.3 percent of GDP. In absolute terms, total spending is budgeted at PKR 4,030 billion for FY2015/16 translating into a growth of about 4.4 percent. While the recurrent expenditures are set to contract by 0.6 percent viz-a-viz last year and reach PKR 3,166 billion by the end of the on-going fiscal year, a 28 percent increase in development outlay has been programmed amounting to a size of PKR 864 billion. In terms of GDP, federal development expenditures are budgeted to increase from 2.0 percent of GDP in FY2014/15 to 2.3 percent for the current fiscal year. Of this, more than 80 percent has been allocated under the budget 2015/16 Public Sector Development Programme (PSDP). Another 12 percent comprises of the flagship cash transfer programme (BISP) that falls outside the PSDP bracket. The remaining includes fertilizer subsidy (traditionally parked under this head), lump sum provision of misc. items, and some other items.

There are structural rigidities within recurrent budget.

Given the rigid nature of non-development spending historically, the three top most heads appear to be interest payments (with 40 percent share in total recurrent expenditure), defense affairs (25 percent) and general administration – 14 percent (see Figure 31). It is apparent that the increased security related spending (manifested by an upsurge in budgeted spending for Defense and Law & Order for FY2015/16) has been accommodated by cutting the budget of general public service. This is encouraging despite the 7.5 percent increase in public sector wage bill announced in the Budget. Grants, mostly directed towards the SOEs, still appear to be making 13 percent of the total recurrent spending despite government’s commitment to move ahead with reforms to restructure the loss-making enterprises.

Higher public investment is expected to crowd in private sector.

In the Budget speech, the Federal Minister for Finance alluded to concerted efforts being made to attract private investment, in addition to increasing public investment, through a variety of mechanisms such as promoting public private partnerships, FDI, and creating special economic zones with fiscal incentives. Key priorities under the Federal annual development plan are listed below (see Table 21 and Figure 32). After infrastructure, rest of the categories appear to be shrinking their allocations towards the PSDP primarily to make space for ‘New Programmes’ that has only been added to the development portfolio during the last fiscal year.

74 This section has been prepared by Mehwish Ashraf (Research Analyst, GMFDR). 75 As per the revised estimates (of authorities) announced at the time of budget.

46

Figure 31: Composition of Federal Current Expenditures

Source: Ministry of Finance (Fiscal Operations)

Figure 32: PSDP Allocation, FY2015/16 Figure 33: Infrastructure Sectoral Allocation,

FY2015/16



76 In Pakistan, National Highway Authority is mandated to look after the ‘highways’ sector.

Infrastructure

55%

Social Services

6%

Economic Services

1%

Others 7%

Special Areas

Programmes

6%

Special Programm

es 8%

New Programm

es 17%

Water 8%

Power 29%

Atomic Energy

8%

Highways 41%

Ports & Shipping

3%

Railways 11%

Infrastructure is one on the biggest priority in the development budget.

Infrastructure is set to receive the highest – 55 percent – allocation with a budget of PKR 386 billion. Within this sub-sector, highways together with power projects are expected to make up 70 percent of the total infrastructure allocation (see Figure 33). National Highway Authority76 (PKR 160 billion): Construction of motorways stand prominent in the current year plan with almost PKR 76 billion allocation. Interestingly, out of the three motorway schemes, Multan-Sukkur Motorway worth PKR 50 billion is the only approved project implying an expected speedy execution of this road project. Additionally, operationalizing the Western and Northern alignment of China Pakistan Economic Corridor (CPEC) appears to be another salient feature of this year, approximating to PKR 58 billion. Power (PKR. 112 billion): Within energy related projects, four allocations stand out:

16.4% 17.1% 13.9%

22.4% 22.6% 24.7%

2.8% 2.8% 3.0% 2.4% 2.4%

2.8%

1.5% 1.7% 1.9% 11.8% 13.1% 12.9%

42.3% 39.9% 40.4%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Budget Revised Budget

