Contrary to earlier fears, Pakistan’s economy performed reasonably well in FY02.1 In particular, the tremendous improvement in Pakistan’s external sector post-September 2001, either directly or indirectly, contributed to positive developments for many macroeconomic indicators during the year. The trade deficit turned out to be much lower than in FY01 as exports recovered in the second half of FY02 to reach the preceding year’s level, while imports dropped; the current account was in surplus and underpinned the unprecedented 6.7 per cent appreciation of the Rupee. An upsurge in workers’ remittances, increased official transfers and savings in interest payments allowed the SBP to increase foreign exchange reserves to an all-time high; the Rupee liquidity injected through the foreign exchange purchases enabled the SBP to ease its monetary policy stance; inflation was down to 3.5 per cent as the appreciating Rupee lowered the cost of imported inputs; external debt restructuring and lower interest rates on domestic debt led to a reduction in debt servicing, thereby aiding the Government ‘s effort to contain the fiscal deficit. Still, there were several negative repercussions of the September 11 events on the domestic economy; there was a lower collection of tax revenues as the tax base was eroded due to a reduced level of imports in Rupee terms; the export target of US$ 10 billion could not be achieved, foreign investors remained hesitant in making new commitments; and the law-and-order situation became difficult as action was taken against terrorist groups.

While acknowledging the salutary impact of the external account improvement, however, it is worth stressing that the trend improvement was visible well before the seminal September 11 events. Interest rates were already on the way down; foreign currency reserves were edging up; the exchange rate was relatively stable; the inflation downtrend was well defined, and the government’s continuing fiscal discipline and commitment to reforms had already set the stage for the IMF PRGF, and the subsequent re-profiling of external debt. Nonetheless, the pre-existing positive trends did gain invaluable momentum in FY02, post-September 11. However, despite these major positives, the economy was not unscathed in FY02.

Real GDP grew by a reasonable 3.6 per cent, but the increase was concentrated in fewer sub-sectors. A third successive year of water shortages took its toll, as major crops recorded another decline. The overall 1.4 per cent agricultural growth thus owed almost entirely to yet another impressive performance by the livestock sub-sector. The manufacturing sector presented, under the circumstances, a more creditable performance. Even though the 4.4 per cent FY02 growth was considerably weaker than the 7.6 per cent increase recorded in FY01, it must be remembered that the economic environment was shrouded in uncertainties through much of FY02, first due to the conflict in Afghanistan and then due to border tensions with India. While some sectors targeting the local economy (electronics, car manufacturers, sugar, etc.) performed reasonably well through most of the year, it was the increased access to key Western markets and a substantial decline in interest rates that catalyzed the textile sector recovery late in H2-FY02. As a result, it was the services sector that dominated the FY02 growth profile with a 5.1 per cent growth. Yet, it is important to note that, here too, the structure of growth was highly skewed, with a single component, public administration & defense, accounting for a major portion of the total increase in sectoral value added during the year. In other words, while the growth rate recorded some improvement in FY02, the quality of growth remained lackluster and shallow as the spread and spillovers to the rest of the economy remained highly limited. Thus the buoyancy and briskness in economic activity was not observed.

Focusing on the external account improvement, there were clearly some one-off inflows into the current account in FY02 that are unlikely to recur in future. The US$ 600 million grant from the US, the payments for logistics support provided to the US troops, and other bilateral grants, fall under this category and should be excluded in determining the trend of current account inflows.

Remittances more than doubled in FY02 to reach US$ 2.39 billion; the rise post-September 2001 has been attributed, at least in part, (1) to a reversal of capital flight, as Pakistani balances held abroad came under greater scrutiny internationally by host countries,2 and then increasingly (2) to the waning attraction of foreign exchange holdings due to an appreciating Rupee. However, the sheer scale and persistence of the improvement suggests that a welcome and more permanent change is emerging, driven by a shift in preferences of remitters away from the informal sector due to increased international scrutiny of informal fund flows, and the collapse of the kerb market premium. These higher inflows offered the SBP a rare opportunity to substantially boost its foreign exchange reserves without an adverse impact on the exchange rate. Indeed, the purchases allowed the Rupee to stabilize around the Rs 60/US$ mark, offering some respite to exporters that had been hit by a disruption in orders due to perceptions of increased regional risk as well as by the already substantial year-to-date gains of the Rupee. Such support was deemed essential since unfettered market forces could have strengthened the Rupee abruptly, leading to a disastrous loss of export market share, even if the improvement in the current account proved temporary. In short, while FY01 SBP foreign exchange net purchases were to support the Rupee,3 the FY02 buying was essentially to prevent it from strengthening too sharply.

