Document o f The World Bank

FOR OFFICIAL USE ONLY

Report No. 46685-PK

INTERNATIONAL DEVELOPMENT ASSOCIATION

PROGRAM DOCUMENT

FOR

A PROPOSED POVERTY REDUCTION AND ECONOMIC SUPPORT OPERATION

IN THE AMOUNT OF SDR 321.3 MILLION

(US$500 MILLION EQUIVALENT)

TO

THE ISLAMIC REPUBLIC OF PAKISTAN

March 2,2009

Economic Policy and Poverty Group South Asia Region

This document has a restricted distribution and may be used by recipients only in the performance o f their of f ic ia l duties. I t s contents may not otherwise be disclosed without World Bank authorization.

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ACO BISP CAS CCP CDNS CFAA

CGA CoA CPAR CPI DFID DISCO EMBI

EOBI ESCA FBR FBS FDI FRDL FSAP GoP GDP GDR GFS GST IBRD ICR IDA IEG IFC 1LO IMF

IPSAS IRA KWH

MDGs

M&E M I C A

Pakistan - Government’s Fiscal Year July 1 - June 31

Currency Equivalents (Exchange Rate Effective as o f January 5,2008)

US$1= PKRs79.2

WEIGHTS AND MEASURES: Metric System

ACRONYMS AND ABBREVIATIONS Agriculture Census Organization Benazir Income Support Program Country Assistance Strategy Competition Commission o f Pakistan

Central Directorate of National Savings

Country Financial Accountability Assessment

Controller General o f Accounts

Chart o f Accounts Country Procurement Assessment Review Consumer Price Index Department for International Development Distribution Companies Emerging Markets Bond Index

Employees Old Age Benefits Institution Employment and Service Conditions Act

Federal Board o f Revenue

Federal Bureau o f Statistics Foreign Director Investment Fiscal Responsibility and Debt Limitation Law Financial Sector Assessment Program Government o f Pakistan Gross Domestic Product Global Depository Receipts Government Finance Statistics (IMF) General Sales Tax International Bank for Reconstruction and Development Implementation Completion Report International Development Association Independent Evaluation Group International Finance Corporation International Labor Organization

International Monetary Fund

International Public Sector Accounting Standards

Industrial Relations Act

Ki lo Watts (per) Hour

Millennium Development Goals

Monitoring and Evaluation

Multilateral Investment Guarantee Agency

MoF MTBF NEP NFC

NSS NWFP

OSHA PAC PBS PCO PDL PRES0 PEPFM

PFMAA PIB

PlFRA PML-N PPP PPRA PRGF PRSP PSDP PSlA PSLM RTO ROSC SBA SBP SCEA SDR SECP SME SOE

SSN T-bill

TSA VAT

WAPDA

Ministry o f Finance Medium Term Budget Framework National Environment Policy National Finance Commission

National Saving Schemes

North West Frontier Province

Occupational Safety and Health Act

Public Account Committee Pakistan Bureau o f Statistics Population Census Organization Petroleum Development Levy Poverty Reduction and Economic Support Operation Public Expenditure, Procurement and Financial Management Review Public Financial Management and Accountability Assessments Pakistan Investment Bond

Project for Improvement in Financial Reporting and Auditing

Pakistan Muslim League (Nawaz) Pakistan People’s Party Public Procurement Regulatory Authority Poverty Reduction Growth Facility Poverty Reduction Strategy Paper Public Sector Development Program Poverty and Social Impact Assessment Pakistan Social and Living Standards Measurement Survey Regional Tax Offices Rotating Savings and Credit Stand-By Arrangement State Bank o f Pakistan Strategic Country Environmental Analysis Special Drawing Rights Securities and Exchange Commission o f Pakistan

Small- and Medium-scale Enterprise

State Owned Enterprise

Social Security Number

Treasury Bi l l

Treasury Single Account

Value Added Tax

Water and Power Development Authority

Vice President: Isabel Guerrero, SARVP Country Director: Yusupha Crookes, S A C P K

Sector Director: Ernest0 May, SASPF Sector Manager: M i r i a Pigato, SASEP

Task Team Leaders: Satu Kahkonen and Kaspar Richter, SASEP

For Official Use Only

THE ISLAMIC REPUBLIC OF PAKISTAN POVERTY REDUCTION AND ECONOMIC SUPPORT OPERATION

TABLE OF CONTENTS

CREDIT AND PROGRAM SUMMARY .................................................................................................................. I

I. INTRODUCTION ............................................................................................................................................... 1

11. RECENT POLITICAL AND ECONOMIC DEVELOPMENTS .................................................................... 2

A. RECENT POLITICAL DEVELOPMENTS B. ECONOMIC DEVELOPMENTS THROU ......................................... C. D. TOWARDS STABILIZATION .............................................................................................................................. 6 E. MEDIUM-TERM OUTLOOK ....................

ECONOMIC DEVELOPMENTS IN 2007108 .......................................................................................................... 4

.......................................................................................... H. STATUS OF IMF ACTIVITIES IN PAKISTAN ..................................................................................................... 15

111. GOVERNMENT’S POVERTY REDUCTION STRATEGY ........................................................................ 16

IV. WORLD BANK GROUP STRATEGY AND THE PROPOSED PRESO ................................................... 17 A. LINKTOCAS 17 B. ANALYTICAL .................................................................................................... 17 c. LESSONS LEARNED FROM PRIOR OPERATIONS .............................................................................................. 18 D. COORDINATION WITH OTHER DEVELOPMENT PARTNERS. .......................................................... 19

V. GOVERNMENT’S AND STATE BANK OF PAKISTAN’S PROPOSED REFORM PROGRAM SUPPORTED BY PRESO ................................................................................................................................ 19

A. OVERVIEW OF PRESO .................................................................................................................................. 19

C. PILLAR 11: ENHANCING COMPETITIVENESS ............ B.

D.

PILLAR I: REGAINING AND MAINTAINIKG MACROECONOMIC STABILITY .

PILLAR 111: PROTECTIKG THE POOR AND VULNERA

VI. OPERATION IMPLEMENTATION .............................................................................................................. 35

A. POVERTY AND SOCIAL IMPACTS ............... ............... B. FIDUCIARY ASPECTS .........

D. ENVIRONMENTAL ASPECTS ........................................................................................................................... 40 E. IMPLEMENTATION AND MONITORING ............................................................................................................ 41 F. R I S K S AND RISK MITIGATION ....... ................... 41

c. DISBURSEMENT AND AUDIT

TABLES TABLE 1 : CONSOLIDATED FEDERAL AND PROVIKCIAL FISCAL ACCOUNTS, 2006107-2007108 .. TABLE 2: FEDERAL GOVERNMENT SUBSI TABLE 3: MEDIUM-TERM MACROECONO TABLE 4: SELECTED RECENT ECONOMIC TABLE 5: CONSOLIDATED FEDERAL AND PROVINCI TABLE 6: MAPPING OF PRES0 REFORM AREAS TO TABLE 7 : POVERTY REDUCTION AND ECONOMIC SUPPORT OPERATION (PRESO): 2008/09 POLICY FRAMEWORK OF

................................ 9

GOVERNMENT AND STATE BANK OF PAKISTAN ............................................................................................ 19

This document has a restricted distribution and may be used by recipients only in the performance o f their off icial duties. I t s contents may not be otherwise disclosed without Wor ld Bank authorization.

FIGURES

FIGURE 1 : TRENDS IN ECONOMIC GROWTH ............................................ ................................................ 3 FIGURE 2: CONTRIBUTION TO GDP GROWTH .................................................................................................................. 3 FIGURE 3: NET RESERVES TO BROAD MONEY (%) ................................... FIGURE 4: MONEY SUPPLY, CREDIT, AND REAL INTEREST RATE ............. ...................................................... 6 FIGURE 5 : SBP FOREIGK EXCHANGE RESERVES (END PERIOD) .................................................................................... 11 FIGURE 6: INTERBANK AND OPEN-MARKET EXCHANGE RATE (RS/US$) ............ ... 11 FIGURE 7: INFLATIOK ........ .................... 12

................................................

.................

BOXES BOX 1: THE IMPACT OF INTERNATIONAL OIL PRICE CHANGES ON THE CURRENT ACCOUNT DEFICIT ........................... 11 BOX 2: APPLICATION OF GOOD PRACTICE PRINCIPLES ON DEVELOPMENT POLICY LENDING TO PRES0 ..................... 22

SCHEDULES

Schedule 1: Schedule 2:

Annex 1: Annex 2: Annex 3: Annex 4: Annex 5: Annex 6: Annex 7: Annex 8: Annex 9 : Annex 10: Annex 11:

Letter o f Development Policy Draft Medium-term Policy Framework o f Government and State Bank o f Pakistan

ANNEXES

Pakistan - At a Glance Pakistan - Social Indicators Pakistan - Key Economic Indicators Pakistan - Key Exposure Indicators Pakistan - Operations Portfolio (IDA, IBRD and grants) Pakistan - Statement o f IFC’s Held and Disbursed Portfolio for Pakistan Pakistan - Selected Indicators o f Bank Portfolio Performance and Management Pakistan - IFC and MIGA Program IMF Assessment Letter Overview o f Social Protection in Pakistan Summary o f Findings from Poverty and Social Impact Assessments on Fuel Price Increases and Food Inflation

Task Team

The World Bank task team includes: Satu Kahkonen (Lead Country Economist, SASEP); Kaspar Richter (Senior Economist, SASEP); Hanid Mukhtar (Senior Economist, SASEP); Saadia Refaqat (Economist, SASEP); Tara Vishwanath (Lead Economist, SASEP); Nobuo Yoshida (Senior Economist, SASEP); Eric Manes (Senior Economist, SASFP); Shamsuddin Ahmad (Senior Financial Sector Specialist, SASFP); Anjum Ahmad (Senior Financial Sector Specialist, SASFP); Shabana Khawar (Senior Private Sector Development Specialist, SASFP); Raghuveer Sharma (Lead Financial Analyst, ECSSD); Rashid Aziz (Senior Energy Specialist, SASDE); Gregory Horman (Debt Management Consultant, BDM); Cem M e t e (Senior Economist, SASHD); Iftikhar Malik (Senior Social Protection Specialist, SASHD); Asif A l i (Sr. Procurement Specialist, SAWS); Ismaila B. Ceesay (Lead Financial Management Specialist, SARFM); Shaheen Malik (Research Analyst, SASEP); Muhammad Shafiq and Irum Touqeer (Program Assistants, SASEP). Peer reviewers are: Shantayanan Devarajan (Chief Economist, AFRCE), Mathew Verghis (Lead Economist, EASPR), and Edgardo Favaro (Lead Economist, PRMED).

11

THE ISLAMIC REPUBLIC OF PAKISTAN

POVERTY REDUCTION AND ECONOMIC SUPPORT OPERATION

CREDIT AND PROGRAM SUMMARY

Borrower: Government o f Pakistan

Implementing Agency:

Financing Data: IDA Credit

Ministry o f Finance, Government o f Pakistan

Terms: standard IDA terms: 35-year maturi ty with a 10-year grace period

Amount: SDR 321.3 mi l l ion (USSSOO m i l l i on equivalent) to be withdrawn in a single tranche

Operation Type:

Main Policy Areas:

Key Outcome Indicators:

Program Development Objectives and Contribution to CAS:

Single-tranche Development Pol icy Credit.

The proposed Poverty Reduction and Economic Support Operation (PRESO) supports:

Regaining and maintaining macroeconomic stability through increased tax revenue mobilization, adjustment o f fuel prices and power tariffs, improved efficiency o f publ ic spending, and strengthened government debt management;

Enhancing competitiveness through reduced barriers to business entry and exit, and strengthened financial sector; and

Protecting the poor and vulnerable through improved targeting o f safety nets and cash transfer programs, and strengthened statistical systems.

Fiscal deficit (excl. grants) reduced f rom 7.4 percent o f G D P in 2007108 to o r below 4.3 percent o f GDP in 2008/09. Current account deficit reduced from 8.4 percent o f GDP in 2007108 to o r below 5.9 percent o f GDP in 2008109.

Improved access to social safety nets for the poorest 25 percent o f the population.

PRESO aims to support the implementation o f Pakistan’s recently adopted Second Poverty Reduction Strategy Paper (PRSP-11). In particular, i t will support the structural reforms o f PRSP-I1 to regain and maintain economic stability and to bring the economy back to a higher growth path over t ime through measures enhancing Pakistan’s competitiveness, while protecting the poor and vulnerable.

The reform program supported by PRESO i s consistent with the CAS priorities of: (i) sustaining growth and improving competitiveness; and (ii) improving lives and protecting the vulnerable. The operation i s complemented by investment operations, such as the Electricity Distr ibution and Transmission Improvement

0

Overal l outcome indicators and targets:

Improved Do ing Business indicators.

Risks:

Project and the proposed technical assistance operation to support social safety nets.