2014/15 2015/16

General Administration Defense Law and Order Social Services

Economic Services Grants Interest Payments Others

47

Table 21: Federal Public Sector Development Program 2015/16

'(PKR Million) 2014/15 2015/16 2014/15 2015/16 Shares

Budget Revised Budget

% Change

Percent Change 2014/15 2015/16

Total Total Total

RE Vs BE

Budget Revised Budget Budget

Infrastructure 312,808 311,723 386,452 -0.3% 23.5% 24.0% 59.6 55.2

Water 43,427 46,058 30,120 6.1% -30.6% -34.6% 8.3 4.3

Power 63,613 49,253 112,288 -22.6% 76.5% 128.0% 12.1 16.0

Atomic Energy 51,475 59,275 30,409 15.2% -40.9% -48.7% 9.8 4.3

Pakistan Nuclear Regulatory Authority

230 230 321 0.0% 39.6% 39.6% 0.0 0.0

Petroleum & Natural Resources 167 167 349 0.0% 109.0% 109.0% 0.0 0.0

Communications 191 5,153 365 2597.9% 91.1% -92.9% 0.0 0.1

Highways 111,563 109,445 159,600 -1.9% 43.1% 45.8% 21.3 22.8

Ports & Shipping 2,576 2,576 12,000 0.0% 365.8% 365.8% 0.5 1.7

Railways 39,566 39,566 41,000 0.0% 3.6% 3.6% 7.5 5.9

Social Services 52,366 58,063 43,672 10.9% -16.6% -24.8% 10.0 6.2

Education 3,451 3,375 2,207 -2.2% -36.0% -34.6% 0.7 0.3

Higher Education 20,069 25,042 20,500 24.8% 2.1% -18.1% 3.8 2.9

Capital Administration and Development

1,806 1,806 1,043 0.0% -42.2% -42.2% 0.3 0.1

National Health Services, Regulations and Coordination

27,015 27,815 19,882 3.0% -26.4% -28.5% 5.1 2.8

Climate Change 25 25 40 0.0% 60.0% 60.0% 0.0 0.0

Economic Services 3,528 3,468 3,770 -1.7% 6.9% 8.7% 0.7 0.5

Food, Agriculture and Livestock 1,071 1,071 1,500 0.0% 40.1% 40.1% 0.2 0.2

Industries and Investment 1,148 1,151 791 0.3% -31.1% -31.3% 0.2 0.1

Information and Media Development

424 391 391 -7.8% -7.8% 0.0% 0.1 0.1

Information Technology and Telecommunications

556 526 923 -5.4% 66.0% 75.5% 0.1 0.1

Textile 329 329 165 -0.1% -49.9% -49.8% 0.1 0.0

Others 62,339 48,056 47,667 -22.9% -23.5% -0.8% 11.9 6.8

Cabinet Division 2,078 5,767 654 177.5% -68.5% -88.7% 0.4 0.1

Commerce Division 363 364 876 0.3% 141.3% 140.7% 0.1 0.1

Defense Division 4,363 6,381 7,158 46.3% 64.1% 12.2% 0.8 1.0

Establishment Division 165 165 149 0.0% -9.7% -9.7% 0.0 0.0

Finance Division 11,062 14,075 9,135 27.2% -17.4% -35.1% 2.1 1.3

Foreign Affairs 255 255 60 0.0% -76.5% -76.5% 0.0 0.0

Interior Division 3,900 3,930 8,300 0.8% 112.8% 111.2% 0.7 1.2

Law and Justice Division 2,352 2,352 1,500 0.0% -36.2% -36.2% 0.4 0.2

77 Baloki and Haveli Bahadursha. 78 With ADB assistance of PKR 8 billion.

Dasu Hydro Power Project (PKR 52.4 billion), two new LNG Based Power projects77 (PKR 45 billion), and installation of new Coal Fired Power Plants at Jamshoro (PKR 20 billion)78. Inclusion of these projects point towards government efforts to explore avenues other than the conventional fuel-based power generation. Railways (PKR 41 billion), Water and Atomic Energy (PKR 30 billion each) sub-sectors are tilted towards completion of on-going schemes. Importantly, CPEC-related railway projects of about PKR 2 billion as well as Chasma Nuclear Power Project Unit worth PKR 26 billion have also been planned for the current year. Moreover, allocation for Ports & Shipping has been increased by almost 4 times from PKR 2.6 billion last year to PKR 12 billion for FY2015/16 owing to construction of Gwadar port under the first phase of CPEC.

