South Asia emerged as the fastest growing region in the world in 2015, posting GDP growth of 7 percent. Weak oil and commodity prices, slowing capital flows and shrinking global trade contributed toward a deceleration of growth in most of the world’s economies. South Asia — as a net importer of oil — was an anomaly, growing significantly on the back of higher private consumption and public investment. Higher remittances and reserve buffers throughout the region offset the fall in exports caused by the drop in global demand. The region is set to maintain real GDP growth above 7 percent over the next few years. However, the tailwinds are now fading — capital flows have declined and remittances are starting to feel the reality of low oil prices.
Pakistan, while not growing as quickly as its neighbours, has continued its steady growth recovery in H1FY16. Strong growth in consumption, rising foreign exchange reserves, fast-growing workers’ remittances and a lower import bill compensated for a significant fall in exports. Low oil prices generated a significant boost, driving a 9.1 percent fall in the import bill and reducing inflation significantly, in turn creating scope to reduce the policy rate. Private sector consumption, propelled by higher remittances and a loosened monetary policy, is expected to account for over half of FY16 GDP growth. While exogenous factors such as oil prices and fast-growing remittances undoubtedly contributed to Pakistan’s growth, the policy environment is also improving. Macroeconomic stability has improved significantly over the last two to three years, as evident in the steady growth of foreign reserves, reduced fiscal deficits and low inflation environment. Further, the government is methodically working through plans to improve the country’s grim investment climate by boosting electricity supply, improving access to credit and increasing tax revenue. While Pakistan continues to score very poorly on doing business indicators, there are some early signs of improvement as a result of these efforts. Private sector credit is showing signs of growth. And structural challenges have not prevented large-scale manufacturing from taking advantage of low global prices for raw materials in H1FY16. Investment is also expected to pick up marginally in FY16 after remaining stagnant in FY15 at 15.1 percent of GDP, a dismal figure. The growth outlook for FY16 remains modest with growth expected to increase slightly to 4.5 percent of GDP in FY16 from 4.2 percent in FY15, driven by large-scale manufacturing growth of 4.0-4.5 percent and services growth of over 5 percent. The agriculture sector, after suffering a poor cotton harvest, is expected to have slowed to between 2.0 and 2.5 percent for FY16, compared with 2.9 percent in FY15. The near-term outlook will be supported by three major near-to-medium tailwinds — rising investments under the China-Pakistan Economic Corridor (CPEC), persistently low international oil prices and the anticipated return of the Islamic Republic of Iran to the international community.
The expected growth rate, however, remains well below the 5.5 percent target envisaged under Pakistan’s Annual Plan FY16 and the growth rates of its South Asia peers. A further growth revival will remain contingent on the government making further progress in addressing structural challenges like poor electricity availability, narrow fiscal space and inadequate access to credit.
Fiscal consolidation, one of the most urgent reform needs, has been central to the current government’s economic reform programme. And the government’s commitment is delivering results. The Federal Board of Revenue (FBR) has posted an impressive 20 percent increase in tax revenue for the first eight months of FY16 on the back of a broad-based increase in direct and indirect tax collection. While this is commendable, Pakistan continues to lag in realizing its tax revenue potential. The tax revenue-to-GDP ratio has increased by 1.5 percentage points over the past three years to 11 percent in 2015, but it remains well below comparative emerging economies and less than half of the 22.3 percent tax capacity recently estimated by the IMF.
Consolidated government expenditure registered a growth of only 8.1 percent, meaning that the fiscal deficit was over 20 percent lower than that in H1FY15. This positive result was largely due to the federal government’s tight rein on its recurrent expenditure, which grew less than 5 percent. Outlays for subsidies also continued to decline, declining since H1FY13 from 0.7 percent of GDP to 0.27 percent of GDP in H1FY16. A positive development has been the commitment of significant resources toward PSDP-related development spending in spite of the broader fiscal restraint—federal PSDP during H1FY16 grew by 24 percent while provincial PSDP registered a growth of 54 percent.
Also contributing to Pakistan’s improved macroeconomic stability was its improved external position. A lower current account deficit and relatively healthy financial inflows contributed to the sustained build-up of foreign exchange reserves during H1FY16. However, this performance masks the structural weaknesses that continue to make the external sector vulnerable. Exports shrank by 11.1 percent as an uncertain global economy magnified existing domestic bottlenecks. Imports similarly declined by 9.1 percent during H1FY16. The 6.2 percent growth in workers’ remittances continued to compensate for the negative trade balance in absolute terms. However, this steady increase in remittances will come under pressure if oil prices remain low and Gulf Cooperation Council (GCC) countries — key destinations for Pakistan’s offshore workers — cut public expenditure.
Pakistan exports to a small number of destination markets, making it vulnerable to exogenous shocks. Low global commodity prices, depressed prospects of economic growth in export destinations and an appreciating Real Effective Exchange Rate (REER) continue to drag on export performance. Furthermore, Pakistan is constrained by domestic challenges including poor trade facilitation, a high cost of doing business and protectionist trade policies. Vessel charges in Karachi, for example, are almost 10 times those of Dubai or Singapore. Dwelling times for shipping containers are three times longer in Karachi than in developed countries or East Asia. Pakistan’s import tariffs are also almost twice as high as global averages, putting local manufacturers at a severe disadvantage if they aim to join global supply chains (by importing intermediate goods).