Several risks attend the proposed PRESO:

Political risks: Attaining a sharp reduction in the fiscal and current account deficits wil l require commitment f rom the pol i t ical leadership. The scale and speed o f the required economic po l i cy response to the macroeconomic imbalances could intensify social tensions in part o f the population, but n o adjustment wou ld ultimately impose even greater economic and social costs. The sustainability o f the program could also be undermined by disagreement among Pakistan’s ma in pol i t ical parties o n other issues, including judicial reform and the war o n terror. The authorities’ draft medium-term pol icy framework attached to this package mitigates this risk and the risk o f pol icy reversals by signaling the authorities’ upfront commitment to a medium-term adjustment path.

Economic risks: On the external side, a renewed rise in international energy and commodity prices, a reduction in foreign remittances especially f rom the countries o f the Midd le East, and a further deterioration in the wor ld economy and international financial markets could weaken the export sector, reduce household transfers, lower capital inflows, limit economic growth and reduce f lexibi l i ty for pol icy reforms. Owing to these reasons, the external imbalances may continue to widen despite the short-term measures taken. On the internal side, the inabi l i ty o f Government to restore fiscal and external balance as agreed could reduce business and consumer confidence. This could cause a fundamental shift in market expectations and a loss o f confidence at home and abroad, leading to a sudden reversal o f financial assets held in Pakistan stock and bond markets. This could generate a vicious cycle between weakening financial markets, stalling economic activity, and a worsening fiscal position. The IMF Stand-By Arrangement wil l mitigate these risks by committ ing the authorities to fiscal and current account deficit targets.

Implementation risks: Stringent implementation o f the reforms wil l be critical for success. The implementation o f reforms may be slower than planned because o f significant institutional capacity constraints. Other projects and initiatives supported by the Bank and development partners have supported the strengthening o f a number o f institutions wh ich mitigates the risk, including the State Bank o f Pakistan, the Audi tor General o f Pakistan, the Controller General o f Accounts, and the Pakistan Public Procurement Authority. The Federal Board o f Revenues reform initiatives are supported through the Bank’s Tax Administration Reform Project and Tax Pol icy Program.

Security risks: There is a risk o f deterioration in the security and law and order situation, which could shift Government’s focus from economic matters. This risk cannot be directly mitigated. PRESO wou ld rely o n the Government’s commitment to improved security, as confirmed by the renewed efforts to end mil i tancy in tribal areas.

Operation ID: P113372

11

INTERNATIONAL DEVELOPMENT ASSOCIATION PROGRAM DOCUMENT FOR

A PROPOSED POVERTY REDUCTION AND ECONOMIC SUPPORT OPERATION TO

THE ISLAMIC REPUBLIC OF PAKISTAN

I. INTRODUCTION

1. This Program Document presents the proposed Poverty Reduction and Economic Support Operation (PRESO) in the amount o f US$SOO mi l l i on to the Islamic Republic o f Pakistan. The a im o f the proposed PRESO wou ld be to support the implementation o f Pakistan’s Second Poverty Reduction Strategy Paper (PRSP-11). Specifically, it will support the structural reforms o f PRSP-I1 to regain and maintain economic stability and to bring the economy back to a higher growth path over t ime through measures promoting competitiveness, whi le protecting the poor and vulnerable. The reform program proposed to be supported by PRESO i s consistent with PRSP-I1 and owned by the Pakistan authorities.

2. Pakistan faced both external and internal shocks in the past year. On the external side, international o i l and food commodity prices sharply rose in 2007/08, and inflated Pakistan’s import bill. Subsequently, the slowdown in the global economy dampened the external demand for Pakistan’s exports, and the deterioration in international credit markets affected the supply o f funds. On the internal side, Pakistan’s pol i t ical turmoil and uncertainties affected investor confidence and, together with the rapid rise o n macroeconomic imbalances, led to capital out f low as we l l as downgrading o f Pakistan’s rating by international rating agencies.

3. The poli t ical situation-Parliamentary elections were held in February 2008-made it di f f icul t for the authorities to take t imely corrective action. The authorities did not pass o n any o f the international price increases to consumers until after the Parliamentary elections, but financed them through the government budget by increasing subsidies. As a result, the fiscal and balance o f payment imbalances widened substantially, inf lat ion rose sharply, growth slowed, and Government’s macroeconomic program went o f f track.

4. In March 2008, the authorities started to take some steps to stabilize the economy. These included passing on some o f the international fuel price increases to consumers, restricting the size o f the fiscal deficit in 2007108 and the 2008109 budget, increasing the pol icy discount rate, and al lowing greater f lexibi l i ty in the exchange rate. However, these actions soon proved to be inadequate and coming too late.

5. Faced with the risk o f a fu l l -b lown balance o f payments crisis, the authorities in the fa l l o f 2008 decided to put in place adjustment measures that facilitate the resumption o f inclusive growth with l o w inf lat ion over the medium term. In November 2008, the authorities entered into a Stand-By Arrangement (SBA) with the IMF to stabilize the economy. In this context, they also requested assistance f rom the Bank to support the structural reform process.

6. The Bank i s proposing to proceed with stand-alone operation wh ich supports the authorities’ short- term pol icy measures to promote economic recovery, along with the needed stabilization. The recently adopted PRSP-I1 provides the framework for this pol icy agenda, and an opportunity to proceed with PRESO to support i t s implementation. PRESO wou ld support the PRSP-I1 objectives related to macroeconomic stabilization, enhancement o f competitiveness and growth recovery, and poverty mitigation. However, given the magnitude o f macroeconomic imbalances, regaining the macroeconomic stability and putting the economy back to a path o f high sustainable growth will require continued decisive pol icy adjustment in 2009110 and 2010111. For this reason, the proposed package also includes a

draft medium-term pol icy framework o f Government and State Bank o f Pakistan (SBP) that lays out the envisaged road map for adjustment. The latter years o f that framework could be supported through a separate programmatic operation.

7. The financing provided through the proposed PRESO wou ld help to finance Government’s budgetary needs, and thereby support the authorities’ commitment to eliminate central bank financing o f Government. Whi le the IMF-supported SBA i s providing Pakistan much needed balance o f payments support, budgetary support i s also urgently required. The projected financing through PRESO is part o f Government’s financing plan. Government’s 2008109 financing plan embedded in S B A assumes Wor ld Bank disbursements o f US$1.4 bi l l ion. O f this amount, US$800 mi l l i on i s projected to be disbursed as budget support, which includes US$500 mi l l i on o f PRESO.’ The proposed PRESO i s critical for Government’s stabilization, economic recovery and social mit igation agenda. Thereby it will also lay the ground for the Bank’s other budget support operations.

11. RECENT POLITICAL AND ECONOMIC DEVELOPMENTS

A. Recent Political Developments

8. Pakistan has undergone rapid pol i t ical changes in the past year and a half. On November 3 , 2007, President Pervez Musharraf, acting as the Chief o f Army, imposed the state o f emergency and suspended the Constitution. At the end o f November 2007, Mr. Musharraf relinquished the Army Chief post and took oath as a c iv i l ian President for another five-year term. Soon thereafter the emergency was lifted, and Parliamentary elections announced. However, the elections had to be postponed, as the former Prime Minister Benazir Bhutto was assassinated at the end o f December 2007.

9. The Parliamentary elections held in February 2008 were widely considered to be free and fair. The main opposition parties won the elections by a wide margin, and a new coali t ion government comprising the former Prime Minister Benazir Bhutto’s Pakistan’s People’s Party (PPP), led by Mr. Asif Zardari, and the Pakistan Muslim League, led by the former Prime Minister Nawaz Sharif (PML-N), was formed, with Mr. Yousaf Raza Gi l lani as the Prime Minister. On August 25, 2008, the coal i t ion government between PPP and P M L - N split, owing to disagreement o n the reinstatement o f deposed Supreme Court judges.

10. Zardari was elected President.

In August 2008, Mr. Musharraf resigned as the President o f Pakistan. In September 2008, Mr.

11. Pakistan is a frontline state in the war o n terror, wh ich has adversely impacted its economic and security environment. The security situation in the country has continued to deteriorate, with frequent bomb explosions. In September 2008, there was a suicide bomb attack o n the Marr iot t hotel in Islamabad. The Mumbai terrorist attacks in November 2008 have strained the relations between Pakistan and India.

B. Economic Developments through 2006/07

12. Pakistan’s development record was strong for part of this decade. The economy grew at 7.3 percent on average per year during 2003104 through 2006107, driven by sol id performances in the services and industrial sectors (see Figure 1). The manufacturing sector grew fast during the earlier part o f the period, but slowed down considerably later in the period due to capacity and infrastructural constraints. At the same time, the services sector, catering pr imari ly to the domestic demand, grew steadily throughout the period. The factors that contributed to growth included a benign external environment

’ In addition to PRESO, the Bank has two other budget support operations in the pipeline for 2008109.

2

availability o f external financing, pol i t ical and macroeconomic stability. Key measures include renegotiation o f external debt with Paris Club creditors, pre-payment o f extensive debt, greater reliance o n concessional borrowing for new loans, and liberalization o f the financial sector. They, together with an expansion in the economy, led to a decline in public debt as we l l as a reduction in debt servicing cost. Growth translated into rising household incomes, with per capita income growing to US$878 in 2006/07, an 18.3 percent increase f rom US$742 two years earlier.

reliance on external 20% -

f inancing and on expansionary fiscal stance, while revenues 15% -

and savings remained stagnant. A surge o f 10% - capital inf lows f rom abroad al lowed the 2 5% government to finance rising fiscal deficits at a l o w cost. The 0% ~

consolidated fiscal deficit increased f rom

-5% ~

~~ ~ ~ _ _ _ Agriculture

mmim Manufacturing 111 Services -GDP (FC)

I

2000101 2001102 2002103 2003104 2004/05 2005106 2006/07 2

14. The effect o f expansionary fiscal policy was compounded 10% ,

8% -

6% -

4 % -

2% ~

0%

Figure 2: Contribution to GDP Growth

by loose monetary policy, which together led to a sharp increase in the domestic demand f rom 2002/03 onwards. Whi le until 2003/04, economic growth had been sustained by external demand, it became consumption-driven thereafter until 2006/07 (Figure 2). Strong growth

-2% 1

-4% - I I

-6% 2000/01 200L02 2002 0 3 2003 04 2 0 0 4 / 0 5 2005106 2006107 in money supply

contributed to the acceleration o f inf lat ion f rom 3.5 percent in 2001/02 to 7.8 percent in 2006/07. Pakistan’s savers continued to receive l o w returns, below the rate o f inflation. L o w returns o n bank deposits discouraged private savings and fuelled asset-price bubbles as households sought higher returns by buying shares and property.

15. With domestic demand outpacing domestic output, the current account deficit reversed f r o m a surplus o f 4.8 percent in 2002/03 to a deficit o f 4.9 percent o f GDP in 2006/07, financed through ample capital inflows. The reliance on external financing le f t the economy vulnerable to external shocks

3

and, despite the clear signs o f overheating, Pakistan concluded 2006107 w i t h n o visible signs o f adjustment.

2005/06 Budget Actual

Power sector ut i l i t ies 0.7 0.6 Food subsidies 0.1 0.1

o f which imported wheat 0.0 0.0 POL (refineries and OMC claims) 0.1 0.1 Fertilizer 0.1 0.1

Total Subsidies 0.9 0.8 R&D support to textile sector 0.0 0.0

C. Economic Developments in 2007/08

2006107 2007/08 Budget Actual Budget Actual

0.6 0.7 0.7 1.3 0.1 0.0 0.1 0.4 0.0 0.0 0.0 0.4 0.1 0.3 0.2 1.6 0.2 0.1 0.1 0.3 0.0 0.1 0.0 0.2 1 .o 1.2 1.1 3.8

16. In 2007/08, the sharp rise in international oil and food (specifically wheat) prices, in combination with policy inaction and internal political turmoil, led to rapidly expanding macroeconomic imbalances in Pakistan. Both fiscal and current account balances widened significantly. In the absence o f adequate remedial po l i cy measures to address the imbalances-in particular not passing o n the international price increases to domestic consumers-the economy begun to adjust through a slowdown in growth and rising inflation.

17. Spending overruns led to a sharp increase in the 2007/08 fiscal deficit to 7.4 percent o f GDP, compared to the budget target of 4.0 percent o f GDP (see Table 1). Expenditures exceeded the budget target by about 2.9 percent o f GDP, whi le revenues fel l short o f the target by about 0.6 percent o f GDP.