48

Narcotics Control Division 324 328 230 1.2% -29.0% -29.9% 0.1 0.0

Planning and Development Division

32,878 6,265 14,000 -80.9% -57.4% 123.5% 6.3 2.0

Science and Technological Research Division

904 1,211 1,060 34.0% 17.3% -12.5% 0.2 0.2

Statistics Division 240 278 100 15.8% -58.3% -64.0% 0.0 0.0

Works Division 1,934 4,415 2,590 128.3% 33.9% -41.3% 0.4 0.4

Others 1,521 2,270 1,855 49.2% 22.0% -18.3% 0.3 0.3

Special Areas Programmes 40,457 41,190 42,937 1.8% 6.1% 4.2% 7.7 6.1

Kashmir Affairs and Gilgit Baltistan

21,357 22,090 23,237 3.4% 8.8% 5.2% 4.1 3.3

States and Frontier Regions 19,100 19,100 19,700 0.0% 3.1% 3.1% 3.6 2.8

Special Programmes 53,500 42,500 55,500 -20.6% 3.7% 30.6% 10.2 7.9

Pak MDGs & Community Dev. Program

12,500 27,500 20,000 120.0% 60.0% -27.3% 2.4 2.9

Fed. Dev. Prog./Projects for Provinces & Special Areas

36,000 10,000 28,500 -72.2% -20.8% 185.0% 6.9 4.1

ERRA 5,000 5,000 7,000 0.0% 40.0% 40.0% 1.0 1.0

New Programmes - 59,000 120,000

103.4% 0.0 17.1

Special Development Programme for TDPs and Security Enhancement

- 52,000 100,000 -- -- 92.3% 0.0 14.3

Prime Minister's Youth Programme

- 7,000 20,000 -- -- 185.7% 0.0 2.9

Total Federal PSDP 524,998 564,000 699,998 7.4% 33.3% 24.1%

Source: Ministry of Planning, Development & Reforms

Social and economic sector, too, received significant allocations.

Social Services: In Pakistan, the fiscal architecture has undergone a considerable shift post 18th Constitutional Amendment79, thereby devolving the social subjects largely to the provinces. Nonetheless, higher education and curriculum development remains the responsibility of Federal government. Higher Education Commission is set to receive PKR 20.5 billion this year. Moreover, the Federal government continues financing of vertical health programmes80,81. As these projects are approaching their culminations, the allocation has declined over time (for instance, from PKR 28 billion last year to PKR 20 billion in the FY2015/16 Federal PSDP). Thus, the share of social services sector in Federal PSDP is budgeted to fall from 10 percent in FY2014/15 to 6 percent in FY2015/16 (or from PKR 58 billion to PKR 43.7 billion).

79 Promulgated on April 19, 2010. 80 Vertical programmes include 9 schemes on health and 7 on population planning, and appear under the National Health Services, Regulations & Coordination Division in the PSDP allocations. 81 By passing the Award before the 18th Amendment, the federal government violated the basic rule of decentralization sequencing i.e. ‘finance follows function’. As a result, the provinces disassociated the transfer of responsibilities emanating from the 18th Amendment from the additional resources allocated under the 7th NFC Award. The federal government thus ended up retaining several big ticket vertical programs within the devolved subjects, which continue to command a significant share of the federal PSDP. This squeeze is likely to continue as the next NFC Award appears to be delayed by at least a year and the 2015/16 federal budget has been prepared on the basis of continuation of the current Award. (Source: Fiscal Decentralization in Pakistan – A Forgotten Agenda, by Saadia Refaqat, The World Bank Policy Paper Series on Pakistan 2015, Islamabad, forthcoming).

49

Economic Services: Almost similar allocations to the ones last year have been made for food, agriculture & livestock82; IT; telecommunications; textile; and media for 2015/16, aggregating to PKR 3.8 billion. Private sector largely dominate the latter economic sectors in Pakistan, explaining low public investment levels.

Figure 34: PSDP Allocation for Federal Divisions, FY2015/16

Source: Ministry of Planning, Development & Reforms

FY2015/16 development budget also focused on some special areas and sectors, and started some new initiatives.

Others: This sector includes development projects envisaged by various Federal Divisions (see Figure 34) and has been allocated PKR 47.7 billion for the on-going fiscal year. Most notably, Planning and Development Division has been allocated PKR 14 billion, compared to only PKR 6.2 billion spent by the division in FY2014/15. This allocation includes a block allocation of PKR 9.7 billion for un-funded or underfunded important projects. This scheme appeared in FY2014/15 and amounted to PKR 27 billion. The considerable reduction in allocation of almost PKR 17 billion in just one year indicates that most of the priority spending is being financed from the regular PSDP, thereby leading to improved transparency with respect to block allocations. Finance Division has been allocated PKR 9 billion, mostly for provincial projects, including PKR 2 billion for Gwadar Development Authority and PKR 1 billion for development of Ziarat Town. Moreover, allocation for Interior Division almost doubled to PKR 8.3 billion, the apparent reason being security related augmented spending. Similarly, Defense Division is set to receive PKR 7.2 billion in this year.

Special Areas: For FY2015/16, PKR 43 billion has been allocated for development projects in special areas – Azad Jammu and Kashmir (AJK), Gilgit Baltistan (GB), Northern Areas and Federally Administered Tribal Areas (FATA) – that are otherwise not included in the resource distribution framework of the federation.

