ISLAMABAD, Sept 22: The Asian Development Bank has forecast a number of risks to Pakistan's economy in 2005, including the possibility of an increase in terror incidents , higher-than-targeted inflation, a major risk to the winter crops and the widening of trade gap.

In its 'Asian Development Outlook 2004 Update' released on Wednesday, the bank said: "International oil prices have been very volatile in recent months and, if they remain high, projections for imports, the fiscal deficit, and inflation will have to be revised upward."

The bank also forecast deficit in current account, continuing pressure on exchange rate and lowering of Pakistan's export growth in view of the fact that high oil prices would also damp the global economic recovery.

On the domestic front, water availability for the winter crops was not projected to be significantly lower than in fiscal 2004. The possibility of an increase in terrorist incidents could not be ruled out, the bank said.

With sound macroeconomic fundamentals, rising private investment and a sharp increase in the public sector development programme, the economy is projected to grow by 6.5 per cent in 2005, compared with the 5.8 per cent forecast earlier.

However, as money supply has been growing much faster than nominal GDP over the past three years, the resulting large liquidity overhang would put pressure on prices. Also, with the surge in oil prices and with most domestic industries approaching full capacity, the inflation forecast for fiscal 2005 had been raised from four per cent to 5.5 per cent.

The current account is now projected to move into deficit, as imports grow faster than exports and as official transfers decline. Agricultural growth is likely to be stronger than last year, but because of emerging water shortages, it is difficult to make any accurate predictions, the report added.

Rice and sugarcane crops were likely to suffer as availability of water for the summer crops is 20-30 per cent lower than last year and the area sown under sugarcane has declined by 11.3 per cent, the report said. An anticipated shortage of water in the country's two main reservoirs posed a major risk to the winter crops, which depend heavily on canal irrigation.

However, cotton production is likely to strengthen by 7-9 per cent in 2005 because of a higher sown area of about seven per cent and a lower incidence of pest attacks due to dry weather.

Growth in manufacturing in 2005 would be lower than a year earlier, but was still likely to be in the double-digit range, given the strong recovery in sector investment seen in fiscal 2004, the bank said.

A raft of incentives, such as reduction in import duties on industrial raw materials and machinery, together with liberalization of import of second-hand machinery and incentives for exports, was expected to boost investment and production in manufacturing, it said.

An anticipated larger cotton crop and lower cotton prices would help the textile sector. The envisaged increase in interest rates was unlikely to hurt manufacturing, because interest rates would still be low.

The banking industry is also expected to register a robust expansion, induced by reforms and privatization. With GDP growth expected to remain well above six per cent and imports maintaining a double-digit increase, tax revenues should grow by about 12 per cent in 2005, the report said.

As public debt indicators were projected to improve further, debt servicing, the largest budget expenditure item, was likely to remain under control, the report said. Similarly, defence expenditures were expected to stay on target, given a significant improvement in relations with India.

The fiscal deficit target of 3.5 per cent of GDP for 2005 was therefore likely to be achieved, the bank said. A rapid economic growth, continuing high oil prices, and the planned import of one million tons of wheat in 2005 point to imports maintaining their 20 per cent rise.

With imports outpacing exports, the trade deficit would widen further, the report said and added that the deficit on the services account was also expected to increase due to anticipated higher expenditures on shipping and lower receipts from the US for logistics support for the conflict in Afghanistan.

These, along with the lower official transfers because of the full-year impact of the discontinuation of the Saudi Oil Facility, would push the current account to a deficit of $1.3 billion or 1.3 per cent of GDP, the report said. This was likely to put pressure on exchange rate, it added.

The bank said that the medium-term prospects for the economy were positive because of substantial improvements in macroeconomic fundamentals over the past 3-4 years and the sharp pickup in investment in 2004.

In addition, improving relations with India might well lead to an upturn in trade between the two countries and a greater foreign investment, and so boost growth, the bank forecast.