A look at the external cash flows depicts more insights on the external account improvement:

(1) While headline figures depict a narrowing of the trade deficit to US$ 1.2 billion in FY02 the realized outcome was even better, with a deficit of US$ 360 million only.

(2) The role of exceptional financing is declining. In FY02 a notional inflow of US$ 1.7 billion on account of the Paris Club re-scheduling, was largely offset by maturities of earlier re-scheduled payments (of frozen FE-45 foreign exchange deposits, etc.). This is a positive development for Pakistan, reflecting that rescheduled loans and higher foreign currency inflows, allowed the termination of more expensive commercial liabilities.

The striking improvement in the current account, and the massive Rupee liquidity injections resulting from the SBP foreign exchange purchases, also had important implications for the conduct of monetary policy. It may be recalled that a major factor behind the monetary tightening in FY01 was the need to support the Rupee. Thus, as the exchange rate stabilized, the SBP immediately signaled an easing by twice lowering the discount rate in successive months.4 The subsequent two, post-September, reductions however were aimed more at mitigating the impact of the prevailing uncertainties in the business environment.5

The increase in Rupee liquidity fueled the exceptional 14.8 per cent growth in M2. This allowed a substantial expansion of banks’ deposit base, but (1) net private sector credit demand did not grow correspondingly, (2) the funding requirement of the government from scheduled banks fell due to higher availability of non-bank finance in FY02, and (3) banks’ demonstrated an apparent preference for less risky assets. This allowed the government to substitute its accumulated borrowings from the SBP with higher net borrowings from scheduled banks without putting upward pressure on interest rates. Consequently, reserve money growth was contained to just 9.6 per cent, as injections through SBP foreign exchange purchases were sterilized by a net retirement of SBP’s government security holdings, thus avoiding an excessive rise in inflationary pressures.

Pakistan’s debt profile also saw significant changes in FY02 reflecting the country’s adherence to the Debt Reduction and Management Strategy (DRMS), as well as a one-off Rs 193 billion stock adjustment of the domestic debt. While the absolute decline in external debt and liabilities (EDL) was a marginal US$ 607 million, the re-profiling of Paris Club debt and the substitution of expensive commercial loans by cheaper IFI credits led to a significant drop in the net present value of outstanding EDL.6 Similarly, the domestic debt profile too saw a shift to longer tenors amidst a fall in interest rates. This said, it must be stressed that the changes, though welcome, only depict an improvement in the dynamics of Pakistan’s debt profile; the country has still a long arduous road to travel before the debt ratios go down to international norms.

1Under a worst-case post-September 11 scenario, it was feared that exports would decline significantly, foreign investment flows would dry up, capital flight would intensify, output losses would be severe and GDP growth would either be stagnant or negative depending on the intensity, duration and scope of the US campaign in Afghanistan.

2It is worth noting that despite the higher remittances, the inflows into the kerb market also accelerated. At times, kerb market rate actually dipped below the interbank market rate, opening an arbitrage opportunity that closed only when local banks imposed higher cash handling charges.

3In FY01, the SBP foreign exchange purchases (kerb and interbank) were being injected into the interbank market to lower volatility and meet lumpy payments. The SBP was a net seller in the interbank market, in FY01.

4In July 2001 and August 2001.

5Exporters were the most immediate beneficiaries. The export re-finance (EFS) rate was benchmarked to 6-month T-bill yields, which closely tracked changes in the discount rate.

6This performance is even more impressive given that FY01 had also seen a large decline in EDL.