VZCZCXRO8128
RR RUEHLH RUEHPW
DE RUEHIL #3853/01 3520559
ZNR UUUUU ZZH
R 170559Z DEC 08
FM AMEMBASSY ISLAMABAD
TO RUEHC/SECSTATE WASHDC 0713
INFO RUEHRC/DEPT OF AGRICULTURE WASHDC
RUEATRS/DEPT OF TREASURY WASHDC
RHEBAAA/DEPT OF ENERGY WASHDC
RUEHRC/USDA FAS WASHDC 4294
RUCPDOC/DEPT OF COMMERCE WASHINGTON DC
RUMICEA/USCENTCOM INTEL CEN MACDILL AFB FL
RHMFISS/CDR USCENTCOM MACDILL AFB FL
RUEKJCS/SECDEF WASHINGTON DC
RUEAIIA/CIA WASHDC
RUEHKP/AMCONSUL KARACHI 0792
RUEHLH/AMCONSUL LAHORE 6523
RUEHPW/AMCONSUL PESHAWAR 5382
RUEHNE/AMEMBASSY NEW DELHI 4210
RUEHBUL/AMEMBASSY KABUL 9584
RUEHKT/AMEMBASSY KATHMANDU 9340

UNCLAS SECTION 01 OF 03 ISLAMABAD 003853 
 
 
SENSITIVE 
SIPDIS 
 
 
E.O. 12958:  N/A 
TAGS: ECON ETRD EAID EFIN ENGY EINV PGOV PK
SUBJECT: STATE BANK OF PAKISTAN ISSUES 2007-2008 ANNUAL REPORT 
 
¶1. (U) SUMMARY:  Pakistan's central bank, the State Bank of Pakistan 
(SBP), released its 2007-2008 annual report on December 11.  The 
report presents a lucid explanation of the already well documented 
deterioration of Pakistan's macroeconomic situation in Fiscal Year 
2007-2008, ending in June.  Pakistan's economic growth moderated to 
5.8 percent in FY08 (well below the target of 7.2 percent).  High 
food and fuel prices, combined with heavy government borrowing from 
SBP to finance the fiscal deficit, pushed year on year Consumer 
Price Index inflation to 25 percent by October 2008 and food 
inflation to 31.7 percent.  The widening fiscal deficit coupled with 
the rising oil and higher international prices of other imports 
combined to double the external current account deficit to 8.4 
percent of gross domestic product (GDP).  In FY 2008-2009, the 
government and the central bank developed a macroeconomic 
stabilization package whose implementation is well underway.  This 
program is now a corner stone of the 23-month Stand-By Arrangement 
negotiated with the International Monetary Fund (IMF). 
Macroeconomic stabilization is predicated upon effective fiscal 
discipline to ensure that the monetary tightening yields the desired 
impact on inflationary pressures.  END SUMMARY. 
 
-------------- 
OVERALL GROWTH 
-------------- 
 
¶2. (U) After strong growth during the past few years, Pakistan's 
economic growth moderated to 5.8 percent in FY08 (well below the 
target of 7.2 percent) due to a combination of insufficient domestic 
energy production, disappointing crop harvests, and rising political 
uncertainty.  Similarly, critical water shortages at sowing time, 
incidence of viral attacks, and a disproportionate rise in 
fertilizer prices weakened the performance of agriculture.  As a 
result, the contribution of commodity producing sector to overall 
GDP growth in FY08 was the lowest in the last six years.  External 
factors, including a rise in international commodity prices and 
lower capital inflows, also slowed growth. 
 
¶3. (U) An important contributor to the slowdown in GDP growth was 
the weak investment activity in the country; reflecting investors' 
cautious response to political uncertainty, the poor law and order 
situation, and high inflation expectations.  Domestic resource 
mobilization lagged behind investment requirements and delays in 
infrastructure investment resulted in acute power shortages, 
impacting overall economic performance.  The investment to GDP ratio 
fell to 21.6 percent in FY08 from 22.9 percent in FY07.  The savings 
to GDP ratio dropped to 13.9 percent in FY08 from 17.8 percent in 
FY07.  Incipient economic stress magnified as the country faced 
exogenous and endogenous shocks that eroded hard earned economic 
gains. 
 
