VZCZCXRO2657
RR RUEHLH RUEHPW
DE RUEHIL #2798/01 3231221
ZNR UUUUU ZZH
R 191221Z NOV 09
FM AMEMBASSY ISLAMABAD
TO RUEHC/SECSTATE WASHDC 6057
INFO RUEHBUL/AMEMBASSY KABUL 1178
RUEHLO/AMEMBASSY LONDON 1819
RUEHNE/AMEMBASSY NEW DELHI 5770
RUEHLH/AMCONSUL LAHORE 8169
RUEHPW/AMCONSUL PESHAWAR 7217
RUEHKP/AMCONSUL KARACHI 2568
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RUEKJCS/SECDEF WASHINGTON DC
RHEHNSC/NSC WASHINGTON DC
RUEAIIA/CIA WASHINGTON DC
RUCPDOC/DEPT OF COMMERCE WASHINGTON DC
RUEKJCS/JOINT STAFF WASHINGTON DC

UNCLAS SECTION 01 OF 03 ISLAMABAD 002798 
 
SENSITIVE 
SIPDIS 
 
E.O. 12958: N/A 
TAGS: ECON EFIN PGOV PREL PK
SUBJ: PAKISTAN'S ECONOMIC PERFORMANCE IMPROVING, BUT STRUCTURAL 
 
REFORMS INSUFFICIENT FOR IMF 
 
REF: A. ISLAMABAD 2698 
 ¶B. ISLALAMABD 1992 
 
¶1. (SBU) Summary: Pakistan's macroeconomic outlook was mixed in the 
first quarter of the fiscal year 2009-2010.  While its year-on-year 
inflation and balance of payments position improved, fiscal and real 
sector performance remained tenuous.  Lending to the private sector 
declined, but the external current account balance improved 
slightly, a result of the emerging global economic recovery.  But 
continued electricity shortages, limited progress on power sector 
reforms, and ongoing fiscal stresses diluted some of these gains. 
Although the International Monetary Fund (IMF) recognized GOP 
efforts to further stabilize the economy, advance structural reform 
and lay the foundations for sustainable growth, doubts about GOP 
commitment to further electricity tariff increases and concerns with 
delays in enacting meaningful tax reform, have outweighed progress. 
The November 12 conclusion of the third review of Pakistan's 
performance under its Stand-By Arrangement with the Fund has not 
resulted in the hoped for disbursement of the third tranche of funds 
for the GOP, although discussions will continue.  End Summary. 
 
¶2. (U) Private sector credit growth was down: $938 million in the 
first quarter, compared to $978 million in the same period last 
year.  The growth rate for the large scale manufacturing sector, 
however, although virtually flat at 0.17 percent in July-August 
2009, is being viewed as a marked improvement over the -8.1 percent 
growth in the same period last year.  Advisor to the Minister of 
Finance Sakib Sherani said the manufacturing growth rate had been 
pulled down by the poor performance of the steel and petroleum 
sectors (affected by the poor performance of Pakistan Steel Mills 
and circular debt, respectively). 
 
Cautious Optimism for the Economy 
--------------------------------- 
¶3. (SBU) Sherani said there are grounds for cautious optimism for 
the Pakistani economy.  The textile sector (despite much industry 
outcry to the contrary) recorded marginal improvement, while the 
automobile sector had been boosted by strong performance in 
agriculture: farmers and workers in related industries had 
sufficient funds to acquire automobiles and trucks, despite banks' 
reluctance to finance these purchases.  Domestic cement sales 
indicate an uptick in construction activity and offset lower orders 
from abroad, particularly from India. 
 
¶4. (U) According to a survey on business sentiment conducted by the 
Pakistan Institute of Development Economics (PIDE), 60 percent of 
major business concerns expect higher sales, increased capacity 
utilization, and higher employment and inventory levels in 
July-December 2009.  These businessmen named slack demand as the 
number one impediment to their business; the high cost of capital 
was second on their list of concerns, followed by security and then 
the energy shortage.  Small and medium businesses, however, suffer 
most from energy shortages, according to Sherani.  Although the 
recent bombings and general deterioration in the overall security 
situation have badly affected FATA and NWFP businessmen, Sherani 
said that bombings have had less effect on business sentiment 
countrywide. 
 