18. About 80 percent o f the fiscal deficit increase was driven b y international oil and commodity price increases. The sharp increase in the budget deficit was mostly caused by the overrun o f 2.7 percent o f GDP in budgetary subsidies ( f rom the budget target o f 1.1 percent o f GDP to 3.8 percent o f GDP) owing to the rise in international commodity and o i l

Table 1: Consolidated Federal and Provincial Fiscal Accounts, 2006/07-2007/08

(Percei

Total Revenue (excl. grants) Tax Revenue Non-tax Revenue

Total Expenditure Current

O f which : Interest Federal Subsidies Defense Other Current Expenditure

Development Expenditure

Budget deficit (excl. grants)

Financing External Domestic

Non-bank Bank

Memo item: GDP (Rs in Billion)

20( Budget

13.3 10.3 3.0

17.5 12.8 2.7 1 .o 2.8 6.2 4.7

-4.2

4.2 4.2 4.2 4.2 4.2

8,808

‘0 7 Actual

14.9 10.2 4.7

19.2 15.8 4.2 1.2 2.9 7.5 4.9

-4.3

4.3 2.3 2.0 0.9 1.2

8,707

of GDP) 20(

Budget 14.9 11.0 3.9

18.8 13.7 3.8 1.1 2.8 6.0 5.2

-4.0

4.0 2.0 2.0 1.7 0.3

9,9 70

108 Actual

14.3 10.4 3.9

21.7 17.7 4.7 3.8 2.7 6.6 4.0

-7.4

7.4 1.4 6.0 1 .o 5.0

10,478

prices (see Table 2). F rom 2006/07 to 2007/08, the domestic price o f Pakistani o i l imports increased by about 60 percent o n average. Yet, in an attempt to protect households and businesses f rom domestic price adjustments, Government kept domestic petroleum prices unchanged until March 2008. This

4

resulted in overruns o f 1.4 percent o f GDP in the petroleum, oil, and lubricants (POL) subsidy, and o f 0.6 percent o f GDP in the electricity subsidy. Furthermore, the rise in international wheat and fertilizer prices led to an overrun o f 0.5 percent o f GDP in expenditure on wheat and fertilizer subsidy.

reduction in net capital 30 -

19. Beyond the rise in government subsidies, an overrun in interest payments by 0.9 percent o f GDP due to an underestimation of interest liabilities in the budget contributed to the increase in the budget deficit. The r i se in the budget deficit wou ld have been even higher without the 1.2 percent o f GDP under-run in development spending.

22. Even though the deterioration in the terms-of-trade put increasing pressure on the exchange rate, the Rupee-Dollar exchange rate remained broadly unchanged around Rs/US$61 until December 2007. During the second ha l f o f 2007108 SBP al lowed some exchange rate f lexibi l i ty and the exchange rate depreciated by 13 percent to reach Rs/US$68.4 by the end o f the fiscal year.

5

borrowing f rom SBP amounted to Rs. 689 bil l ion, increasing the 26

total stock o f government debt ' 23 owed to SBP to Rs. 1.1 tr i l l ion $

I

20 -

~ 2 0

24. The rise in government borrowing kept the growth of reserve money over 20 percent and fueled inflation (see Figure 4). The average CPI for 2007108 was 12 percent, with year-on-year CPI at 2 1.5 percent at end June 2008. SBP responded to the rise in inf lat ion by increasing the pol icy discount rate by a total o f 200 bp by end-June 2008, but real interest rates remained negative by a large margin.

I 5

1 .. ,* I

2 i ~ I.

-1JuF02 Feb03 Sep-03 Apr-0'4 -God-O4 Jun-05 Jan-06 Aug-06 Mar-0: Oct-07 Mky-08 De&,'

-4 . .,

t ' 8 ' - - BraadMoney Reserve Money - - - -Real Interest Rates I I - -10

-7 - Source Sate Bank o f Pakistan: \Vorld Bank Staff Calculations N o t e The real interest rate IS the difference between nominal m e r e s t rate on the 6-month T-bill and CPI inflation

- ,o ~ - , 5

25. I n response to the widening imbalances and supply side shocks, real GDP growth declined from 6.8 percent in 2006/07 to 5.8 percent in 2007/08. In agriculture, floods and pest attacks depressed rice and cotton production, whi le industrial production and services were constrained by acute power and gas shortages.

26. Pakistan's risk rating worsened as the economic situation deteriorated. B o t h Standard & Poor's and Moody's downgraded Pakistan's sovereign debt ratings in M a y 2008 (from B+ to B and f rom B 1 to B2, respectively) owing to the sharp erosion in the fiscal position and the inadequate pol icy response to the worsening macroeconomic situation.

D. Towards Stabilization

27. Recognizing the need to correct the macroeconomic imbalances, Government embarked on a concerted effort to stabilize the economy starting with the 2008/09 budget. The budget, among other things, envisaged sizeable fiscal consolidation through power and fuel subsidy cuts and increased revenue effort. However, by November 2008 i t was apparent that the budget measures were inadequate to contain the economic slide, aggravated by the global financial crisis, and to restore the investor confidence. The foreign exchange reserves o f SBP had dropped to US$3.3 b i l l i on (about three weeks o f imports) by mid- October 2008, the nominal exchange rate had depreciated to Rs/US$84, Government had borrowed additional Rs. 356 b i l l i on f rom SBP during July-November 2008, the average C P I had risen to about 25 percent and core inf lat ion to 18.9 percent at end November 2008, and the EMBI Global B o n d spread of Pakistani sovereign bonds had cl imbed above 2,000 bp. In response to these developments, Moody's had further downgraded i t s ratings outlook for Pakistan sovereign bonds f rom stable to negative in September 2008 and the rat ing f rom B2 to B3 in October 2008. Similarly, Standard & Poor's had downgraded Pakistan's rating further f rom B to CCC+ in early October 2008 and to CCC in early November 2008.

6

28. To avoid a balance of payments crisis and default on foreign debt payments, the authorities developed a home-grown stabilization program, which was supported by the IMF through a 23- month SBA in November 2008. The program includes a medium-term macroeconomic framework, which envisages fiscal and monetary tightening to bring down inf lat ion and reduce the external current account deficit to sustainable levels. The 2008/09 program framework supported by S B A builds on the 2008109 budget, modif ied to account for higher inf lat ion projections and greater exchange rate adjustment than envisaged at the t ime o f the budget. The framework was revised during the f i rs t program review in February 2009 to take into account the impact o f significantly deteriorated global economy, resulting lower exports, foreign inf lows and growth prospects in the short and medium term, as we l l as the change in the terms o f trade through lower international o i l and food prices. Table 3 summarizes the revised framework, and compares it with the init ial November 2008109 program framework for 2008109.

29. The revised framework i s built around the following economic parameters for 2008/09:

Real GDP growth of 2.5 percent: the target was lowered f rom 3.4 percent owing to sharper than anticipated economic slowdown;

The f iscal deficit (excluding grants) of 4.3 percent of GDP: the in i t ia l fiscal deficit target remained unchanged in nominal Rupee terms, but owing to the moderated GDP growth projection, the target as a share o f GDP increased f rom 4.2 to 4.3 percent;

The current account deficit of 5.9percent of GDP: the in i t ia l target o f 6.5 percent o f GDP was revised downwards due to a larger than anticipated decline in imports; and

Annual average consumer p r ice inflation at 20 percent: the annual inf lat ion target was adjusted downwards f rom 23 percent, as a resul t o f fal l ing food and energy prices and lower economic activity.

e

30. The fiscal deficit reduction i s to be achieved by a combination o f expenditure cuts and revenue increases, with the burden o f adjustment falling primarily on expenditures. Overall revenues (excluding grants) are to be increased f rom 14.3 percent o f GDP in 2007108 to 15.2 percent o f GDP in 2008109 through a rise in tax revenues. Further, the reduction in the fiscal defici t relies o n a consolidation o f overall expenditures by about 2.5 percent o f GDP to 19.3 percent o f GDP. About ha l f o f the reduction is to come f rom current spending-primarily f rom cuts in fuel and power subsidies-and the other ha l f f rom rationalization in development spending. The proposed operation i s supporting orderly reductions in both areas, ensuring productive social and infrastructure spending i s protected.

31. On the external side, the 2008/09 revised program framework projects a rapid decline in import growth (14.5 percent contraction) due to decreases in international commodity and oi l prices and the slowdown in economic activity. The decline in imports i s expected to outweigh the projected 5.5 percent contraction in exports, leading to a strong improvement in the trade balance. Bo th gross national savings and gross capital formation are predicted to further decline, with capital formation decreasing w i th the economic downturn.

32. The 2008/09 program assumes that Government’s net borrowing from SBP will be zero on a quarterly basis from November 1, 2008 onwards, and Government will rely increasingly on non- bank borrowing and external financing. This, in addition to a sharp decline in aggregate demand during the second ha l f o f 2008109 i s expected to bring down average annual inf lat ion to the program target.

33. At the first quarterly review o f SBA in February 2009, the stabilization program remained on track. The rapid decline in international commodity and o i l prices since August 2008 has reduced the risks, facilitated improvement in the external position and the achievement o f targets. Table 4 highlights the developments in select recent economic indicators by month during 2008109.

7

Table 3: Medium-Term Macroeconomic Framework

Initial Revised Actual Program Program Projections

2006107 2007108 2008109 2008109 2009110 ZOlOi l l 2011112 2012113 2013114 (Annual changes: in percent) lutput and prices

leal GDP at factor cost 'onsumer prices (period average) 'akistani rupees per U.S. dollar (period average) aving and lnvestment iross national saving iross capital formation 11 'ublic finances .evenue and grants .evenue Tax revenue

Non-tax revenue Grants

xpenditure (including statistical discrepancy) 12 Current expenditure

ofwhich : Federal Board o f Revenue

Interest Other federal Provincial

o f which: one-off-outlays Development expenditure

Net lending tatistical discrepancy

lverall balance 'nderlyinp (excluding grants and one-off-outlays) xcluding grants lcluding grants inancing External

Domestic otal government debt xtemal government debt 'omestic government debt Ionetary sector et foreim assets et domestic assets road money ribate credit ix-month treasuw bil l rate (period average; in %) xternal sector lerchandise exports, U.S. dollars (growth rate: in %) lerchandise imports, U.S. dollars (growth rate; in %) urrent account including official current transfers (as % o f GDP) Toss official reserves (in millions o f U.S. dollars) /3 I months o f next year's imports of goods and sewices [ernorandurn Items: ea1 effective exchange rate (annual average; percentage change) ea1 per capita GDP (percentage change) f4 DP at market prices (in billions o f Pakistani rupees)

o f f which; privatization receipts

6.8 7.8 I .3

18.1 22.9

15.2 14.8 10.9 9.7 3.9 0.3

20.6 15.8 4.2 6.9 4.6 4.9 0.5 -0.1 -1.4

-3.9 -4.3 -4.0

4.0 2.0 0.6 2.0

54.1 24.2 29.9

8. I 11.3 19.3 17.2 8.8

4.4 8.0 -4.8

14,302 3.8

0.5 5.1

8.723

5.8 12.0

13.2 21.6

14.6 14.3 10.4 9.6 3.9 0.3

21.8 17.7 4.7 8.9 4.2 4.0 0.2 -0.3 0. I

-7.3 -7.4 -7.1

7. I 1.2 0.0 6.0

57.4 26.2 31.2

-7.8 23.2 15.3 16.4 9.6

16.5 31.2 -8.4

8,591 2.7

-0.8 4.1

10.478

3.4 23.0

13.5 20.0

15.1 14.9 11.0 10.2 3.9 0.2

19.0 16.0 4.6 7.6 3.9 3.0 0.2 0.0 0.1

-4.0 -4.2 -4.0

4.0 2.5 1.1 I .6

54.6 26.9 27.7

-4.9 15.7 10.8 25.2 12.7

12.0 1.1

-6.5 8.591

2.1

I'.6 13,384

2.5 4.0 5.0 20.0 6.0 5.5

(In percent of GDP) 14.2 15.6 20.1

15.4 15.2 11.3 10.0 3.9 0.2

19.3 16.1 4.8 7.3 4.0 3.2 0.2 0.0 0.2

-4.1 -4.3 -4.2

4.2 I .4 0.0 2.8

56.9 27.8 29.1

19.9

16.0 15.8 12.0 10.6 3.8 0.2

19.2 15.2 4.7 6.3 4.2 4.0 0.1 0.0 0.0

-3.3 -3.4 -3.2

3.2 1 .o 0.2 2.2

55.3 26.2 29.1

17.3 21.6

16.8 16.4 12.8 11.5 3.7 0.4

19.4 14.2 3.5 6.4 4.3 5.2 0.0 0.0 0.0

-3.0 -3.0 -2.6

2.6 I .5 0.2 1.1

54.1 26.2 27.9

(Annual chanpes: in percent) -3.4 -1.4 ,,

11.8 12.1 .. 8.4 10.6 ., 8.3 14.2 ..

