COMMENT – Pakistan is facing a convergence of crisis from record high inflation, a crippling power crisis, rising unemployment and deteriorating security environment. The solution of all these problems lies in a strong, effective and resourceful government. In this background, the FY12 Budget will be a critical policy statement from the government and the markets are hoping that a credible plan is introduced to bring the economy back on the path of stabilization and growth.
The government is targeting to reduce the fiscal deficit in FY12 to Rs1 trillion (4.5 percent of GDP) from six percent of GDP in FY11. Consolidation will come from new tax measures and reduction in energy subsidies. The government estimates that it will raise Rs1.9 trillion (nine percent of GDP) tax revenues in FY12 from estimated collection of Rs1.55 trillion (8.6 percent of GDP) in FY11. The additional revenues will be generated through removal of exemptions on the sales tax (GST) on sectors including fertilisers, tractors, pesticides, garments, leather, carpets, surgical and sports goods, poultry feed, cattle feed, domestic oil and medicines.
The government plans to eliminate power sector subsidies in the FY12 Budget. Energy subsidies are estimated to have cost 1.5 percent of GDP in FY11. The subsidies arise due to an inefficient energy transmission network, with close to 30 percent in line losses and rising cost of energy generation. Power tariffs have been raised over a 100 percent in the last three years but escalating line losses and rising oil prices have hampered government efforts to rein in subsidies.
The government must benchmark rise in tariffs to tangible gains in reducing line losses in order to eliminate subsidies. This will also be critical to resolving the crippling energy crisis with industries and businesses facing six to eight hours of power cuts a day.
Between a rock and a hard place:
The capture and death of Osama bin Laden, the world’s most wanted terrorist, by US forces has shaken the government. The failure of the intelligence agencies to capture Osama, who had declared war on the Pakistan state for being a key ally of the NATO forces in Afghanistan, has damaged the powerful military establishment’s credibility. Terrorists have stepped up deadly attacks inside Pakistan, and government is bracing itself for escalation in violence going forward.
The PPP led government has now forged a new broader coalition to deal with the political and economic crisis. The new coalition includes pro-Musharraf party PML-Q, the third largest party in parliament. Smaller regional ally MQM, which had walked out of the coalition over cut back in fuel subsidies in January 2011, has also rejoined the coalition.
This strengthens the government’s position ahead of the key FY12 Budget due in June; failure to pass the FY12 Budget would have resulted in fresh elections. The broader coalition government should give confidence to the government to pass through critical tax and subsidy reforms, critical to putting the economy back on track.
Pakistan-US relations face trust deficit:
The US’s unilateral action deep inside Pakistan has reignited debate inside the country especially over the trust deficit between the two allies. While the government is relieved to see the end of Osama bin Laden, the parliament has come up with a tough-worded unanimous resolution condemning the unilateral US action deep inside Pakistan, a breach of its sovereignty. Parliament is also offended with the scale up in drone attacks inside Pakistan, inflaming resentment in the tribal region due to the civilian casualties.
Taliban ranks have swelled as a result of drone strikes and fuelled the insurgency inside Pakistan. The Obama administration has sent over its highest ranking officials including Senator John Kerry to re-engage the government. However, US lawmakers are frustrated at what they perceive to be a double game played by Pakistan, taking aid from the US and supporting the Taliban on the other hand. Osama’s capture inside Pakistan has heightened fears that he enjoyed support from people inside the Pakistan government.
Relations are unlikely to normalise until these deeply contentious issues are resolved. This could possibly lead to a slowdown in US aid flows to Pakistan, the US had pledged $1.5bn annual assistance under the Kerry Lugar bill and USD 500 m under military assistance to Pakistan. More importantly, breakdown in relations between the two allies will strengthen Al-Qaeda and Taliban forces, slowing down progress in the war on terror.
The scourge of stagflation:
According to preliminary government estimates Real GDP growth has slowed down to 2.4 percent year-on-year in FY11, down from 4.1 percent in FY10. The slowdown was due to the damage caused by the August 2010 floods, estimated at $9.8 billion (five percent of GDP), with heavy damage to cash crops and infrastructure. Industry output declined 0.1 percent annually, whereas private investment spending continued to decline for the third straight year, posting negative 3.1 percent in FY11. Private consumption spending (seven percent) and government spending (7.5 percent) were the key drivers of growth.
Real per capita GDP has increased 0.8 percent annually to $1,200 in FY11. Headline inflation remains the biggest headache for policy makers with CPI inflation averaging 14.1 percent in FY11, up from 11.7 percent in FY10. The key driver of inflation has been money printing by government to finance its large deficits. In the first ten months of the fiscal year the government printed Rs213 billion (1.2 percent of GDP), fuelling inflation. Rising food and energy prices have also fuelled inflation. According to the government estimates, headline inflation is likely to remain high at 14 percent in FY12. This is due to cut back in power subsidies and new tax measures in the FY12 Budget.
Debt concerns:
The $11.3 billion IMF loan arrangment has remained suspended since May 2010 as government has delayed key tax and expenditure reforms, leading to widening of the fiscal deficit and sharp increase in debt. $3.8 billion remains outstanding under the IMF loan, with the loan extended till September 2011. The IMF wants to see significant fiscal consolidation in the FY12 Budget, reducing the deficit to four percent of GDP in FY12 from an estimated six percent in FY11. Debt sustainability remains a concern and unless the government raises tax revenues and reduces spending by curtailing subsidies, it is unlikely that IMF will release more funds.
The writer is Country Economist, Pakistan at the Standard Chartered Bank Limited.