------------------ 
REAL SECTOR GROWTH 
------------------ 
 
¶4. (U) Real productive sectors performed below expectations due to 
high input commodity prices, energy shortages, uncertainty during 
political transition, and below-target harvest of some key crops 
that were hit by water shortages. 
The agriculture sector growth rate fell to record lows of 1.5 
percent during FY08 -- the lowest growth since FY03 and 
significantly lower than the 4.8 percent target for the year.  Major 
crops also had a disappointing performance because of issues 
surrounding resource management and pricing policy.  For instance, 
area under cultivation of cotton, rice and wheat fell because of 
water shortages at sowing time.  As the government delayed 
announcement of pricing policy, there were delays in harvesting of 
wheat.  Stubbornly high prices of fertilizers and pesticides also 
led to lower usage of these inputs, resulting in depressed yields. 
 
¶5. (U) The industrial sector suffered from a mix of economic, 
political and structural setbacks in FY08.  Rising fuel and raw 
material prices and intensifying energy shortages in the country 
obstructed industrial activities in FY08.  The heightened political 
 
ISLAMABAD 00003853  002 OF 003 
 
 
uncertainty and law & order issues during the year also took their 
toll.  Provisional estimates of FY08 industrial growth are 4.6 
percent compared with 8.0 percent in FY07.  Other than the 
construction sub-sector, all industrial sub-sectors performed below 
their long-term trend in FY08.  Manufacturing sector growth 
continued to decline for the third consecutive year and posted the 
lowest growth in six years during FY08.  Most of the slowdown was 
seen in large scale manufacturing, due to a relative moderation in 
domestic demand, power and gas outages, as well as capacity and 
input constraints in certain industries. 
 
¶6. (U) In sharp contrast to the weak performance by commodity 
producing sectors, the services sector showed above-target growth 
for the sixth time during the last seven years.  The sector grew by 
8.2 percent in FY08, significantly higher than the 7.2 percent 
annual target for the year and the 
7.6 percent growth seen in FY07.  The resilience exhibited by the 
services sector helped to keep GDP growth to a respectable level by 
contributing about three-fourths of the total value added during 
FY08. 
 
--------------- 
MONETARY POLICY 
--------------- 
 
¶7. (U) Inflationary pressures in the economy remained strong 
throughout FY08.  The steep rise in inflation in FY08 was the result 
of the unanticipated strength of international commodity prices, 
upward adjustment in administered prices of key fuels and pressure 
on wheat prices (due to rationalization of its support price as well 
as artificial shortages in some parts of the country) and a sharp 
depreciation of the rupee.  In particular, Pakistan witnessed a 
sharp surge in food inflation since March 2008 as a result of a 
steep rise in the prices of some essential food staples.  Non-food 
inflation showed sharp upward trend in the second half of FY08 on 
account of pass-through of petroleum products prices to domestic 
consumers, rising air and road fares, and gas & electricity charges. 
 By October 2008, year-over-year Consumer Price Index inflation rose 
to record highs of 25 percent with food inflation hitting 31.7 
percent and core inflation rising to 18.3 percent. 
 
¶8. (U) Capital flight put pressure on the exchange rate, and drained 
liquidity from the interbank rupee market.  So great was the 
liquidity drain that interest rates in the money market spiked, 
triggering rumors of runs on banks.  SBP promptly diffused the 
liquidity risks by easing statutory reserve requirements. 
 
¶9. (U) During fiscal year 2007/2008, the central bank had to tighten 
its monetary policy stance in three rounds, which cumulatively 
resulted in an increase in SBP Policy rate by 350 basis points. 
With the unabated rise in core inflation, the SBP raised policy rate 
by 200 basis points again in November. 
 
