VZCZCXRO8070
RR RUEHLH RUEHPW
DE RUEHIL #3694/01 2351343
ZNR UUUUU ZZH
R 231343Z AUG 07
FM AMEMBASSY ISLAMABAD
TO RUEHC/SECSTATE WASHDC 1298
INFO RUEATRS/DEPT OF TREASURY WASHDC
RUCPDOC/USDOC WASHDC
RUEHRC/USDA FAS WASHDC 4092
RUEHNE/AMEMBASSY NEW DELHI 1615
RUEHKA/AMEMBASSY DHAKA 2201
RUEHLM/AMEMBASSY COLOMBO 1428
RUEHLO/AMEMBASSY LONDON 6205
RUEHML/AMEMBASSY MANILA 2865
RUEHKP/AMCONSUL KARACHI 7143
RUEHLH/AMCONSUL LAHORE 3226
RUEHPW/AMCONSUL PESHAWAR 1660

UNCLAS SECTION 01 OF 04 ISLAMABAD 003694 
 
SIPDIS 
 
STATE FOR SCA/PB, EB/TPP, EB/IFD/OIA, AND EB/IFD/OMA 
USAID FOR ANE MWARD 
TREASURY FOR OSSA 
COMMERCE FOR ANESA/OSA 
MANILA PASS USED AT ADB 
STATE PASS USTR FOR RGERBER, DHARTWICK 
 
SENSITIVE 
SIPDIS 
 
E.O.  12958:  N/A 
TAGS: EFIN ECON EINV PREL PK
SUBJECT: Will Pakistan's growth continue 
 
REF:  Islamabad 3654 
 
INTRODUCTION AND SUMMARY 
 
¶1. (SBU)  Pakistan is in its fifth year of seven percent economic 
growth, but a number of international and private sector observers 
in Islamabad and Karachi question whether this growth is sustainable 
without additional reforms and a clear path through the election 
season. This cable is based on a series of meetings with GOP 
Economic Adviser, Ashfaque Hasan Khan; IMF Resident Representative, 
Henri Lorie; Asian Development Bank Country Director, Peter Fedon; 
Citibank representatives; Standard Chartered Bank Chief Executive 
Badar Kazmi; and the World Bank team to discuss economic 
developments in Pakistan following the July release of the FY07 
economic growth and trade statistics. 
 
¶2.  (SBU)  The domestic consumption boom led economic growth over 
the past year, resulting in a large import bill and growing trade 
deficit.  Many of our interlocutors questioned whether this growth 
pattern is sustainable over the long-term.  While Pakistan's 
economic performance is widely commended, particularly the record 
levels of foreign investment and remittances, the ADB and the IMF 
both question whether Pakistan can achieve the ambitious 10-11 
percent growth GOP Medium Term Plan target.  We share their 
observations, particularly given Pakistan's current relatively low 
investment levels. All observers cited infrastructure problems, low 
skill levels, export concentration in few commodities, lack of 
opportunity for small and medium enterprises and energy shortages as 
major obstacles to increased (and even continued) growth.  Everybody 
is watching to the current political and security situation as well 
as the choppiness in the international financial markets to see the 
effects on incoming investment, domestic investment decisions, and 
economic growth.   End introduction and summary. 
 
CONSUMPTION-LED GROWTH ATTRACTIVE TO FOREIGN INVESTORS 
 
¶3.  (SBU)  Private consumption expenditures grew 13.8 percent in 
nominal terms in FY07 over FY06. Consumer expenditures alone made up 
close to 75 percent of the Gross Domestic Product, while investment 
expenditures accounted for only 21 percent of the GDP in FY07. 
Purchases of durable consumer goods (particularly electronics and 
automobiles) have grown considerably over the past few years, with 
the growth of the purchasing power of the middle class.  Pakistan's 
consumption-led growth story is unique in Asia, and has attracted 
significant interest from overseas investors. $8.4 billion in 
foreign investment flowed in FY07, compared to $4.48 billion in 
FY06. 
 
¶4.  (SBU)  Private sector inflows and foreign purchases of global 
depository receipts from the privatization of the Oil and Gas 
Development Company Ltd (worth $730 million) and United Bank Ltd 
(worth $650 million) accounted for the majority of inflows.  The IMF 
Rep told us that non-privatization related FDI exceeded $4.8 
billion.  Remittances were also at a record high $5.4 billion. The 
U.S has been the biggest source of remittances; Pakistanis living in 
U.S sent $1.45 billion in remittances, up 17.4 percent from the 
previous year. Saudi Arabia with $1.02 billion and UAE with $866 
million are other major sources. The capital flight problem that 
plagued Pakistan in the 1990s does not exist in any significant way 
now.  In addition, services -- especially banking and telecom 
sectors -- performed exceptionally well while construction activity 
also spiked. 
 