-5.5 1.5 6.2 -14.5 -5.5 6.8 -5.9 -4.3 -4.3

9,091 10,591 11,091 3.0 3.3 3.2

0.9 2.4 3.4 12,970 14,298 15,838

6.0 5.5

18.6 23.0

17.4 17.0 13.5 12.3 3.5 0.4

19.7 14.1 3.1 6.6 4.4 5.7 0.0 0.0 0.0

-2.7 -2.7 -2.3

2.3 2.1 0.4 0.2

52.1 26.2 25.8

8.0 7.0 -4.3

11,891 3.2

4.4 17,712

6.5 5.5

19.7 23.9

17.7 17.3 13.9 12.7 3.4 0.4

19.6 14.0 2.8 6.7 4.5 5.6 0.0 0.0 0.0

-2.3 -2.3 -1.9

1.9 1.9 0.1 0.0

49.9 26.3 23.6

8.0 7.6 -4.2

11,891 3.0

4.9 19,90 I

7.0 6.0

21.5 25.2

17.9 17.5 14.3 13.1 3.3 0.4

19.7 13.8 2.5 6.9 4.5 5.9 0.0 0.0 0.0

-2.1 -2.1 -1.7

I .8 I .8 0.1 0.0

47.4 26.0 21.4

8.5 6.8 -3.7

12,891 3.0

5.4 22,572

DP at market prices (in billions o f U S dollars) 144.0 167.6 .. 162.6 171.0 180.8 193.1 207.4 224.0 Including changes in inventories. Investment data recorded by the Federal Bureau of Statistics are said to be underreport true activiry.. Expenditure on social assistance in 2008/09 is budgeted at 0.Spercent of GDP. Theprogram wi l l target an additional 0.3-0.Spercent of GDP. Excluding gold, foreigti deposits of comniercial banks held with the State Bank of Pakistan. The Realper capita G D P f o r y a r s FYII, FY12, FY13. and FY14. the population growth rate is assumed to be 1.6?6p.a.

'urces: Govenrment of Pnkistm for rhe Aistoricnlyenrs, mid IMFprojecrions.

8

Table 4: Selected Recent Economic Indicators

International Commodity Piices Crude Oil, Dubai (end-period) Shbl l a Wheat, US (average) S/mt I b

Current Account Deficit % o f GDP ofwhrch Trade ofGoads % ofGDP Trade ofSrrv iccs 36 ofGDP Workers' Remittances % ofGDP

Net Capltai Flows %ofGDP 2' ofwhich. Foreign Direct Investment ?4 ofCDP Portfolio Investment 96 ofCDP

Net Portfolio lnwstment (end-penodj 5 mn EMBl Global Band Spread (end-penod) bpr Foreign Exchange Reserves (end-penodj S mn Exchange Rate (end-period) RslS

Consumer Price Index %, YoY growth CPI food %, YoY growth CPI "on-food and non-energy %, YoY growth

6-manth T-bill (% end-period)

Reserve money Braad money

56% YoY giouih %, YoY growth

Government Borrowing 1 SBP

Uorc I P c r i d dwragc un1~11 indicafed o l h m i i c Uorc2 IMFpro,ccrcdCDPofUSSI61 billion i iu iedfor2908I09 id Source GEM U o r l d B m k I bl Source I V F Primary Cammod8ty Pricer 2'DrRnedai Iheo\cral l balanecminusIheculTenfaccouni brlance

Scheduled Banks

2004105 2005106 2006107

40.2 5 7 6 60.9 148 8 169.7 202.2

-1.4 -3 9 -4 8

-4.1 -6 5 -6.8 -3 0 -3 4 -2 9 3 8 3 6 3 8

I 0 4.9 7 4

I 4 2.7 3 6 0.6 0 7 2 3

6 2 0 0 964.0 3,288 0 229 251 214

9.805 IO,i65 13,345 5 9 7 6 0 2 6 0 6

9 3 7 9 7 8 12.5 6.9 10.3 7 2 7.5 5 9

7 9 8 4 8 9

1 7 6 1 0 2 2 0 9 1 9 2 1 4 9 193

91 I 8 6 9 92.8 1556 135.1 -586 - 8 8 4 -680 1606

- 90 3

343.8

-8 4

-9 I -3.8 3 8

4.9

3.1 0 0

41 0 687

8,625 68 4

12 0 17.6 8.4

II 5

=

21 6 15 4

583.8 688 7 -134 I

2008109

Jul Aug Sop Oct Xot Dec Jan

123.2 110.3 9 0 0 5 9 4 47.1 3 7 1 43.2 328.2 329.0 296.0 237.0 226.9 220.0 2 3 9 0

-0.6 - 0 9 -0.8 -1.3 -0 5 -0.3 -0.3

- 0 8 - 0 9 - I O - I O -0.4 -0.7 - 0 5 - 0 3 - 0 4 -0.1 - 0 3 -0.2 -0.2 -0.1 0 4 0.4 0.4 0 3 0 4 0.4 0.4

-0 3 0.4 0 2 0 4 0 2 0.6 0.6

0.2 0 3 0 2 0 1 0 2 0.4 0.1 0 1 0.0 0 0 0 0 0 0 0.0 0 1

-133 -218 -235 -250 -278 -308 -408 782 1,040 1,600 2,005 2,132 2,112 2,046

6.968 5,760 4,866 3,379 6,001 6,619 6,793 7 1 5 76.2 78.4 81.7 78.9 79.1 79.0

24 3 25.3 23 9 25 0 24 7 23.3 20.5 3 3 8 3 4 1 29.9 31.7 30.4 27.9 21.6 I 4 7 1 6 4 17.3 18.3 18.9 18.8 18.9

l l 5 11.5 1 2 7 1 2 7 1 4 0 1 4 0 14.0

1 9 3 21.3 2 5 2 10.9 1 0 7 1 0 1 10.1 I 3 8 13.4 12.7 14.2 I I 4 10 4 8.8

f14 - Fehruaty 7. 2009 324.4 308.1

3 4

- 2008109

'umulativ

Jul-Jan - -

-4.8

-5.2 -1.5 2 6

1 8

1 6 0 2

23.9 29.8 17.6

- -

34. Fiscal consolidation was on track at end December 2008 (see Table 5). The estimated ha l f a year fiscal deficit (excluding grants) was 1.9 percent o f GDP against the target o f 2.0 percent o f GDP set in November 2008. Savings o n non-essential development spending and a reduction in power and fuel subsidies, facilitated by rapidly declining international o i l prices, helped the fiscal deficit stay within the target, despite o f weak revenue performance.

35. During July-December 2008, recurrent and development expenditures were below their targets by 5 and 18 percent, respectively. On the recurrent side, the bulk o f savings accrued f rom federal subsidies. Expenditure o n federal subsidies (at 0.9 percent o f GDP) was only 36 percent o f the budgeted amount, as expenditure o n fuel and food subsidaies fe l l substantially short o f the (pro-rated) budget targets. The authorities started passing on the international fuel price increases to consumers in March 2008, with the a im to eliminate fuel subsidies by end December 2008. The parity with international fuel prices was reached already in mid-October 2008, helped by rapidly declining international o i l prices. The authorities are also committed to eliminate the power sector subsidies by end June 2009. To achieve that, they increased electricity tariffs o n average by 9 percent in February 2008 and 18 percent in November 2008. In parallel, stringent expenditure controls measures adopted by the federal government and the impact o f pol i t ical transition in the provinces contributed to smaller than targeted development spending.

36. However, inter-corporate debt in the energy sector increased sharply from Rs. 51 billion in mid-October 2008 to about Rs. 147 billion at end January 2009. Whi le there are several reasons for the debt, including delayed payments to energy companies, this highlights the continued need for fiscal adjustment .

9

Table 5: Consolidated Federal and Provincial Fiscal Accounts, 2008/09

13,384

37

I 13,384 I 12,970

Revenue (excluding grants) Tax revenue

Federal FBR revenue Oil and gas surcharges and other

Provincial Nontax revenue

Federal Provincial

Expenditure

Federal Interest Other

Provincial Development expenditure and net lending

Public Sector Development Program

Current expenditure

Federal Provincial

Net lending Statistical discrepancy Overall Deficit (excluding grants) Financing External Domestic

Bank Nonbank Privatization receipts

Memo item: Nominal GDP

Budget 14.6 10.8 10.3 10.0 0.4 0.5 3.8 3.0 0.8

19.2 15.7 11.6 4.2 7.4 4.1 3.5 3.5 2.3 1.2 0.0 0.0

-4.6 4.6 1.8 2.8 0.8 2.0 0.0

12,556

(Pem July-Dt

Program Target

6.5 4.7 4.5 4.3 0.2 0.2 1.8 1.4 0.3 8.4 7.4 5.7 2.3 3.4 1.7 1 .o 1 .o 0.6 0.4 0.0 0.1

-2.0 2.0 0.4 1.5 1.1 0.4 0.0

13,384

ember

Actual 6.2 4.6 4.4 4.1 0.3 0.2 1.6 1.5 0.2 7.9 7.0 5.2 2.2 3.0 1.8 0.9 0.9 0.5 0.4 0.0 0.2

-1.9 1.9 0.3 1.6 1.4 0.2 0.0

t of GDP) Full

Initial Program Target

14.9 11.0 10.5 10.2 0.4 0.4 3.9 3.2 0.7

19.0 16.0 12.2 4.6 7.6 3.9 3.0 3.0 1.8 1.1 0.0 0.1

-4.2 4.2 2.6 1.6 0.7 0.9

0

(ear

Revised Program Target

15.2 11.3 10.9 10.0 0.9 0.4 3.9 3.3 0.6

19.4 16.4 12.4 4.8 1.6 4.0 3.0 2.9 1.8 1.2 0.0 0.2

-4.3 4.3

1.69 2.7 1.5 1.2

0

During July-December 2008, national revenue collection reached Rs. 834 billion, which was 0.3 percent o f GDP below the initial program target o f 6.5 percent o f GDP. The relatively weak performance was due to lower tax collection o f the Federal Board o f Revenue (FBR), as the sharp economic slowdown reduced the buoyancy o f Pakistan’s two main tax bases o f manufacturing and imports. F rom July 2008 to January 2009, FBR tax revenues reached Rs. 628 bi l l ion, an increase o f only 22 percent year-on-year compared to the in i t ia l program target o f 35 percent. In response to these developments, the authorities decided to step up the tax audit efforts to cover part o f the revenue shortfall, and the FBR revenue target was revised downwards f rom Rs. 1,360 b i l l i on to Rs 1,300 b i l l i on during the February 2009 program review. In addition, Government intends to compensate the shortfall in FBR revenues through higher petroleum development levy (PDL) collection. PDL collection reached already Rs. 29 b i l l i on during the first ha l f o f 2008/09, exceeding by over 100 percent the fiscal year target o f Rs. 14 bi l l ion. Instead o f passing o n the international price decreases to consumers, Government has maintained a premium above the import pari ty levels to cover part o f the tax revenue shortfall.

38. The external imbalances narrowed towards the end December 2008 on the back o f a lower oil import bill (see Table 4). The monthly current account deficit dropped sharply f rom the peak o f 1.3 percent o f GDP in October 2008 to 0.3 percent o f GDP in January 2009, bringing the July-January 2009 current account deficit to about 4.8 percent o f GDP (US$7.8 billion). Imports are projected to decline further as Pakistan reaps the benefits f rom lower international o i l prices (see B o x 1).

10

Box 1: The Impact of International Oil Price Changes on the Current Account Deficit

in 2007/08 to US$2.9 billion in 15,000

2008l09, foreign exchange reserves c

o f SBP rose to about US$6.9 12,000

5 billion by early February 2009 be

(see Figure 5). The rise in SBP reserves reflects the release o f the first SBA tranche over US$3.1

2 9,000

6,000

b i l l i on in end November 2008, in 3,000

Changes in the international oil price have had significant impact on the external current account deficit and economic performance of Pakistan. As mentioned earlier, the current account deficit increased from 4.8 percent o f GDP in 2006107 to 8.4 percent o f GDP in 2007108. Over 50 percent of this increase (1.9 percent of GDP) was on account of a 38 percent increase in the import price o f petroleum.

During the first half o f 2008109, Pakistan did not benefit from the reduction in international oil prices because o f its long-term contracts for oil imports, which were based on higher oil prices. As a result, in the case o f Pakistan, the import price per barrel of petroleum increased by another 19 percent during July-December 2008 compared to the average import price in 2007108. This additional price increase accounted for 13 percent (0.6 percent of GDP) of the current account deficit o f 4.6 percent o f GDP during July-December 2008.

i \ I

However, the import value o f petroleum i s expected to come down sharply during the second hal f of 2008109. The average price of crude petroleum imports during July to December 2008 was US$103/barrel for Pakistan, while the internaiional price of Dubai crude oil was only US$37/barrel in December 2008 (see Table 4). Assuming the

80 -

3 75 - 2 ' 70 -

. 65 -

60

average price of petroleum imports will be halved from over US$lOO/barrel to US$SO/barrel during January to June 2009, and import volumes remain constant, this would reduce the half-yearly petroleum import bil l from 3.7 percent of GDP during July-December 2008 to at most 1.8 percent o f GDP during January-June 2009.