Special Programmes: Two of these projects appeared in the Federal PSDP list last year and are budgeted to continue this year. However, these largely encompass block allocations on (i) MDGs & community development (PKR 20 billion), and (ii) federal development program/projects in provinces & special areas (PKR 28.5 billion). In Pakistan, where federal financing of provincial projects has been an

82 A provincial subject post 18th Constitutional Amendment.

Cabinet Division 1%

Commerce Division 2%

Defense Division 15%

Finance Division 19%

Interior Division 18%

Law and Justice Division

3%

Narcotics Control Division

1%

Planning and Development Division

30%

Science and Technological Research

Division 2%

Works Division 5%

Others 4%

50

important instrument of fiscal equalization, yet given that the provincial PSDP itself has been increased by an almost parallel 26 percent, the financing of provincial programs from the federal budget needs to be limited. Spending on earthquake reconstruction and rehabilitation83 is projected at PKR 7 billion.

New Programmes: This category – with 17 percent share – comes second after infrastructure as the Federal government priority for 2015/16. Allocation for two new programs that appeared in the revised estimates of last year, Special Development Programme for Temporary Displaced Persons (TDPs) & Security Enhancements and Prime Minister’s Youth Programme, is budgeted to continue and to increase. Former is allocated PKR 100 billion while latter is set to receive PKR 20 billion for 2015/16.

Benazir Income Support Programme: BISP, as it is abbreviated, was launched in July 2008 with an immediate objective of consumption smoothening and cushioning the negative effects of slow economic growth, the food crisis and inflation on the poor, particularly women, through the provision of cash transfers of PKR 1,000 per month84 to eligible families. The non-PSDP item is an important pillar of government’s development agenda as the project focuses on poverty eradication and women empowerment over the long term. The programme has been allocated PKR 102 billion for 2015/16, representing more than 155 percent increase since FY2012/13. Moreover, out-reach of this cash transfer programme is envisaged to expand to 5.3 million beneficiaries by the end of next financial year, showing an increase of 29 percent since FY2012/13.

83 Established on 24 October, 2005 as a direct response to deadly earthquake of October 5 (7.6 on the Richter scale) in North-Western Pakistan, ERRA is an independent, autonomous, and federal institution of Pakistan tasked and responsible for the operational planning, coordinating, monitoring, and regulating the reconstruction and rehabilitation operations in the earthquake affected areas of the country. 84 The monthly installment was enhanced to PKR 1,200 per month w.e.f. July 1, 2013 by the

present government and has now been fixed at PKR 1,500 per month w.e.f. July 1, 2014.

51

V. Fiscal Disaster Risk Assessment Report

Table22: Estimated Economic Impact of Major Natural Disasters in Pakistan since 2005 Estimated Losses (both US$M, and as percentage of GDP) are as at time of event

Event Provinces impacted Estimated Losses

(US$M) Estimated Losses as % of

national GDP

Earthquake (2005) AJK and KPK 2,857 2.6%

Cyclone Yemyin (2007) Sindh and Baluchistan 322 0.2%

Floods (2010) Entire country 10,500 6.0%

Floods (2011) Sindh and Baluchistan 3,730 1.8%

Source: Preliminary Damage and Needs Assessments (DNA)

The Fiscal Disaster Risk Assessment (FDRA) Report has been prepared by the World Bank on the request of the National Disaster Management Authority (NDMA).

It has been formulated over the last two years in close partnership with the Ministry of Finance (MoF), the Securities and Exchange Commission of Pakistan (SECP), the Provincial Disaster Management Authorities (PDMAs) and the Provincial Finance Departments. The objective of the section is to highlight fiscal impacts of frequent natural disasters on the budget of the Government of Pakistan and to present options for a national disaster risk financing strategy drawn from international best practices.

Historical Economic and Fiscal Impact of Natural Disasters. In Pakistan, approximately 3 million people are affected by natural catastrophes each year, which equates to approximately 1.6 percent of the total population.

According to an analysis of historical natural disaster data, since 1973 approximately 77 percent of the all the people affected by natural disasters were impacted by flooding events. Eighty seven percent of the people affected by natural catastrophes were resident in Punjab and Sindh. Since 1973 there have been 11 natural catastrophe events that - were they to occur in the present day - could affect over four million people in Pakistan. Pakistan is vulnerable to a number of adverse natural events and has experienced a wide range of disasters over the past 40 years, including floods, earthquakes, droughts, cyclones and tsunamis. These hazards are further exacerbated by growing urbanization, increased vulnerability and shifting climatic patterns, that can result in the occurrence of increasingly severe natural disasters. Over the past decade, damages and losses resulting from natural disasters in Pakistan have exceeded US$ 18 billion. As the population and asset base of Pakistan increases, so does its economic exposure to natural disasters. A summary of the economic impact of selected natural disasters since 2005 is shown in the Table 22.