In the first eight months of FY16, the capital and financial account posted a surplus of US$ 3.13 billion, fractionally higher than the corresponding period in FY15 of US$ 3.09 billion. This positive outcome was made possible by some improvement in foreign direct investment (primarily on account of inflows from China related to the CPEC), issuance of a US$ 0.5 billion Eurobond in the international market, and loans from IFIs. However, FDI from other countries has dried up, likely due to global economic uncertainty. Official reserves reached US$ 16.1 billion in the final week of March 2016, an increase of US$ 2.5 billion in the nine months since the start of the financial year. The Rupee remained largely stable in nominal terms against the US dollar with a small depreciation of 2.8 percent during the first nine months of FY16.
While cheap oil imports kept inflation low in H1FY16, the broad-based decline in y-o-y inflation seen in FY15 seems to have bottomed out. Headline inflation registered at 3.3 percent at the start of H2FY16 compared with 1.9 percent at the start of H1FY16. Similarly, y-o-y core inflation (non-food, non-energy) started inching upwards in December 2015, touching 4.7 percent in March 2016 after a low of 3.4 percent in September. However, these inflation measures are still significantly lower than those witnessed in the same period last year, likely allowing a continued low policy rate.
A 50 basis point cut in the monetary policy rate in H1FY16 brought it to a decade’s low of 6.0 percent. However, the uptick in headline inflation since October 2015 has arrested the slide in the policy rate. Monetary aggregates remained on course, with broad money supply growing by 13 percent during H1FY16 compared to 10.9 percent in the same period last year. The government continued to retire its debt to the State Bank of Pakistan (SBP) while borrowing substantially from the scheduled banks, thus expanding the net domestic assets of scheduled banks by 6.8 percent in December 2015. However, fiscal consolidation has led to a decline in government’s incremental borrowing needs. This, coupled with lower interest rates, led to an encouraging increase in lending to the private sector by 9.7 percent as of March 11, 2016 (y-o-y).
The banking sector remains robust, largely because of heavy investment in risk-free government securities. Commercial banks hold about Rs. 6.1 trillion of government domestic debt as of December 2015, equal to 43 percent of their total assets. Furthermore, investments in government securities constitute approximate 90 percent of total banking system investments. While profitability remained high for the quarter ending December 2015, it is expected to come under pressure in the current environment of low interest rates and reduced government borrowing. Commercial banks have started to look towards riskier asset classes as SME lending grew marginally by 3.7 percent after a downward trend over the preceding five years. Going forward, growth in the sector is thus expected to reflect the slow recovery in the real sector.
The outlook for FY16 to FY19 is for moderately higher economic growth. Growth acceleration will be gradual, driven by strengthening investment flows and productivity gains in services, large-scale manufacturing and construction.
These sectors should benefit from expected reforms leading to decreased electricity load-shedding and improvements in the business climate. Gross fixed investment is expected to increase from 13.4 percent of GDP in FY15 to 14.2 percent by FY19, primarily due to the CPEC lifting FDI flows over the medium-term. Any demand-driven economic expansion as a result of CPEC’s implementation is expected to be limited in the short-run as increased investment will likely be offset by a significant increase in imports. However, supply-side effects facilitated by higher power generation capacity and better infrastructure will be beneficial for the economy in the medium- to long-term.
To achieve growth comparable to its South Asian neighbours, however, Pakistan will need to achieve steady progress in the key pillars of its medium-term reform programme. In the electricity sector, the ambitious expansion in generation will need to be matched by investments in transmission and distribution. Privatization of distribution will be a necessary step toward funding these upgrades, as will elimination of circular debt. In lifting tax revenues, efforts may need to focus on strengthening authorities’ capacity to monitor and enforce compliance through market analysis, access to data and increased recourse to tax audits. Successful completion of the CPEC will also be crucial to addressing Pakistan’s low investment rates.
These structural reforms are particularly important given the shifting winds likely to affect the Pakistan economy. While the country is currently benefitting from a CPEC-driven spike in Chinese investment, fast-growing remittances and low oil prices, these factors all face downside risk. A further slowdown in China would deliver a knock to Pakistan’s exports and FDI. And low oil prices, if sustained, are likely to drive GCC economies to cut public expenditure, thereby reducing remittances to Pakistan from these countries.
Pakistan’s recent adoption of a new poverty line is a hopeful sign that inclusive growth will continue to be a policy focus. Pakistan registered a continuously declining poverty trend on the poverty line set in 2001. By 2014, poverty rates fell below 10%, making the old poverty line less policy-relevant. The new poverty line incorporates changes in the economy over the past 10 to 15 years, and sets a higher bar for inclusive development. The new line identifies almost 30 percent of the population as poor, which is close to 60 million people — as compared to 20 million people who were identified as poor on the old poverty line. This implies the country has committed to focusing more on pro-poor and inclusive development policies.
The recent pick-up in growth is encouraging, but at 4.5 percent, it remains modest — not sufficient to create jobs for the large number of youth joining the workforce every year, and significantly below the growth path that some countries have taken to become strong and confident middle income countries. GDP per capita only increased by about 50 percent over the past 25 years, which is far lower than most of its peers. GDP growth rates closer to that of China would quadruple Pakistan’s GDP per capita within a generation. Given the strong relationship between growth and poverty in Pakistan, strong growth would also allow Pakistan to make a more significant dent on its recently revised poverty estimate of almost 60 million people.
Source: World Bank Group