-- -

39. While net capital inflows during July 2008 to January 2009 almost halved from US$5.1 billion

Figure 5: SBP Foreign Exchange Reserves (End Period) 18,000 1

40. Over the last few months, Government has met its financing needs mainly through non-bank borrowing. The T-bill market responded we l l to the 200 bp rise in the pol icy discount rate to 15 percent in mid-November 2008, and the increase in T-bill placements since then has enabled Government to reduce the level o f net borrowing from SBP by end December 2008 to below the cei l ing stipulated.

Figure 6: Interbank and Open-market Exchange Rate (Rs/US$)

90

85 Ai I

55 ' Jul-05 Feb-06 Sep-06 Apr-07 Nov-07 Jun-08 Jan-09

Interbank -Open-market Source: State B a n k o f Pakistan.

11

41. Improved aggregated demand management and lower commodity and o i l prices have begun to reduce inflation. The monthly year-on-year CPI declined to 20.5 percent in January 2009, and food inf lat ion to 21.6 percent (see Figure 7). However, core Figure 7: Inflation inf lat ion (non-food, non-energy CPI) remained high, and reached 18.9 percent.

42. Standard & Poor's upgraded Pakistan's long-term 24

foreign currency credi t rat ing 2 1s back to CCC+ in December 2

$ 1 2 - 2008. However, the EMBI

42

36 -

E 30 -

Y ,--A- - -v"---rt_ 6 - ,--" ./- Global Bond spread o f Pakistan 0

sovereign bonds remained above Jul-03 Feb-04 S e p O 4 4p.-05 Nor05 Jun-06 Jan-07 Aug-07 Mar-OS Oct-08

2,000 bp in early January 2009, suggesting that investor confidence remains fragile.

43. Despite favorable trends in the agricultural sector, domestic production and sales declined during the f i r s t ha l f o f 2008/09 compared to the previous year, due to power shortages, increased input costs, lower domestic demand, decreased private sector credit growth, and worsened prospects fo r exports. In particular, the growth o f the large-scale manufacturing sector turned negative 4.7 percent. Owing to these trends, the real GDP growth target for 2008/09 has been reduced to 2.5 percent.

E. Medium-Term Outlook

44. Given global economic crisis, the medium-term outlook presents significant downside r isks. The external environment i s expected to deteriorate further, with global growth turning negative and a gradual recovery starting only 2010.

45. Pakistan's real GDP growth i s projected to remain l ow in 2008/09 and 2009/10, and increase gradually f rom 2.5 percent in 2008/09 to 6.5 percent by 2012/13, although longer-term projections are part icular ly uncertain in view o f the volatile global economic environment. A ided by increasing public investment-among other things in infrastructure, power, and transport-gross capital formation wil l rise and contribute to growth recovery and facilitate private sector activity. In parallel, gradually increasing private sector credit growth wil l help economic activity. Agriculture is showing good growth prospects, whi le manufacturing and services are expected to recover only gradually as the domestic aggregate demand picks up and the availability o f power improves as a result o f investments in power generation. With the global recovery, exports are also projected gradually improve and reduce Pakistan's external vulnerability over time.

46. Over the medium term, Government's revised macroeconomic f ramework targets projects a decline in the fiscal deficit (excluding grants) f rom 4.3percent o f GDP in 2008/09 to 2.3 percent o f GDP in 2012/13. The cornerstone o f this outlook i s a significant increase in FBR tax revenues which are projected to rise by 3.1 percentage points o f GDP to 12.7 percent o f GDP by 2012113. Excluding grants, overall revenues are to rise f rom 14.3 percent o f GDP in 2007108 to 17.3 percent o f GDP in 2012113.

47. To meet the ambitious revenue targets, the authorities p lan to implement bold and comprehensive tax policy and administration reforms. This will include quick and decisive implementation o f value-added taxation (VAT) o f goods and services, elimination o f tax exemptions and

12

zero-ratings, and revamping o f the tax administration. The work o n the new VAT law has started, with the a im to get it ready for implementation in the 2010/11 budget. This wil l b e the key measure to expand the tax base and revenues, since currently services, which account for about 60 percent o f GDP, currently remain outside the tax net. In the meantime, as part o f the 2009/10 budget, Government expects to adopt significant legal changes to the current General Sales Tax (GST), mov ing it closer to VAT by minimizing exemptions and zero-ratings, and thereby broadening tax base and revenues. The proposed operation supports these efforts. Significant untapped revenue potential remains also at the provincial level, which wou ld warrant attention.

48. Owing to this sizeable revenue effort, total expenditures are projected to slowly climb back to about 20 percent of GDP in 2012/13. In l ine with current projections o f l o w o i l and commodity prices, and fol lowing the elimination o f power and fuel subsidies and maturing o f the remainder o f high interest- yielding Defense Savings Certificates, current expenditures wil l decline as a share o f GDP and make space for a steady increase in development spending from 3.2 percent o f GDP in 2008/09 to 5.6 percent o f GDP in 2012/13.

49. Lowering inflation remains a challenge. Headline inf lat ion i s projected to decrease f rom 20 percent in 2008/09 to 5.5 percent in 2012/13. The economic downturn is, however, l ikely to put stress on banks’ financial positions and close monitoring wil l be warranted. The proposed operation supports tightening o f prudential regulations to strengthen the financial sector.

50. The external current account deficit i s projected to decline to about 4.2 percent o f GDP by 2012/13. Foreign exchange reserves are expected to build-up from US$9.1 b i l l i on by end-June 2009 to about US$1 1.9 b i l l i on by end-June 2012/13. The sharp decline in international commodity prices, reduced private sector credit growth, and the economic recession are expected to curtail import growth in 2008109 and 2009/10. Exports are projected to start recovering f rom 2009110 onwards with gradual global recovery and imports f rom 2010/11 onwards, but the growth o f both remains moderate during the medium term. Remittances are projected to grow over the medium term. FDI, after a drop in 2008109, i s projected to start gradually recovering in 2009110 with the re-launch o f the privatization process, and portfol io f lows are predicted to turn positive only f rom 2010/11 onwards.

5 1. I n the medium term, increased productivity and export competitiveness are necessary to generate growth and reduce external vulnerability. To this aim, structural reforms to strengthen the investment climate and competitive environment are required. These will include measures to ease firm entry and exit, reduce barriers to competition and trade, and enhance the labor market f lexibi l i ty. In addition, efforts to improve the financial sustainability and efficiency o f the power sector will be essential to attract investment in new power generation. The proposed operation supports reforms in these areas.

52. Protecting the poor and vulnerable i s essential during the stabilization process. Recognizing this, the federal Government and the Punjab province increased spending o n social safety nets by total o f 0.5 percent o f GDP in 2008109. Further spending increases are projected in 2009/10. The federal Government launched the Benazir Income Support Program in the fal l 2008, with the objective to provide cash grants to the poorest families in Pakistan. In parallel, the province o f Punjab established i t s own income support program to protect the poor and vulnerable o f Punjab. The proposed operation helps the federal Government to strengthen the new national social safety net.

53. I n conclusion, despite a highly uncertain external environment, Pakistan i s now in a better position to attain the projected medium-term recovery path. Over the last few months, the stabilization efforts together with a decline in international commodity prices have succeeded in reducing external imbalances, rebuilding foreign exchange reserves, narrowing fiscal overruns and lowering inflation. However, the sharp deterioration in the global economic and financial outlook poses significant risks to exports, remittances and external financing, notwithstanding the fiscal stimulus packages prepared

13

in a number o f countries. Even though projections in these areas as we l l as forecasts about the speed o f real economy recovery were significantly moderated during the first program review in February 2009, they may s t i l l turn out to be optimistic. This highlights the need for a rigorous implementation o f reforms, whi le protecting core development spending, in particular social spending, to ease the adjustment for the poor and vulnerable people. There i s a risk that the sharper than anticipated economic downturn wil l lead to social tension as business activity slows down and f i r m s shed labor. Also, the risks to the domestic financial sector may increase. To mitigate this latter risk, SBP has adopted a problem bank management and contingency plan for dealing with problem banks, and measures to improve banking resolution and banking supervision are being implemented.

54. T h e med ium- term revenue project ions are ambit ious a n d there i s a risk tha t they wil l no t be met. However, the authorities want to retain the stretch targets in order to maintain the pressure for reform. Recognizing the need to substantially raise the tax to GDP ratio, they are keen to seize the opportunity for bo ld tax reforms, and are committed to take compensatory action in case revenues fal l short o f targets. This wil l include cutting o f expenditures.

55. Str ingent implementat ion o f the economic p r o g r a m wil l be c r i t i ca l t o success, and timely responses of fiscal and monetary authorit ies t o emerging r i s k s wi l l be essential t o ensure i t remains o n track. In the current economic environment, any medium-term projections are uncertain and regular adjustments are necessary in response to changed circumstances. The quarterly monitoring o f the IMF and the Bank’s proposed programmatic operation wil l mitigate these risks through continued pol icy dialogue with the authorities o n a proper adjustment path.

F. Governance

56. Pakistan exhibits problems in m a n y dimensions o f governance. The delivery o f publ ic services i s adversely affected by leakages, difficulties with bureaucratic structure and quality, and opaque decision-making. However, Government recognizes that corruption constitutes a threat to Pakistan’s development agenda, undermining revenue collection and service delivery, and eroding Government’s credibility and state legitimacy. Public pressure to tackle corruption under the democratic government i s increasing.

57. The authorit ies have made progress in pub l ic sector account ing a n d aud i t ing reforms, and in improv ing regulatory structure f o r pub l i c procurement. The accounting and audit functions have been separated and the Off ice o f the Controller General o f Accounts established. Government has made significant progress in transitioning to the international publ ic sector accounting standards using a computerized integrated financial management information system. The timeliness and rel iabi l i ty o f financial reports o f Government have improved. A new Chart o f Accounts for budgeting, accounting, and financial reporting, wh ich i s consistent with international standards, has been rol led out across federal, provincial, and district governments. The overall quality and rel iabi l i ty o f Government financial statements has also improved, and unidentified expenditures reduced. There i s a significant reduction in the“pay-bill” processing t ime as computerization has minimized manual processing and human discretion, and financial reports are disclosed. Expenditure irregularity has been reduced with monthly budget execution reports generated electronically and made available to spending agencies for budget monitoring and with pre-audit activities. Internal management practices, whi le s t i l l weak and a source o f corruption, are being strengthened. Some progress has also been made in public procurement. In 2003, the Public Procurement Regulatory Authority was set up to provide efficiency and transparency in public procurement. In 2004, publ ic procurement ru les consistent with good practice were prepared and notified. However, several challenges remain to be addressed, including an effective appeals process and monitoring and evaluation system (see paragraphs 124 and 167- 174). Since enhancing accountability, transparency, and reducing opportunities for corruption are core elements o f improved governance, these and other related actions wil l need to be strengthened and deepened as part o f ongoing reforms.

14

58. Government has strengthened key regulatory institutions, deregulated, and proceeded with privatization to reduce opportunities for corruption. In 2007, an Ant i -Money Laundering bill was promulgated that allows the authorities to seize property derived f rom or invested in money-laundering and impose penalties, and a National Commission for Government Reform presented in 2008 a proposal for c iv i l service reform and restructuring o f government processes.

G. Poverty

59. The 2005/06 Pakistan Social and Living Standards Measurement Survey (PSLM), which i s the latest available household survey, suggests that Pakistan witnessed from the early to mid-2000s improvement in key aspects of human development, such as poverty incidence and access to basic education. Irrespective o f the methodology deployed, poverty dropped significantly between 2001102 and 2005/06. The off icial poverty estimates suggest that the national poverty rate fe l l by more than 11 percentage points in four years, which i s equivalent to over 17 mi l l i on people mov ing out o f poverty. Even the more conservative estimate suggests that the national poverty rate fe l l by close to six percentage pointsS2 The results f rom the 2006/07 P S L M conf i rm that progress in basic social indicators continued over the last few years.

60. Since then a new set o f challenges has emerged. First, there are signs suggesting that rapid poverty reduction can be transitory and reversed by small shocks. For example, the poverty trend has shown sizeable fluctuation since 1998199, especially in the provinces o f Sindh and Balochistan. Second, a slow pace o f employment generation i s a source o f concern. Third, there i s a need to make economic growth and human development more inclusive and regionally balanced. Fourth, the rise in the cost o f living over the last year may have reversed at least some o f the earlier progress in poverty reduction. Section V1.A and Annex 1 1 o f this document present some in i t ia l analysis o f this. The release o f the 2007108 PSLM, which i s expected in early 2009 and includes a consumption module, wil l provide an opportunity to establish the latest trends. These emerging challenges are being analyzed in the ongoing work for the 2009 poverty assessment, and need attention if Pakistan’s good performance o n poverty reduction i s to continue.