There remains a lack of standardization in procedures related to disaster risk management across provinces, despite specifications in the NDM 2010 Act.

In general, the disaster risk management system defined in the NDM Act of 2010 and national disaster response plans are not followed in full at the provincial level. Across the provinces approaches vary, in the case of Punjab disasters are typically managed following instructions given in war books such as the financial war book; elsewhere instructions in the Natural Calamities Act, 1958 are followed. At present, there are no institutional mechanisms to calculate the financial impacts of disasters within the federal or provincial exchequers. Following a disaster, with the support of the World Bank and Asian Development Bank (ADB), the GoP undertakes a Damage and Needs Assessment (DNA) which estimates the direct losses as well as the reconstruction costs by sector and province across both the public and private sector.

52

Figure 35: Post-Disaster Cost Estimates by Phase for Four Selected Major Natural Catastrophes in Pakistan

Source: Flash Appeals, Humanitarian Response Plans and Damage and Needs Assessments

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000

2005 Earthquake 2007 Cyclone Yemyin 2010 Floods 2011 Floods

Mil

lio

ns

US

$

Relief Recovery Reconstruction

The post-disaster financial responsibilities of provincial governments are not well defined.

At the provincial level, although the financial responsibilities of governments are not defined, generally they can be broadly categorized as Emergency Relief, Recovery and Reconstruction and Livelihoods Assistance to Affected Populations. In addition to these expenditures, other relief mechanisms may be provided. In Punjab, for instance, short term waivers on taxes on water and land are common following a disaster. In certain cases waiver of interest on agriculture loans are allowed as well as a delay in the repayment of these loans. Since 2005, estimates of the total costs through the three post-disaster phases have exceeded US$5 billion on two occasions. Total estimates for post-disaster costs for the 2005 earthquake and the 2010 floods were approximately $US5.2 billion and US$8.7 billion respectively. Estimates made during the respective preliminary damage and needs assessments for four selected events since 2005 are shown in the following Figure.

Donor assistance can represent a significant, although uncertain, part of financing natural disasters, indeed since 2005 donor assistance has accounted for between approximately 60% and 80% of total post-disaster expenditures during the relief and recovery phases.

For example, following the 2005 earthquake approximately US$520 million (62%) of a total estimated expenditure of US$845 million for relief and recovery came from international donors. For the 2007 Cyclone Yemyin, international donor assistance accounted for approximately 59% of total relief and recovery spending (US$21 million of a total of US$36.2 million). In 2010 and 2011, following the devastating flood events, donors contributed 81% (US$1.37 billion) and 65% (US$157 million) of the relief and recovery spending. This information is summarized in Figure 36. However, it should be noted in the Figure 35 above that the total costs of the events summarized are between 4 and 7 times greater than the expenditures contributed to recovery and reconstruction. Thus, while donor financing plays an important role in financing recovery and reconstruction, it accounts for only 5%-16% percent of the financing needs.

Pakistan faces a Preliminary analysis of the Fiscal Disaster Risk Assessment Report estimates the

53

Figure 36: Financing of Post-Disaster Operations in Pakistan

Source: Flash Appeals, Humanitarian Response Plans and Damage and Needs Assessments.

major financing challenge arising from natural catastrophes, with flooding causing an estimated annual economic impact of between 3 and 4 percent of the Federal Budget.

annual economic impact of flooding at between US$ 1.2 billion and US$ 1.8 billion, equivalent to between 0.5 percent and 0.8 percent of national GDP; however simulations show that a major flood event (occurring, on average, once every 100 years) could cause losses in excess of US$ 15.5 billion, which equates to around 7 percent of national GDP, equivalent to almost 40 percent of the Federal Budget. While the Government tries to meet the needs arising from the aftermath of natural disasters, the funding gaps especially for reconstruction of affected infrastructure lead to its deterioration especially the protective capacity resulting in additional losses in proceeding disaster events.

The annual expected earthquake loss to residential properties/housing sector alone is approximately US$ 1 billion and that once every 100 years these losses are expected to exceed US$18.7 billion.

A recurrence of the 2005 earthquake would cause a present day economic loss of approximately US$ 2.8 billion which is almost double as compared to the losses caused to the housing sector by the 2005 earthquake. The contingent liability of the government due to natural disasters can create significant fiscal risk. However the GoP’s contingent liability is not clearly defined in law and makes a fiscal risk assessment difficult to perform. Beyond its explicit contingent liability and associated spending needs (such as the reconstruction of public assets and infrastructure), the government may have a moral and social responsibility (implicit contingent liability) to assist the population in the aftermath of an extreme disaster event. For example, the government provides not only emergency assistance (e.g. food, shelters and medical supplies) but it can also finance recovery and reconstruction activities such as assistance for the rebuilding of low-income housing. Contingent liabilities arising through the establishment of disaster-linked social protection schemes also need to be considered in such an analysis.