------------- 
FISCAL POLICY 
------------- 
 
¶10. (U) Fiscal management weaknesses surfaced more glaringly as the 
budget for 2007/2008 was grossly underestimated and the spending was 
not aligned properly to the resource availability.  The tax/GDP 
ratio has been stagnant for some years and higher than budgeted 
interest and subsidies expenses contributed to a larger fiscal 
deficit.  A slowdown in revenue growth coupled with a strong rise in 
total expenditures (driven by exceptionally large interest payments 
and consumption subsidies) caused serious deterioration in fiscal 
performance in FY08.  Fiscal deficit in FY08 reached 7.4 percent of 
GDP, a level not observed since FY99, against the budget target of 
4.0 percent of GDP for the year and compared to 4.3 percent of GDP 
witnessed in the preceding year.  The intensity of the surge in 
international prices was severe but consumption remained robust as 
the transitional government did not pass through higher costs to 
consumers. 
 
¶11. (U) After consistent improvement from FY01 to FY07, Pakistan's 
 
ISLAMABAD 00003853  003 OF 003 
 
 
debt position deteriorated sharply in FY08, reflecting the country's 
large fiscal and current account deficits, as well as slowing 
economic growth.  The stock of Pakistan's total debt and liabilities 
(TDL) increased by 27 percent year over year, to PKR 6,417.4 billion 
(USD 80.7 billion at 79.5 rupees per dollar), with a commensurate 
deterioration in the debt sustainability indicators.  In particular, 
the ratio of total debt and liabilities to GDP, a broad measure of 
the country's capacity to sustain debt, saw an end to a seven-year 
declining trend, rising in FY08 to 60 percent.  Domestic and 
external debt contributed almost equally to the sharp increase in 
TDL stock during FY08.  The rise in the growth of domestic debt 
reflected a larger FY08 fiscal deficit relative to the previous year 
and also the relatively low availability of external financing 
receipts.  The accelerated growth in the rupee value of external 
debt in FY08 was the result of a larger current account deficit and 
substantial depreciation of the rupee. 
 
---------------- 
OUTLOOK FOR FY09 
---------------- 
 
¶12. (U) The pressures on the economy have intensified in the initial 
months of FY09, as seen in all key macroeconomic indicators, and 
downgrades of the country's sovereign credit ratings.  Inflation is 
persisting at 25 percent in October 2008 with food inflation 
touching a staggering 31.7 percent year-over-year.  Monetization of 
the deficit through central bank lending during Jul-Nov 17, FY08 
reached PKR 378.9 billion (USD 4.8 billion), as compared to PKR 74.7 
billion (USD 940 million) in the same period last year, supporting 
inflationary pressures.  The growth of the external account deficit 
has also accelerated sharply.  It grew 98 percent year-over-year to 
reach almost USD 6.0 billion during Jul-Oct FY09, as compared to USD 
3.0 billion in the same period last year.  At the same time 
international financing flows have dropped sharply to a mere USD 1.1 
billion from USD 3.1 billion in Jul-Oct FY08, reflecting weakening 
fundamentals of the domestic economy and the deepening international 
financial crisis. 
 
¶13. (U) The drain on the country's foreign exchange reserves has 
continued in FY09.  The reserves dropped to USD 11.4 billion by 
end-June 2008 from the end-October 2007 peak of USD 16.5 billion. 
Foreign exchange reserves declined to USD 6.4 billion by November 
25, 2008.  Growing uncertainty emanating from the drop in foreign 
exchange reserves combined with the weakening macroeconomic 
fundamentals, resulting in cumulative depreciation of 23.3 percent 
of the rupee between July 2007 and November 25, 2008.  The pressures 
on the economy continued to persist and intensified during the 
initial months of FY09 with soaring inflation, slowing growth, a 
substantially increased current account deficit, low foreign 
exchange reserves and downgrades in sovereign credit ratings. 
 
¶14. (U) Comment:  In FY 2008/2009, the government and the central 
bank have together developed a macroeconomic stabilization package 
whose implementation is well underway and has helped to have a 
buy-in from the international agencies.  This program is now a 
corner stone of the 23-month Stand-By Arrangement negotiated with 
the International Monetary Fund.  Macroeconomic stabilization is 
predicated upon effective fiscal management, and to ensure that the 
monetary tightening reduces inflationary pressures.  On the fiscal 
side, the government has phased out most subsidies.  The government 
has now widely acknowledged the inflationary impact of its sizeable 
borrowings from the central bank that reached undesirable levels 
close to PKR 380 billion (USD 4.78 billion) during Jul-November 
¶2008.  End Comment. 
 
PATTERSON