H. Status o f IMF Activities in Pakistan

61. The IMF-supported Poverty Reduction and Growth Faci l i ty (PRGF) was concluded in December 2004, and the Government o f Pakistan did not request a successor IMF program. Between 2005 and October 2008 Pakistan was o n a standard Art icle IV surveillance schedule. The Art ic le IV consultations concluded in December 2007 highlighted the widening current account defici t as the economy’s main vulnerability. The IMF carried out i t s bi-annual Staff Visit in M a y 2008, and concluded that a major fiscal adjustment effort accompanied by a substantial tightening o f monetary pol icy (including the elimination o f central bank financing o f government) and further exchange rate depreciation wou ld be needed to contain inf lat ion whi le reducing the large current account deficit. A t the request o f the Pakistani authorities, an IMF technical mission visited Islamabad during September 2008 to provide technical input to quanti fying the economic stabilization package being developed by the authorities and preparing an updated medium-term macroeconomic framework.

The official poverty rates are estimated based on poverty lines updated with CPI-based inflation rates. According to the official estimates, the overall poverty declined by more than 12 percentage points, from 34.5 to 22.3 percent between 2001102 and 2005106. Poverty in urban areas declined from 22.7 to 13.1 percent and in rural areas from 39.3 to 27 percent. One issue for poverty monitoring, however, i s that the CPI for Pakistan currently focuses only on urban price data, although there has been some progress in recent years in expanding rural price data collection. With urban population constituting only about 40 percent o f national population, the inclusion o f rural areas in price data collection would improve the monitoring o f poverty trends.

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62. In light o f the rapidly deteriorating balance o f payments position and substantial financing needs, the authorities entered into an IMF-supported 23-month S B A in late November 2008. The program supports the macroeconomic stabilization program in 2008109 and 200911 0 to reduce inf lat ion and the external current account deficit to more sustainable levels. The pace o f adjustment aims to balance the need to address the macroeconomic imbalances with protecting social stability. The medium-term macroeconomic framework presented earlier i s supported by the SBA. The f i rs t review o f S B A was carried out in February 2009, and the program i s on track.

63. The SBA and PRESO have some mutual ly reinforcing actions in select areas, where monitoring f rom both IFIs i s considered vi ta l for success, or where the authorities have requested involvement by both the Bank and IMF. These areas are: power tar i f f adjustment, revenue mobilization, the establishment o f a treasury single account, and protection o f the poor.

111. GOVERNMENT’S POVERTY REDUCTION STRATEGY

64. PRSP-I: A strategy for poverty alleviation and economic development was articulated by the previous Government in i t s Poverty Reduction Strategy Paper (PRSP-I) o f December 2003 entitled “Accelerating Economic Growth and Reducing Poverty: the Road Ahead. ” PRSP-I focused o n second generation reforms to: (i) achieve and sustain a high growth rate w i th macroeconomic stability, and translate this high growth into reduced poverty; (ii) improve governance and consolidate devolution, as a means o f delivering both development results and ensuring social and economic justice; (iii) invest in human capital, with emphasis on effective delivery o f basic social services; and (iv) target the poor and vulnerable, and bring the marginalized sections o f the population and backward regions into the mainstream o f development. The strategy was fully aligned with the Mi l lenn ium Development Goals (MDGs) and focused o n raising incomes, achieving universal primary enrollment, reducing gender disparities, lowering chi ld and maternal mortality, combating communicable diseases, and eradicating poverty. The strategy was implemented and, as mentioned earlier, the economy grew rapidly, poverty incidence declined, and many human development indicators improved during the PRSP-I period.

65. PRSP-IZ: The current administration recently finalized the second PRSP (PRSP-11). The new strategy i s also fully aligned with MDGs. I t focuses on regaining the macroeconomic stability and structural reforms required to support the recovery o f strong and sustainable growth. The strategy envisions an economy with competitive enterprises, productive employment opportunities, transparent governance and l o w poverty. PRESO i s fully aligned with the new strategy. Table 6 below highlights the mapping between PRSP-I1 pillars and PRESO reform areas.

TABLE 6: MAPPING OF PRES0 REFORM AREAS TO PRSP-I1 PRSP-I1 PillarKhapter PRESO Reform Area

Macroeconomic Stability and Real Sector Growth Increased revenue mobil izat ion Governance for a Just and Fair System Improved efficiency o f publ ic spending

Integrated Energy Development Program Adjustment o f fuel prices and power tariffs Making Industry Internationally Competitive Reduced barriers to business entry and exit

Capital and Finance for Development Strengthened financial sector Protecting the Poor and Vulnerable Better targeted social safety nets Monitoring and Evaluation o f PRSP-I1 Strengthened statistical system

Strengthened government debt management

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IV. WORLD BANK GROUP STRATEGY AND THE PROPOSED PRESO

A. LinktoCAS

66. CAS: The Bank Group’s Pakistan Country Assistance Strategy (CAS) was discussed by the Board in June 2006 (Report No. 35718-PAK). The goal o f the CAS, wh ich i s aligned with the strategic priorities o f the former Government’s PRSP, i s to support Pakistan’s efforts in: (i) sustaining growth and improving competitiveness; (ii) improving government effectiveness and service delivery; and (iii) improving lives and protecting the vulnerable.

67. the Board in the calendar year 2009.

The Bank i s in the proces? o f preparing a new CAS. The new C A S i s expected to be presented to

68. The reform program supported by the proposed PRESO, with i t s focus o n economic stabilization and regaining o f economic growth whi le protecting the poor and vulnerable and improving competitiveness, i s consistent with the current CAS priorities.

B. Analytical Underpinnings o f PRESO

69. the fo l lowing analyses:

The proposed PRESO is based o n a series o f economic and sector work o n Pakistan. This includes

70. Tax policy: The specific tax pol icy measures proposed to be supported have been informed by the ongoing programmatic tax pol icy work, which consists o f po l i cy papers, country case studies, and technical assistance for institutional development and capacity building. This work provides a comprehensive assessment o f Pakistan’s tax system, lessons f rom other countries, and options for tax reform at both the federal and provincial level.

7 1. The proposed measures to strengthen tax administration build on the recommendations o f the Federal Board o f Revenue (FBR) review conducted in September 2008. At the request o f Pakistan fiscal authorities, a team o f international consultants reviewed the state o f tax administration in FBR. The team prepared an assessment o f various aspects o f tax administration, and identified where and why FBR i s fal l ing behind and what remedies are available to bring about improvements.

Tax administration:

72. Public expenditure management: The public expenditure management component and proposed actions reflect the results o f the ongoing Public Expenditure, Procurement, and Financial Management (PEPFM) Review, wh ich integrates the three areas and analyzes the effectiveness o f publ ic expenditures in a holistic manner. The review explores ways to finance the significant developmental needs, in particular on power, water, roads and social sectors, whi le ensuring fiscal sustainability. I t highlights the need to rationalize the Public Sector Development Program (PSDP) to reduce the throw-forward and ensure the spending yields results, strengthen the medium-term budget framework process, improve cash management, and enhance transparency in public procurement.

73. Financial sector: The financial sector component i s based o n the Financial Sector Assessment Program (FSAP) carried out jo in t l y by the Wor ld Bank and IMF in September 2008. The proposed PRESO focuses on the most critical short and medium-term pol icy measures recommended by the assessment.

74. Debt management assessment: The above mentioned FSAP 2008, the technical assistance mission conducted in M a y 2008, and the assessment o f central government debt management and domestic debt market development f rom 2004 informed the development o f the debt management component.

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75. The competition pol icy component builds o n an extensive program o f technical assistance by the Wor ld Bank since 2006, wh ich has provided diagnostic and recommendations for a new legal and institutional framework. The analytical aspects are documented in the report on Competition L a w and Policy published in 2007.

Competition policy:

76. Business registration: The proposed actions on business registration derive f rom the work carried out by the Do ing Business project, which has been extended to the sub-national level. Do ing Business indicators were collected for six Pakistan cities and analyzed in a report produced by the Wor ld Bank in 2007.

77. Poverty and social impact assessment: As discussed in Section V1.A and Annex 11, the fuel price and power tar i f f adjustments may have distributional impacts. Assessments o f (i) direct impacts o f fuel price increases o n poverty; (ii) incidence o f power subsidies; and (iii) the impact o f food price increases on poverty have been carried out.

78. Poverty assessment: The previous poverty assessment o n Pakistan was completed in the fal l 2002. The work i s ongoing on the next one, which, in addition to poverty diagnostic, wi l l analyze employment and labor market dynamics.

79. Social safety net: The social safety net component i s based o n a series o f technical assistance the Bank has provided to the authorities in the area o f social protection in the past few years. This includes support provided to the preparation o f the National Social Protection Strategy and to the development o f an improved targeting mechanism for cash transfer programs. A new targeting instrument (scorecard) has been developed to support the identification o f the poor.

C. Lessons Learned from Prior Operations

80. Country Assistance Evaluation: In 2005, IEG conducted an evaluation o f Bank assistance to Pakistan during 1994-2003. The report rated the effectiveness o f Bank’s assistance mixed, with the overall outcomes o f Bank’s assistance program rated as moderately unsatisfactory. Bank support for macroeconomic management and growth was rated as moderately satisfactory, whi le the Bank’s assistance was found to be unsatisfactory in poverty reduction, social sector development, governance, agriculture, natural resource management, f ixed infrastructure, revenue mobilization, and expenditure management.

8 1. The key recommendations o f the evaluation were: (i) the Bank should continue i t s strong support o f analytical work, whi le translating analysis into implementable actions, taking into account pol i t ical economy constraints; (ii) Bank interventions should have a greater focus o n building sustainable institutional capacity; (iii) projects should be more focused and scaled to fit the capacity o f implementing agencies; and (iv) the Bank should invest additional effort into improving donor relations.

82. Other prior budget support operations: The other pr ior budget support operations to Pakistan provide two lessons relevant for the proposed PRESO. First, the experience highlights the importance o f aligning the reform program with the roles and responsibilities o f the concerned level o f government. For example, since the delivery o f education and health are pr imari ly provincial responsibilities, reforms in these areas are best handled through provincial-level operations. Second, the pr ior experience suggests the need to address capacity and institutional issues in parallel to ensure that the reforms are fol lowed through.

83. The proposed PRESO continues supporting select unfinished critical reforms f rom the past PRSC series, wh ich are consistent with the current administration’s priorities. These include: power sector reform, competition policy, statistical reform, revenue mobil izat ion at a significantly expanded scale and focus, and social safety nets.

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D. Coordination with Other Development Partners

Outcome goal: Increased tax to GDP ratio through broadening o f

84. Coordination with IMF: Bank and Fund staff collaboration in Pakistan continues to be effective with consultations o n macroeconomic issues and technical assistance. The Bank and IMF teams have coordinated closely both the S B A and PRESO-supported reform programs. The Bank has continued participating in the IMF missions as an observer.

Outcome indicator and target: 1. FBR tax revenues to GDP ratio increased by 0.4% o f GDP in 2008/09.

85. Coordination with other development partners: The Bank i s collaborating with DFID o n select reforms supported by PRESO. A DFID-financed trust fund has generously supported the analytical work and technical assistance that i s underpinning a number o f supported reform measures, in particular in the areas o f revenue mobilization, competition policy, social protection, and poverty analysis.

V. GOVERNMENT’S AND STATE BANK OF PAKISTAN’S PROPOSED REFORM PROGRAM SUPPORTED BY PRESO

A. Overview o f PRESO

86. Objective: The objective o f PRESO wil l be to support the implementation o f Pakistan’s recently adopted PRSP-11. In particular, PRESO wil l support the structural reforms needed to regain and maintain economic stability and to bring the economy back to a higher growth path over t ime through measures enhancing competitiveness, while protecting the poor and vulnerable.

87. The reform program supported by PRESO i s bu i l t o n three pillars focusing on: (i) regaining and maintaining macroeconomic stability; (ii) enhancing competitiveness; and (iii) protecting the poor and vulnerable. Table 7 lays out the home-grown 2008/09 Pol icy Framework o f Government and State Bank o f Pakistan with the pillars, reform areas and actions proposed to be covered under each o f them. These areas and actions are consistent with PRSP-11. The specific reforms to be supported in each area are detailed in the Government and State Bank o f Pakistan’s Letter of Development Policy (see Schedule I) . PRESO wil l focus on actions that are critical for economic stabilization and promotion o f competitiveness, protection o f the poor and vulnerable, as we l l as for achievement o f the set outcome goals (see below).

Proposed reform areas:

88. As highlighted in PRSP-11, the immediate task at hand for the authorities wi l l be to re-stabilize the economy and narrow macroeconomic imbalances. This wil l involve prudent fiscal and monetary policies, consistent with the IMF-supported SBA. To limit the scale o f publ ic expenditure cuts, there i s a need to raise tax revenues decisively, substantially and sustainably. Raising domestic tax revenues to a higher level wou ld also enable Pakistan finance i ts significant development needs and thereby facilitate inclusive economic growth over time. This wil l require renewed effort to reform both tax administration and tax policies, and hence these areas are covered by the proposed reform program to be supported by PRESO.