¶5.  (SBU)  Not surprisingly, Pakistan's balance of payment surplus 
nearly tripled, from $1.3 billion in FY06 to $3.5 billion in FY07. 
Large foreign flows have generated rupee liquidity in the system; 
the State Bank Pakistan has tightened credit, increased bank ratios, 
and performed more frequent open market operations to keep inflation 
under 8 percent.  According to State Bank of Pakistan, Net Foreign 
Assets (NFA) of the banking sector rose by 30 percent, which 
resulted in money supply growth of 16.7 percent. 
 
EXPORTS SLOWDOWN PUZZLING 
 
 
ISLAMABAD 00003694  002 OF 004 
 
 
¶6.  (SBU)  Exports grew only 3.4 percent in FY07 (compared to 13.8 
percent in FY06) to $17 billion while imports increased by 6.8 
percent to $30.5 billion. Pakistan posted a record trade deficit of 
$13.5 billion due to slow down in exports.  Dr. Ashfaque Hasan Khan, 
the Economic Adviser to GOP, explained that the slowdown in exports 
has been sudden and abrupt. He attributed the slow growth in exports 
to the government's decision to end the export refunds and rebates 
programs.  He suspected that many refunds were falsified, and the 
exporters counted them as export proceeds. Elimination of rebates 
has led to a smaller but in his view, more realistic export number. 
Mr. Khan, however, said that some part of slower growth in exports 
can be attributed to market access problems in European Union 
pointing to preferential treatment granted to Bangladesh and India, 
two of Pakistan's primary textile export competitors. State Bank of 
Pakistan Governor Shamshad Akhtar commented that the GOP cannot 
subsidize its textile industry to the same extent as India and 
China, and that Pakistan is losing market share as a result. The IMF 
Resident Representative said that slowdown in exports can also be 
attributed to domestic consumption boom that has left lesser 
exportable surplus. 
 
RESERVES GROW, DESPITE LARGE CURRENT ACCOUNT DEFICIT - THANKS TO 
FOREIGN INFLOWS 
 
¶7.  (SBU)  As a result of consumption-led growth, Pakistan's current 
account deficit increased 41 percent in FY07 and now stands at $7.0 
billion or 4.8 percent of GDP.  Thanks to the strong foreign 
inflows, however, reserves grew $2.5 billion in FY07, from $10.7 
billion to $13.3 billion. The growth in reserves protected the rupee 
from depreciation -- it lost only one percent in nominal terms 
against the U.S dollar in FY07.  (Comment:  We are watching 
carefully to see to what extent the GOP can continue to finance its 
current account deficit through foreign inflows.  The majority of 
the financial experts we met are concerned that the government 
cannot continue to depend in the long term on foreign inflows to 
finance its current account deficit.  Several pointed out that 
"Pakistan is not the United States -- it is not an engine of world 
economic growth and the rupee is not a world currency."  End 
comment.) 
 
HIGH INFLATION STILL A RISK 
 
¶8.  (SBU)  Core (non-food/non-oil) inflation slowed to 5.5 percent 
in FY07, down from 7.1 percent last year.   Overall inflation, 
however, remained at 7.8 percent, driven by food inflation (up 10.3 
percent year-over-year).  Food prices increased because of higher 
international lentil and cooking oil prices, and the high 
international price of wheat and corn also affected domestic prices 
for these two commodities, driving up Pakistan's overall inflation 
rate.  Citibank commented that the growing use of grains to make bio 
fuels, such as ethanol, contributes to tight international supplies, 
affecting Pakistan because it must import cooking oil to meet the 
domestic demand. 
 
¶9.  (SBU)  Pakistan has failed to capitalize on the global 
agriculture price run-up despite bumper crops of wheat and maize. 
While Pakistan's wheat production increased 10.5 percent year over 
year, the GOP recently imposed a wheat export ban to curb rising 
domestic prices. According to Khadim Ali Shah Bukhari at the 
Karachi-based Brokerage House, this decision will divert $450-500 
million in exports to the local market.   Despite its service-based 
economy, 70 percent of Pakistanis still live in rural areas, and 
agriculture employs 43 percent of the labor force. 
 
¶10.  (SBU)  According to Bukhari, the summer floods will not 
contribute to further food inflation since the Punjabi breadbasket, 
which feeds approximately 75 percent of Pakistan, has been spared 
floods and heavy rainfalls. However, disruption due to heavy rains 
has disrupted food supply to Sindh and Baluchistan, temporarily 
increasing food inflation in these areas. 
 