Disaster phase

Budgetary vehicle

Financing sources

Reconstruction Recovery Emergency Response/Relief

Annual public sector development programme

Contingency budget, supplementary budgets

Contingency budget, supplementary budgets

Federal/provincial budget

Federal/provincial/ district budget

Federal/provincial/ district budget

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Figure 37: Financing of Post-Disaster Operations in Pakistan

Source: Flash Appeals, Humanitarian Response Plans and Damage and Needs Assessments.

Way forward. A comprehensive national disaster risk financing strategy should be designed to improve the capacity of the GoP to access immediate financial resources in the event of a national disaster and to ensure that required funds are efficiently delivered to beneficiaries, while maintaining the fiscal balance. The strategy should follow the operational framework of: (i) assess risk; (ii) arrange financial solutions; and (ii) deliver funds to beneficiaries.

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VI. National Financial Inclusion Strategy

Access to Financial Services Contributes to Economic Empowerment, which is a Key Challenge for Pakistan

85 World Bank Global Financial Inclusion Database (Global Findex 2014).

Access to financial services contributes to economic empowerment, which is a key challenge for Pakistan.

Evidence suggests that financial inclusion is positively related to income levels as well as a more equitable income distribution. Theoretical and empirical economic research over the years has shown that financial inclusion as measured through access to and usage of financial sector products is positively correlated with growth and employment generation. At the macro level, greater inclusion causally impacts economic growth through lower transaction costs, enhanced deposits base, and efficient distribution of risk across the financial sector. At the micro level, financial inclusion fosters development through enhanced access to credit, increased household consumption, and consumption smoothing through savings.

Pakistan has been a pioneer in championing reforms aimed at providing an enabling environment for financial inclusion for over a decade.

There have been a large number of significant milestones which include: the creation of a regulatory framework for MFBs (2001); the expansion and modernization of the online credit information bureau (e-CIB, 2005); the adoption of Branchless Banking Regulations (2008, amended in 2011); the adoption of a tiered approach to know-your-customer (KYC) requirements; the establishment of a specialized microfinance credit information bureau (m-CIB, 2009-2012); and the launch of a nationwide Financial Literacy Program (2012). As a result, the enabling environment for microfinance is ranked among the world’s best, according to the Economist’s Global Microscope 2014.

Despite these sustained efforts, the level of financial inclusion remains very low.

Pakistan is home to 5.2% of the world’s unbanked population and only 13.0% Pakistani adults have an account with a formal financial institution, making the financial inclusion agenda important from a country as well as global context.85 The gender divide remains a key challenge to address, as women are largely financial excluded. Only 4.8% women are included in the formal financial sector compared to the South Asian average of 37.4%. Additionally, those who are included have a narrow range of credit and savings products to choose from, while not having access to other specialized financial services such as insurance, pensions, and agriculture and MSME finance.

Around 50 countries worldwide have set national targets for financial access/inclusion.

This is evidence of the global recognition of the importance of financial inclusion to income distribution and growth. Given that about 25 countries account for over 73% of the world’s financially excluded population, there has been a global call for action for Universal Financial Access by 2020, through ambitious country-led reforms which enable transformative and technology-led business models that would lower costs, manage risks, and improve access to financial services for low-income individuals and MSMEs.

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Pakistan has realized the National Financial Inclusion Strategies have allowed for Accelerated Progress

While SBP has been very proactive in promoting an inclusive financial sector, many of the issues that need to be addressed fall outside of its regulatory mandate.

For example, a number of longstanding problems cannot be solved without legislative changes, but important draft bills, including those on secured transactions, deposit insurance, insolvency and credit bureaus, have been in an uncertain legislative process for years. Progress towards a more inclusive financial system has also been slowed because of limited commitment and weak coordination between several government and private sector stakeholders.

Weaknesses in the basic financial sector infrastructure and the legal and judicial framework discourage lending, particularly to those perceived as riskier borrowers.

The supply of credit to underserved markets is further depressed by: poor contract enforcement, serious deficiencies in land titling and registration, the absence of a secured transactions framework and electronic collateral registry for moveable collateral and the inability to enforce collateral outside of the slow and unpredictable judicial system.

Lack of capacity in both financial institutions and clients is also a constraint to greater financial inclusion.