T a b l e 7: Poverty Reduct ion a n d Economic Support Operat ion (PRESO): 2008/09 Policy F r a m e w o r k of Government a n d State B a n k of Pakistan

Overall outcome goals: 1. Reduced macroeconomic

2. Improved equity and

3. Enhanced competitiveness. 4. Improved protection of the

imbalances.

efficiency of public finances.

Overall outcome indicators and targets: 1.

2.

3 . Improved Doing Business Indicators. 4.

Fiscal deficit (excl. grants) reduced from 7.4% o f GDP in 2007108 to or below 4.3% o f GDP in 2008/09. Current account deficit reduced from 8.4% of GDP in 2007108 to or below 5.9% of GDP in 2008109.

Improved access to social safety nets for the poorest 25% o f the population.

19

tax bases. I Governm'ent approved establishment o f a new integrated tax administration on functional basis, and related FBR top management changes implemented. Task forces to pursue unregistered entities, non-filers and stop f i lers established, and preparation o f risk-based

LTU or RTO selected as pilot for the new Integrated Tax Systems based on System 2009. Government approved policy action plan to amend legislation o f domestic indirect taxes to ensure comprehensive taxation o f goods and services in the f o r m o f VAT. Measures to limit revenue leakage implemented.

P compliance strategies launched.,

4 .- 4

Adjustment o f fuel prices and power tariffs: Outcome goal: Reduced government subsidy bill. 1. Fuel subsidies eliminated by end 2008.

Outcome indicators and targets:

2. Power sector subsidies eliminated by end June 2009.

.- I determination o r re-determination. 2

Automatic monthly adjustment o f consumer fuel prices introduced, and a minimum level o f PDL specified. Month ly determination o f fuel adjustment surcharge introduced; new electricity tariffs notif ied in 15 days from

A satisfactory plan to eliminate power sector subsidies b y end June 2009 consistent w i t h the budget adopted and imolemented.

5

Improved efficiency o f public spending: Outcome goal: Better prioritized development spending with medium-tem focus on the budget.

Outcome indicators and targets: 1. 2. 3. Medium-term budget planning established 4.

PSDP throw-forward reduced from 6.1 to 4.9 years in 2008109. Efficient cash balance management in place.

Social and poverty-related public spending at least 4.5% o f GDP. The PSDP portfolio consolidated b y at least 20% consistent w i t h development priorities. MTBF expanded to a l l federal ministries, revised Budget Call Circular and 3-year indicative ceilings provided to line

Use of assignment accounts for budget expenditure fully operational. Contract awards over Rs. 50 million posted on PPRA's website.

P ministries. ' Strengthened government debt management: Outcome goal: Government debt managed at lowest cost, subject to prudent level of risk and consistent with sound monetary and fiscal oolicv.

.- e

Outcome indicators and targets: 1. 2.

3 .

Government borrowing consistent with sound monetary and fiscal policy. Domestic debt-servicing forecast of S S S instruments differs from actual outtum by less than 5%. Public guarantees annually at or below 2% of GDP.

Credible January-June 2009 calendar for PIB auctions published and adhered to, with quarterly updates. MoF amended rules defining roles and decision-making rights fo r PIB issuance and issued related instructions to SBP. CDNS has gathered complete data on outstandings and early encashments o f Defense Savings Certificates due to mature in 2008109 and 2009/10.

.- I '

Reduced barriers to competition: Outcome goal: Enhanced competition in domestic markets.

' ' Strengthened Financial Sector: Outcome goal: Increased soundness and stability o f the financial sector.

Outcome indicator and target: 1. Starting a business time reduced from 27 days in 2008 to 22 days in 2009.

.- e CCP rules notif ied providing the terms and conditions o f CCP members; and automatic source o f financing. Electronic platform for business registration system rolled out and announced.

Outcome indicator and target: 1. Lending portfolio o f banks diversified over time.

1 Prudential regulations amended to introduce a phased reduction in the group credit exposure limit f rom 50% to

Better targeted social safety net: Outcome goal: Improved targeting and implementation o f cash transfer and safety net programs.

Outcome indicator and target: 1. Increased coverage o f the poorest 25% of the population by BISP.

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Outcome goal: More reliable and timely economic and social data for pol icy analysis and formulation.

89. The sharp increase in economic imbalances in 2007108 was largely caused by government overspending-in particular o n fuel and power subsidies-and under-forecasted domestic interest payments. Therefore, in addition to ensuring that energy subsidies remain within the limits o f the budgeted amounts, it will be essential to reinstitute automatic price adjustment mechanisms for both fuel and power to avoid similar problems in the future. Bringing the power ta r i f f to the cost recovery level wil l also be essential for putting the power sector on financially sustainable footing and attracting foreign investors to the sector. Thus, the proposed reform program wil l support these efforts.

Outcome indicator and target: 1. Increased reliability o f the national statistical system.

90. In addition, the proposed program wil l support reforms to improve the efficiency and prioritization o f publ ic spending. Government’s development program portfol io has expanded to an unmanageable level with about 2,000 different schemes, a large annual throw-forward, and l i t t le sense o f prioritization o f activities. Eff icient cash management i s also lacking, and public procurement remains relatively non- transparent. In the current resource-strapped environment, i t i s imperative to raise the efficiency o f public spending.

9 1. Further, Government’s debt management needs urgent attention. In the past year, Government effectively withdrew f rom market-based funding. This was possible by unl imited recourse to central bank financing, the heavy reliance on National Savings Schemes (NSS) retai l instruments, and the application o f y ie ld cut-offs in wholesale auctions. At the same time, the significant rise in net government borrowing from SBP undermined the central bank’s abi l i ty to implement a monetary pol icy consistent w i th macroeconomic stability and l o w inflation. The macroeconomic re-stabilization wou ld need to be underpinned by strengthened public debt management, and hence it i s proposed to be supported by the reform program.

92. In parallel with stabilization efforts, the authorities wil l need to take measures to enhance Pakistan’s competitiveness to achieve the PRSP-I1 goal o f mov ing the economy back to a higher growth path. Remaining barriers to business entry and exit wou ld need to be addressed. Unhindered entry, exit, and turnover o f f i r m s are crucial for productivity growth, as competition induces f i r m s to adopt new technologies and raise efficiency. Thus, i t i s essential that Government’s legal and pol icy framework promotes competition. PRESO i s proposed to support reforms in a l l these areas.

93. A sound and stable financial sector i s also essential for development. The global financial crisis and, above all, the needed macroeconomic adjustment can be expected to put strain o n the financial sector, threatening i t s soundness and stability. Thus, the proposed reform program will support measures to improve the stability o f the system.

94. Finally, to mitigate the adverse impact o f domestic price increases and adjustment o n the poor, Government’s social safety net system wou ld need to be strengthened. Hence, the proposed reform program wou ld support the efforts o f the authorities to improve the targeting o f the existing social safety net system, and in particular the targeting o f the Benazir Income Support Program. The program is also proposed to support statistical reform to enhance the rel iabi l i ty o f economic and social data.

95. In addition, the general requirement o f a satisfactory medium-term macroeconomic framework for a l l

Proposed PRESO Prior Actions: PRESO i s proposed to have in total ten pr ior actions.

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Bank’s budget support operations applies. PRESO prior actions fo l low the good practice principles (see B o x 1) and are as follows:

0

0

0

0

0

0

0

0

0

0

Government approved establishment o f a new integrated tax administration o n a functional basis, and related FBR top management changes implemented. Government approved pol icy action plan to amend legislation o f domestic indirect taxes to ensure comprehensive taxation o f goods and services in the fo rm o f a VAT. Automatic monthly adjustment o f consumer fuel prices re-introduced, and a minimum level o f PDL specified. Month ly determination o f fuel adjustment surcharge introduced; new electricity tariffs noti f ied in 15 days from determination or re-determination. A satisfactory plan to eliminate power sector subsidies by end June 2009 consistent with the budget adopted and implemented. The PSDP portfol io consolidated by at least 20 percent consistent with development priorities. M o F amended rules defining roles and decision-making rights for P I B issuance and issued related instructions to SBP. CCP rules noti f ied providing the terms and conditions o f CCP members, and automatic source o f financing. Prudential regulations amended to introduce a phased reduction in the group credit exposure limit f rom 50% to 25% over time. Government adopted the scorecard as the new targeting instrument for B ISP and noti f ied the plan for i t s ro l l out, w i t h the rol l-out launched in January 2009.

Box 2: Application of Good Practice Principles on Development Policy Lending to PRESO ~ ___ ~~

Principle 1: Reinforce ownership The PRESO-supported reform program i s in line with Government’s priorities as spelled out in PRSP-11. The program reflects policy measures which Government has proposed and i s committed to do.

Principle 2: Agree up front with the government and otherfinancialpartners on a coordinated accountability framework The PESO-supported medium-tern policy matrix, which outlines short and medium-tern actions with clear and measurable outcome indicators and targets, was developed jointly with the Pakistani authorities.

Principle 3: Customize the accountability framework and modalities of Bank support to country circumstances The reform program i s based on the needs o f Pakistan. I t reflects the significant policy measures on various fronts needed for stabilization of Pakistan’s economy and enhancement o f competitiveness and economic growth for poverty reduction. Also, the program focuses on outcome-oriented actions to achieve program objectives.

Principle 4: Choose only actions critical for achieving results as conditions for disbursement PRESO focuses on actions that are critical for achieving the set outcome goals. The number o f prior actions has been limited to ten.

Principle 5: Conduct transparent progress reviews conducive to predictable and performance-basedjinancial support Progress made with the implementation o f reforms and achievement of outcome goals wil l be monitored through preparation of regular macroeconomic updates, and a progress matrix, which outlines the status of reforms and outcome indicators.

96. Link to medium-term policy framework: A full correction o f existing macroeconomic imbalances i s not feasible in the current fiscal year, and therefore the authorities will continue stabilization and economic recovery efforts in 2009110 and 201011 1.

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97. The draft medium-term pol icy framework o f Government and SBP, wh ich lays out the envisaged roadmap for adjustment over time, i s attached as Schedule 2. As mentioned earlier, PRESO wil l support the implementation o f actions taken in 2008/09 only. The implementation o f the latter two fiscal years o f the framework i s expected to be supported trough another operation.

98. PRESO:

Expected outcomes of PRESO: The fol lowing outcomes are expected as a result o f the proposed

Fiscal defici t reduced f rom 7.4 percent o f GDP in 2007/08 to o r be low 4.3 percent o f GDP in 2008109; Current account defici t reduced f rom 8.4 percent o f GDP in 2007/08 to o r below 5.9 percent o f GDP in 2008/09; Improved Do ing Business indicators; and Improved access to social safety nets for the bottom 25 percent poorest population.

99. Mitigation of poverty and social impacts: Poverty and social impact assessments (see Section V1.A) were carried out on fuel and power tar i f f adjustments and o n the impact o f food price inflation. The results indicate that price increases o f food products and, to a lesser degree, o f fuel products, would be the main concerns f rom the poverty impact point o f view. Electricity ta r i f f increases are unl ikely to have any direct adverse impact on poor people. Fortunately, the recent decline in, international commodity prices makes reductions in domestic food and fuel prices currently more l i ke ly than increases, which allays the earlier mentioned concerns. The proposed PRESO action o n f u e l i s expected to benefit a l l households.

100. The fol lowing sections wil l describe in further detail the actions proposed to be supported by PRESO.

B. Pillar I: Regaining and Maintaining Macroeconomic Stability

Increased Revenue Mobilization

101. Outcomegoal: The FBR tax revenue to GDP ratio increased by 0.4 percent o f GDP in 2008109.

102. Issues: A sustainable improvement in the Government resource envelope has to come through higher tax revenue mobilization. Yet Pakistan’s tax collection has failed to improve since the late 1990s. The tax-to-GDP ratio recovered to 10.9 percent in 2006107. In 2007108, the di f f icul t economic circumstances took a to l l o n tax collection and the Federal Board o f Revenue (FBR), wh ich collects over 90 percent o f Pakistan’s tax revenues, collected less than the in i t ia l ly set target. As a result, the total tax- to-GDP rgtio decreased to 10.4 percent in 2007108. The outtum o f first six months o f 2008/09 suggests revenues continue to be stagnant.

103. The stagnation in tax collection i s related to administrative limitations. Supported by the Bank’s Tax Administration Reform Project, FBR has made some good progress since 2005 in moving towards the introduction o f self-assessment for income tax; extensive development o f information technology systems; the development o f a strong taxpayer facilitation approach; rapid progress in e-filing; and the establishment o f a modem tax off ice network, with upgraded infrastructure at many offices. However, the process is s t i l l incomplete: self-assessment i s partial; the organizational structure s t i l l reflects separate taxes; and the full benefits o f a function-based and integrated administration have yet to be realized. At the provincial level, tax administration reforms have s t i l l to be launched.