FDI Down, Portfolio Investment Up 
--------------------------------- 
 
¶5. (SBU) Foreign direct investment (FDI) decreased by 58.8 percent 
to $463 million in the first quarter FY 2009-2010, down from $ 1.1 
billion in the same period last year.  According to the PIDE 
business survey, the majority of firms reported an unchanged level 
of investment in their businesses from January-June 2009 and they 
did not plan any significant investment in July-December 2009. 
Major portfolio investment outflows were reversed from an outflow 
-$172.9 million to an inflow of $208 million in the first quarter: a 
220 percent increase.  The Finance Ministry ascribes this turnaround 
to attractive stock valuations in comparison to other countries in 
the region and an upgrade in Pakistan's debt by international rating 
agencies (Ref A). 
 
Imports Down, Remittances Up 
---------------------------- 
 
¶6. (SBU) Weak demand caused Pakistan's total imports to decline from 
$10.8 billion in the first quarter of FY 2008-2009 to $7.58 billion 
 
ISLAMABAD 00002798  002 OF 003 
 
 
in the same period this year, a 29.8 percent drop, and contributing 
to a 44.7 percent decrease in Pakistan's trade deficit compared to 
last year.  Supported by the continued strong inflow of worker's 
remittances, this fall in import growth has resulted in an $82 
million surplus in the external current account balance in August 
¶2009.  The cumulative July-August external current account deficit 
of $527 million is still much lower than $2.67 billion deficit in 
the same period last year.  Workers' remittances increased by 24.5 
percent to $2.33 billion in the first quarter, from $1.87 billion in 
the same period last year.  Remittances in September 2009 alone 
totaled a record $806 million.  Sherani ascribed the steady increase 
to GOP measures such as a crackdown on illegal money changers (Ref 
B). 
 
Exports Expected to Increase 
---------------------------- 
 
¶7. (SBU) Sherani also pointed out that the 13.8 percent decline in 
exports in the first quarter is worrisome and continues to pose an 
underlying risk to Pakistan's balance of payments.  The GOP expects 
exports to grow at a rate of 3-4 percent in FY 2009-2010, however, 
because order books for the textile firms "looked very healthy," 
reflecting improvements in the global economy; order books for the 
spinning sector are fully booked for the next six months. 
Improvements in spinning sector performance in turn bode well for 
the health of the banking sector, Sherani said, because spinners are 
major borrowers and can add to banks' bad debt if the sector's 
performance falters.  Finally, depreciation of Pakistan's real 
effective exchange rate, due to falling domestic inflation and an 
appreciation of India's currency, has increased the competitiveness 
of Pakistani exports. 
 
ForEx Improves 
-------------- 
 
¶8. (U) Cash injections from the IMF, both for budgetary support 
($745 million) and the increased allocation of special drawing 
rights (some $1.2 billion), substantially improved Pakistan's 
external financial account balance.  As a result, SBP's foreign 
exchange reserves reached $10.9 billion on September 28, 2009 - an 
increase of $1.8 billion since July 1.  This is also reflected in 
the $1.58 billion increase in net foreign assets, which contributed 
to the economy's improved liquidity and brought stability to foreign 
exchange markets.  Despite an impressive drop in credit default 
swaps from 30 to 8 percent, Pakistan's rate (Note: On par with 
Argentina.  End Note) is still high for it to raise money through 
the Eurobond markets. 
 
But Revenue Collection Is Still Too Low 
--------------------------------------- 
 
¶9. (SBU) Tax collection is down by 0.95 percent to $3.12 billion in 
the first quarter, from $3.15 billion in the same period last year, 
further complicating fiscal management, according to Sherani.  He 
was hopeful that shortfalls in collection could be made up in coming 
quarters, however, because first quarter collection is based on FY 
2008-2009 corporate profits and incomes - all of which were low due 
to the economic slowdown.  The GOP blames slower than expected 
disbursements from donor countries for the fiscal challenges - both 
revenues and expenditures -facing the Finance Ministry. 
 