SERVICES SECTOR DWARFS MANUFACTURING 
 
¶11.  (SBU)  Pakistan's services sector has overtaken both 
 
ISLAMABAD 00003694  003 OF 004 
 
 
agriculture and manufacturing with more than a 53 percent GDP share, 
while manufacturing sector only has a 19 percent share.   Foreign 
direct investment inflows have mostly been confined to the services 
sector, with only 0.5 percent going to the manufacturing sector. 
Citibank Country Manager Aziz Rahman commented that Pakistan appears 
to have skipped over the manufacturing step in the economic 
development progression. 
 
¶12.  (SBU)  The manufacturing sector grew 8.8 percent, falling short 
of its target of 12.5 percent due to overall lack of 
competitiveness.  The textile sector, which accounts for 25 percent 
of the large scale manufacturing sector and 60 percent of export 
earnings, is dominated by family groups. There is general lack of 
corporate culture in the manufacturing sector, which has restricted 
dynamism and reduced competitiveness. In addition, Pakistan's low 
skill levels were pointed out by nearly everyone we spoke with as an 
impediment to further growth. 
 
SECOND GENERATION REFORMS ESSENTIAL FOR CONTINUED GROWTH 
 
¶13.  (SBU)  Sustained 7 percent growth much less the 10-11 percent 
growth the GOP seeks to make real inroads on poverty reduction, 
however, depends on implementation of second generation reforms and 
growth in the energy supply. The ADB believes that the GOP target is 
not possible with the current investment levels, currently 23 
percent of GDP (as compared to 40 percent in China and around 30 
percent in India), and that GOP predictions that the private sector 
will make 80 percent of this investment are ambitious.    The ADB 
told us that given the composition of Pakistan's private sector and 
its traditional reluctance to invest here, it is not likely invest 
at this level. In addition, macroeconomic imbalances such as large 
current account deficit and Pakistan's lack of industrial 
diversification also make higher growth rates more difficult. The 
International Monetary Fund ResRep shared ADB's view. Standard 
Chartered Bank Pakistan's Executive Director, Badar Kazmi, however, 
related his experience that Pakistanis are more likely to invest at 
home today than at any time in the past; post-9/11, they are seeing 
a good return on their investment.  His bank is also putting 
significant resources into developing its small and medium 
enterprise sector. 
 
WATCHING TO HOW THE CURRENT SITUATION AFFECTS INVESTMENT 
 
¶14.  (SBU) The GOP economists, IFI reps and banking sector are all 
monitoring the current political and security situation carefully as 
Pakistan heads into its election season to see how investment and 
growth are affected.  The World Bank sources said that it is very 
hard to get the real sense of economic fallout of the recent law and 
order problems and suicide attacks in Pakistan. They are watching to 
see whether this is a passing phase.  The Citibank sources said that 
the risk premium on Pakistani bonds rose in the international 
capital markets due to recent suicide attacks in Pakistan. However, 
global investors will be looking at Pakistan as an investment 
opportunity due to good spreads. No matter what happens, it will 
always be less expensive to invest here rather than India or other 
Asian countries.  Standard Chartered Bank's Kazmi remarked that "the 
picture over the next three to six months is blurred" but has 
confidence in the medium-term outlook. 
 
¶15.  (SBU)  The Karachi Stock Exchange gained 37.9 percent during 
the FY07. There has, however, been a decline of 11.8 percent in the 
Karachi 100 Index while market capitalization dropped by 13.7 
percent or $8.46 billion since July 13, 2007. Foreign selling has 
triggered the drop in Karachi Stock Exchange as there has been a net 
outflow of $53.9 million during the last one month.  (reftel) 
 
COMMENT 
 
¶16.  (SBU)  Over the medium term, Pakistan's economy has done 
exceeding well. Per capita income grew at an average rate of 13 
percent during the last five years.  There has also been progress on 
the poverty front, even as the exact numbers are debated.  Social 
indicators, including primary school enrollment and immunization, 
also improved by 44 percent and 43 percent respectively over the 
 
ISLAMABAD 00003694  004 OF 004 
 
 
last five years. International debt reduction has allowed federal 
and provincial spending to double between 2003 and 2007.  We are 
watching the current political and security situation as well as the 
choppiness in the international financial markets to see the 
magnitude of the effect on incoming investment, domestic investment 
decisions, and economic growth. 
 
¶17.  (SBU)  There is a general perception that it will be very 
difficult for any political party to reverse the reform process in 
Pakistan. The media has become increasingly independent, and middle 
class spending in particular has fueled much of the current growth. 
However, the remainder of the current government and certainly the 
new government must address the structural issues -- lack of 
competitiveness, export concentration in few areas, low skill 
levels, insufficient infrastructure, dependence on foreign inflows 
to finance the trade deficit, and lack of investment in the energy 
sector - which prevent the China-style growth necessary to grow 
Pakistan's middle class. 
 
BODDE