Most financial institutions have focused on the upper end of the business and retail markets and have not developed the skills, techniques and products required to serve other market segments profitably. Microfinance providers have developed this knowledge for microfinance clients, but there is a large “missing middle” which is currently not being served. On the client side, a basic lack of financial literacy and awareness serves to limit demand for financial products and services.

Given the positive welfare effects of increased financial inclusion, and a global push for inclusive growth, as highlighted by the commitments made by the G-20 nations and Alliance for Financial Inclusion (AFI), the State Bank of Pakistan (SBP) in collaboration with the World Bank, launched a National Financial Inclusion Strategy for Pakistan in May 2015.

The NFIS has been agreed to at the national level following extensive consultations with the stakeholders. It is being championed by the SBP, with shared leadership from the Ministry of Finance (MoF) and the Securities and Exchange Commission of Pakistan (SECP). The stated vision for financial inclusion in Pakistan is that: “individuals and firms can access and use a range of quality payments, savings, credit and insurance services which meet their needs with dignity and fairness”. A set of cross cutting conditions – the key enablers – will need to be put in place as they will lay the foundations for implementing this vision. The key enablers cut across all priority sectors, and are; (1) public and private sector commitment to the NFIS and coordination; (2) enabling legal and regulatory environment; (3) adequate supervisory and judicial capacity; and (4) financial, payments and information and communications technology (ICT) infrastructure. The key enablers will support targeted actions – the drivers – aimed at increasing access and developing an ecosystem of financial services that will have the quality and features required by the Pakistani population and enterprises. These drivers are: (i) promoting Digital Transaction Accounts (DTAs) and reaching scale through bulk payments; (ii) expanding and diversifying access points; (iii) improving capacity of financial service providers; and (iv) increasing levels of financial capability.

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Pakistan’s National Financial Inclusion Strategy Framework

Figure 38: National Financial Inclusion Strategy - Framework for Action

The current network to distribute financial services in Pakistan falls short, particularly in rural areas, and it does not permit all firms and individuals, especially women, to have easy and convenient access to even basic accounts.

Hence, the NFIS prioritizes the need to increase and diversify financial service access points such as bank branches, bank agents, ATMs, POS, mobile money agents and remote access through mobile phones and the internet. The vision aspires to having universal access to formal accounts, not be limited to simply traditional savings and checking accounts but would also include digital transactional accounts (DTAs) such as branchless banking accounts. Universal access to formal accounts depends on a balanced KYC regime, improvements in the national payment system (NPS), and on shifting large payment streams from cash to digital platforms. These large payment streams include wages in the public and private sectors, government-to-business (G2B) payments, social cash transfers, other government-to-person (G2P) payment streams such as pensions, and also P2G (person to government) payments such as fees and taxes.

Aspiring to a large increase in the number of adults with accounts is a necessary but insufficient condition to meet the objectives of the NFIS.

Individuals and firms must also have the convenience, tools and confidence to use a range of quality services through these accounts, including simple payments, remittances, savings, credit and insurance products. These services should be provided in both conventional and Islamic-compliant structures. The NFIS calls for the development of a varied set of financial services that meet the needs of consumers and respects their right to dignity and fairness, with a special focus on historically marginalized segments such as low-income households (e.g., small farmers), women, and micro- and small-enterprises. This will require coordinated and parallel efforts with the goals of:

Diversifying the range of basic payments, remittance and savings products offered to the Pakistani population and enterprises through DTAs and bank accounts;

Increasing the financing opportunities for urban and rural micro-, small- and medium-enterprises, including agricultural finance for men and women small farmers;

ENABLER 1: Public & Private Sector Commitment, Coordination

ENABLER 4: Financial/Payments/ICT Infrastructure

PRODUCT ECOSYSTEM Diverse set of tailored and responsible financial products (savings,

credit, insurance…), available to all

ENABLER 2: Enabling Legal and Regulatory Environment

DRIVER 3: FINANCIAL SERVICE PROVIDERS

• Providers develop systems, knowledge, products to serve new market segments profitably and safely

DRIVER 2: ACCESS POINTS

• Expand and Diversify Access Points

DRIVER 1: DTAs

• Expand Access to Digital Transaction Accounts (DTAs)

• Drive Scale and Viability - digitize payments

ENABLER 3: Supervisory & Judicial Capacity

DRIVER 4: FINANCIAL CAPABILITY

• Raise Financial Awareness & Capability (Consumers, SMEs)

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There is Considerable Momentum leading to Implementation for which Coordinated Support is Necessary

Increasing penetration of insurance services;

Bringing pensions to more workers, including those in the informal sector;

Developing housing finance products, including for low-income segments;

Fostering Islamic finance to serve those who prefer Islamic products or who are excluded or underserved due to their religious beliefs; and

Ensuring consumer protection and increasing financial awareness and literacy, as two foundational pillars for responsible inclusion.