Borrowing Is Down - Or Is It? 
----------------------------- 
 
¶10. (U) Pakistan's fiscal deficit was 1.5 percent of GDP in the 
first quarter, marginally higher than the IMF-agreed target of 1.3 
percent.  Sherani said the slight slippage on the fiscal deficit was 
not a cause for concern, as the GOP had had to make advance salary 
payments on the occasion of the post-Ramazan Eid holiday.  The 
government also retired $882 million-worth of debt to the State Bank 
of Pakistan during July 1-October 3 in order to meet the IMF zero 
net borrowing condition.  However, the GOP borrowed extensively from 
commercial banks: some $1.4 billion during July-September 2009, vs. 
the retirement of $1.27 billion-worth of commercial debt in the same 
period last year.  This borrowing crowded out private sector credit, 
which fell by $940 million in the first quarter. 
 
Good News on Inflation 
---------------------- 
 
ISLAMABAD 00002798  003 OF 003 
 
 
 
¶11. (SBU) Both consumer price inflation (CPI) and core inflation 
(non-food, non-energy inflation) decreased in July-September 2009. 
CPI dropped to 10.7 percent and core inflation fell to 12.9 percent, 
down from 24.5 percent and 16.1 percent respectively in the same 
period last year.  Despite this positive news, former Advisor to the 
Minister of Finance and now Dean of the National University of 
Science and Technology Dr. Ashfaque Khan pointed out that the pace 
of decline in inflation has been slow.  Furthermore, a 0.5 percent 
increase in inflation in September over August, coupled with poor 
management of the food supply chain (Note: leading to shortages of 
such staples as sugar and wheat.  End Note) and projected increases 
in electricity prices could well fuel higher inflation in coming 
months.  Unpredictable increases in international oil prices were 
also an underlying risk to inflation as well.  In response to 
ongoing concern about inflation, the State Bank kept the policy rate 
unchanged at 13 percent in its October monetary policy 
announcement. 
 
Not Enough for the IMF? 
----------------------- 
 
¶12. (SBU) Working level contacts in the Ministry of Finance and the 
IMF/Islamabad office reported November 13 that the IMF has 
registered concern over the slow pace of agreed structural reforms, 
especially the slow pace of tax reforms and imposition of a value 
added tax (VAT), at the third review under Pakistan's Stand-By 
Arrangement (SBA) in Dubai November 2-12.  Tasnim Aslam, Senior 
Economist at the IMF, said that the lack of progress on tax reforms 
has resulted in a revenue shortfall in the first quarter of the 
current fiscal year.  The IMF team in Dubai also expressed concern 
about the GOP failure to implement the automatic fuel adjustment 
mechanism, which will more effectively pass on changes in fuel 
prices to electricity consumers. 
 
¶13. (SBU) Comment: Sherani's predictions that Pakistan would have an 
easier time in its third review than it had in its second (Note: 
which dragged on for over a month.  End Note) do not appear to be 
borne out.  The GOP hoped making changes in the Banking Companies 
Ordinance and SBP Act to enhance the Bank's autonomy (Note: The Act 
is currently with the National Assembly. End Note), coming in more 
or less on the mark with the fiscal deficit target, and in 
particular implementing the six percent electricity tariff increase 
would outweigh Pakistan's shortcomings.  However, the Fund's concern 
with the GOP's inability to move forward with meaningful tax reform 
and to collect taxes already levied seem to have prevailed; the 
conclusion of the third review has been suspended from its scheduled 
November 12 date (septel).  Continued doubts about the GOP 
commitment to further increases in electricity tariffs (Note: two 
more increases are due in the next six months.  End Note) also 
contribute to the Fund's caution.  Minister of Finance Shaukat Tarin 
told media November 13, however, that he expected Pakistan's third 
tranche of funds to be released "soon." 
 
¶14. (SBU) Comment cont'd: Uncertainty regarding the timing of 
official foreign inflows, continued pressure on the country's fiscal 
management and limited progress on resolution of Pakistan's serious 
electricity problems remain a drag on economic growth and stability. 
 If expectations of a recovery in at least some exports are 
mistaken, the low export figures will constitute a major threat to 
the country's balance of payments; low imports are already having an 
adverse effect on revenue, as 40 percent of GOP revenue income comes 
from import taxes.  Instituting a value added tax (VAT), essential 
to improving Pakistan's dismal 9 percent tax-to-GDP ratio, is making 
only slow progress in the face of thorny constitutional issues 
requiring federal and provincial government agreement.  End 
Comment.