The World Bank also provided ten detailed technical notes which complemented the National Financial Inclusion Strategy.

The technical notes covered a detailed analysis of the respective subject areas and proposed reform actions related to development of each area, both from a financial inclusion perspective as well as from a sector development focus. The priority areas included:

1. Digital Transactional Accounts – digitization; more access points to achieve scale / viability

2. MSME Finance – enabling policy and legal environment for product diversification

3. Agricultural Finance – enabling legal framework, and capacity of FIs and farmers

4. Islamic Finance – capacity building and policy / regulations to further diversify sector and products

5. Housing Finance – housing policy; property registration reforms; market development

6. Payments Systems – digitization; payments infrastructure; interoperability; remittances

7. Secured Transactions – legal framework and market/credit infrastructure 8. Insurance – supervision and capacity of sector for outreach and market

development 9. Pensions – expand pensions to more workers and digitize payments 10. Consumer Protection and Financial Literacy – widespread awareness,

investor education and standards

The commitment to achieving results is collectively shared by policy makers, regulators, private sector stakeholders, and international development partners.

The National Financial Inclusion Strategy has been developed at a particularly opportune moment for Pakistan as technological innovation now allows financial institutions to capture economies of scale, while expansion of branchless banking offers unprecedented opportunities to transform not only the financial sector, but the broader economy as a whole. The timing is right to utilize the enabling environment to deliver significant impacts towards financial inclusion.

The NFIS has put forth a vision, a framework, a coordination structure, an action plan, and measurable targets – all critical

Policymakers, regulators and other financial sector stakeholders are already using the NFIS framework to guide the financial inclusion reform agenda. The Finance Minister has led the way by endorsing and launching the NFIS in May 2015, as well as constituting and chairing the National Financial Inclusion Council.

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Figure 39: National Financial Inclusion Strategy - Framework for Action

Source: Financial Inclusion Strategy

86 Nonetheless, there is a need to strengthen the implementation process particularly for legislative reforms so that they achieve the core principle of reform actions.

elements to drive implementation.

Implementation has already begun.

Critical policy level measures have been taken, such as Pakistan joining the global Better then Cash Alliance focused on digitizing government payment platforms. Legislative improvements are underway, such as passing of the Credit Bureaus Act and approval of the secured transactions bill for onward submission to the Parliament – both activities were supported by the NFIS86. Such policy reforms are complemented by regulatory reforms such as the introduction of a new account category called "Asaan Account" in June 2015 with simplified account opening requirements/procedures for low-income low-risk customers. The NFIS has also allowed for a more focused sub-sectoral planning process, such as with the launch of the Microfinance Growth Strategy which highlights a critical funding and human resource gap within the microfinance sector. Similarly, the World Bank will be providing support to develop Pakistan’s national payments system strategy, which would cover a comprehensive framework to guide the development of the national payments system.

Coordinated support is the key to implement reform actions needed to meet the ambitious financial inclusion

The scope, scale and timelines for reforms imply that there is a need for an effective coordination structure not only within the government and private sector, but also coordinated support from international development partners. Currently, the World Bank Group, UKAID Department for International Development (DFID) and the Bill and Melinda Gates Foundation are leading the way in donor support to financial inclusion. There are several complementarities in their programs which will form

National Financial Inclusion Council

National Financial Inclusion Steering Committee

Technical Committees / Consultative Working Groups

Finance Secretary, Governor, SBP Chairman, SECP, Chairman, PTA, Chairman,

FBR, Secretaries, Provincial Finance Departments, Chief Commissioner ICT, co-Opted

Members

Ministry of Finance

Finance Minister

Technical level representatives from MoF,

SBP, SECP, PTA, PBA, IAP etc. SBP

Governor

Digital payments

Housing Finance

Awareness and literacy

Insurance

Pensions

Agriculture finance

MSME finance

Islamic finance Gender

NF

IS S

ecre

tari

at

Updates the NFIS

Action Plan, conducts data aggregation, reporting to the

Steering Committee, M&E, research,

technical and administrative support

to lead agencies.

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targets. the basis for successful support to the financial inclusion reform agenda. The World Bank Group’s program focuses on (i) technical assistance for the NFIS coordination structure, payments systems, SME finance, and consumer protection and financial literacy, and (ii) financial support for investments in upgrading the countries financial infrastructure and liquidity support to specialized banks and the microfinance sector.

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