104. The weaknesses in tax administration are compounded by weaknesses in tax pol icy. L o w tax pol icy capacity has contributed to continuous piecemeal changes in tax legislation that have eroded the coherence of the tax structure. In particular, the tax code needs to be further simpli f ied for smooth

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implementation and compliance. In addition, the revenue i s raised in an inefficient way by favoring certain sectors and economic activities over others. For example, the advantageous treatment o f services and agriculture compared to industry deters industrial enterprises f rom doing better, and ultimately gets in the way o f economic growth. Furthermore, there are questions to what extent the tax system i s sufficiently equitable. For example, persons relying on income f rom capital are taxed far more l ight ly than persons relying o n labor income. One reason for these inefficiencies and inequities i s that federal tax bases are tapped more strongly than provincial tax bases. The federal tax administration i s more efficient than provincial tax administration, and the bulk o f the fiscal transfers o f the National Finance Commission to provinces are allocated only on population basis.

105. To ensure adequate public funding for development priorities, Government aims to increase tax collection by 3.1 percentage points over the next f ive years, whi le improving the buoyancy o f the tax system, broadening the tax bases, reducing distortions and phasing out exemptions. T o attain this goal, major tax administration and tax pol icy measures will need to be introduced in the short and medium run. Government i s strongly committed to pursuing the required tax reforms across the three areas o f tax administration, tax policy, and provincial taxation.

106. Reform strategy to reach the outcome goal: PRESO will support the fo l lowing Government actions to improve revenue mobil izat ion in an efficient and equitable manner:

Establishment of function-based and integrated tax administration: The objective o f tax administration reform i s the creation o f an FBR organizational structure based on functional rather than tax-type lines. This involved a full integration o f the domestic taxes into a single organization. Because there i s lack o f accountability in key areas and in some cases a duplication o f accountability, re-organization at the top management level has also been a necessary early step under PRESO in the process to achieve full integration. Now that the organizational structure has been revised, FBR’s tax administration wil l require formal business process re-engineering.

Risk-based compliance management: The recent efforts to facilitate taxpayer compliance through automation, education and assistance will be augmented with a strengthened and targeted enforcement program to detect and deter non-compliance. Under PRESO, the authorities have established task forces to pursue unregistered entities, non-filers, and stop filers, as we l l as launched the preparation o f risk-based compliance strategies. Effective risk-based compliance management i s vi tal for ensuring that taxpayers meet their obligations to register, keep proper records, f i le correct returns, and pay taxes on time.

Alignment of information technology with business needs: The I T system wil l also need to be aligned with the new integrated tax system and focus o n i t s deployment. Under PRESO, FBR has sanctioned the current suite o f systems as the core o f System 2009, and ceases development work o n any competing systems. Also, the Lahore Large Taxpayer Un i t has been selected as testing ground for System 2009. Once functionality i s ensured, FBR intends to deploy System 2009 throughout a l l Large Taxpayer Units and Regional Tax Offices. System 2009 will be modif ied o n an ongoing basis in l ine w i th the changes in business processes and tax policies.

Reform of tax policies: Government intends to boost the tax-to-GDP ratio over the medium-term in a sustainable, efficient, and equitable manner through reforms o f the three main domestic taxes. The General Sales Tax (GST) i s the most conspicuous under- performer among Pakistan’s taxes. The federal GST o n goods i s fragmented through mult iple exemption and zero-rating provisions. Pakistan’s constitution preserves the taxation o f services for the provinces, wh ich make l i t t le use o f this tax base. Introducing a well-administered GST on both goods and services w i t h minimum exemptions would widen the tax base substantially and deliver a sizeable increase in tax collection. Under

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PRESO, Government has endorsed the pol icy proposal to amend legislation o f domestic indirect taxes to ensure comprehensive taxation o f goods and services in the fo rm o f VAT. As part o f the 2009110 Finance Act, Government expects to adopt significant legal changes that move GST closer to a comprehensive VAT, as we l l as simplify tax rate schedules, rationalize withholding taxes, and broaden the base o f Pakistan’s tax system, including for income tax. Legal tax reforms are expected to be completed by June 20 10.

Adjustment o f Fuel Prices and Power Tariffs

107. Outcome goals: (i) Fuel subsidies eliminated by end 2008; (ii) power sector subsidies eliminated by end June 2009.

108. Issues: The proposed fiscal adjustment requires substantial cut in subsidies. The proposed operation focuses on fuel and power subsidies, wh ich are largest in size and wh ich were the main reason for the ballooning fiscal imbalance in 2007/08.

109. The former system o f fortnightly adjustment in domestic o i l prices to establish parity with international prices was abandoned in February 2007, and Government continued to absorb fully the international price increases in the budget until March 2008. As a result, fuel subsidies ballooned in 2007/08 and, in the absence o f adjustment in domestic prices, the growth in domestic demand for petroleum products continued unabated.

110. Government recognized that it cannot continue to provide subsidies on petroleum products, and took actions to eliminate subsidies on al l petroleum products by end December 2008. Specifically, in the f i rst four months o f 2008109, it did not reduce the domestic prices o f petroleum products whi le crude and product prices were fal l ing sharply in international markets. Since the delivered cost o f almost al l petroleum products has fallen below the level o f domestic prices-the parity between the domestic and international fuel prices was reached in mid-October 2008-Government has n o w started passing o n the impact o f further reductions in import costs to consumers.

11 1. The power sector is facing severe physical and financial deficits, wh ich have started to constrain economic growth and erode investor confidence as frequent power outages have become common throughout the country. Improvements in the quantity and quality o f power supply wil l take 3 to 4 years, owing to inadequate investment in the past and the t ime required to expand generation capacity and the transmission and distribution grids.

112. The financial deficit i s the result o f inadequate increases in electricity tariffs, wh ich have not been commensurate with the changes in the cost o f supply (primarily o n account o f r is ing fuel cost^).^ Also, since February 2007 NEPRA has determined consumer tariffs o n the basis o f the cost o f service o f each distribution company (disco), while Government has noti f ied a un i fo rm consumer ta r i f f across discos. The difference between the NEPRA determined and Government noti f ied tariffs has been covered by Government through increasing subsidies. This i s a large drain on the budget, wh ich i s not sustainable.

Government has adjusted electricity tariffs four times-in February 2007, March 2008, November 2008, and February 2009- since November 2003. These adjustments involved increases o f about 10, 9, and 18 percent respectively in consumer tariffs. However, some consumer categories/slabs were exempted f rom these increases (including the l i fel ine tariff), whi le tariffs were increased more modestly for other consumers. Consequently, for example, the revenue impact o f the February 2007 tar i f f adjustment was estimated to be less than 7 percent. The revenue impact o f the March 2008 tar i f f adjustment was o f a similar order o f magnitude. In addition, to reduce the power sector subsidies, Government discontinued o n July 1,2008 the GST rebate which was provided to electricity consumers.

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1 13. In addition, the utilities have accumulated significant arrears and payables/receivables to fuel suppliers and Government. This has constrained the utilities’ abi l i ty to borrow commercially for investments and to service debts. A financial restructuring program wou ld be needed, including, inter alia, quantifying the magnitude o f such arrears and options to address these obligations. A combination o f short and medium-term policies and actions wil l be essential for ensuring a financially sustainable electricity sector, which i s able to meet the needs o f a growing economy, while protecting the To enhance the efficiency o f power sector publ ic outlays, PEPCO, with financial support f rom the Wor ld Bank,’ has embarked upon a program o f strengthening the capacity o f the distribution and transmission networks so as to improve rel iabi l i ty and quality o f service.

114. Reform strategy to reach the outcome goals: PRESO will support the reinstatement or establishment o f systems that make fuel price and power tar i f f adjustments automatic. For power, one action-the introduction o f a monthly tar i f f fuel price adjustment-is designed to address the potential future increases in international prices and prevent further build-up o f subsidy (flow), while another action i s designed to clear the accumulated difference between the consumer ta r i f f and the cost recovery level o f tar i f f (stock). Poverty and social impact assessments have been carried out o n the proposed actions (see Section VI.A), and they indicate that the proposed actions are not expected to adversely affect the poor:

Re-introducing automatic fuel price adjustment: To prevent any future build-up o f o i l subsidy, the authorities have under PRESO introduced an automatic monthly adjustment o f consumer fuel prices, but with a minimum level o f P D L specified. This wou ld ensure that over the medium t e r m fuel prices wil l be adjusted o n a regular basis to reflect changes in international prices. Also, the authorities eliminated the fuel subsidies by end-2008.

Introducing regular power tariff adjustment: The 2008 Finance A c t authorizes N E P R A to make automatic monthly determinations o f fuel adjustment surcharge, and N E P R A started exercising this authority in September 2008. In addition, new electricity tariffs reflecting the changed fuel cost are being noti f ied within 15 days f rom determination or re- determination.

In parallel, the authorities have prepared and implemented under PRESO a plan for the base power tar i f f adjustment so as to eliminate the power sector subsidies by end June 2009, whi le also ensuring the 2008/09 power subsidies are consistent with the budget. A power tar i f f increase, consistent with the plan, has been implemented, with the f irst tar i f f adjustment noti f ied in February 2009.

Improved Efficiency o f Public Spending

115. Outcome goals: (i) Throw-fonvard reduced from 6.1 to 4.9 years in 2008/09; (ii) medium-term budget planning established; (iii) efficient cash balance management in place; (iv) social and poverty- related spending at least 4.5 percent o f GDP.

1 16. Issues: To create additional fiscal space for priori ty development initiatives and to achieve results, there i s a need to rationalize the development portfol io to a more manageable level and focus it on current development priorities. Over the last six years, development expenditure has increased six fold. Given the development needs o f the country, this was a positive development. Nonetheless, this increase was not accompanied by the required institutional and procedural improvement to ensure the max imum impact o f these expenditures. In addition, there was a sizeable increase in the number o f schemes in the

For example, consumers wi th in the first block o f residential tariffs (0-SO kWh per month) could be exempted from the planned

Electricity Distribution and Transmission Improvement Project. increases.

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development portfolio, wh ich over the last f ive years increased to about 1,9 17-almost three times the number o f schemes included in the 2002/03 Federal Public Sector Development Program (PSDP). This has imposed considerable strain on public sector institutions responsible for implementation and monitoring and evaluation o f PSDP. Another unwarranted outcome o f the substantial PSDP expansion has been a rapid increase in the PSDP throw-forward, wh ich has had an adverse impact o n the efficiency o f publ ic spending.6 A large part o f potential development resources for at least next six years are committed to the present portfolio, leaving l i t t le space for new development initiatives and programs. In order to ensure t imely completion o f development schemes, government intends to reduce the throw- forward o f the development portfol io to a manageable level over the med ium term by cutting unproductive schemes and focusing the portfol io schemes achieving result^.^

117. One reason for accumulation o f a large throw-forward i s that development programs and projects are approved without any consideration o f the fiscal space available to their financing. Similarly, no fiscal impact assessment i s undertaken for any government po l i cy initiative. As such, ad hoc fiscal adjustments are required to accommodate these projects and initiatives into the budget. To remove this major deficiency f rom the budget-making process, i t wou ld be important to make the fiscal impact assessment o f a l l major projects and pol icy initiatives mandatory.

11 8. The efficiency and effectiveness o f other publ ic expenditure are also low. A large port ion o f such expenditure is undertaken by sub-national governments, wh ich have uneven track record o n public expenditure reforms. The Wor ld Bank i s supporting a number o f projects at a sub-national level, including o n health and education, which cover reforms and po l i cy actions related to improving the development outcomes and efficiency o f public spending.

119. Although the Government has decided to move away f rom single-year budgeting to a Med ium Term Budget Framework (MTBF), the process has remained slow and continued to have a number o f weaknesses inherited f rom pre-MTBF period. The budget preparation i s st i l l dominated by a bottom-up aggregation o f l ine ministries budget and therefore lacks the strategic content and a clear link between budgetary allocations and outputs-the two critical elements o f MTBF. L ine ministries’ budgets are prepared without any fo rm o f pr ior indication o f the resources l i ke ly to be available (such as indicative ceilings), making them either unrealistic or largely incremental in approach.

120. Eff icient cash management i s lacking. Cash f l ow forecasts are prepared only o n a quarterly basis as opposed to a higher granularity, such as weekly. This gives rise to a high degree o f unpredictability o f daily government cash flows, wh ich complicates SBP’s management o f systemic liquidity. Cash balance management i s passive and reactive, relying on recourse to central bank funding to accommodate differences between expected and actual outturns. A comprehensive cash management framework, with a treasury single account (TSA), sweeping and netting o f subsidiary accounts, and an overall target balance, i s absent. One consequence has been the accumulation o f id le cash by public-sector entities in advance o f their immediate need for it, wh ich i s costly and hinders the abi l i ty to adjust expenditure choices in light o f changing budgetary priorities. The authorities have begun taking measures to prevent this accumulation o f idle cash as a first step toward developing a TSA.

The throw-forward i s an indicator of the claim of the present development portfolio on future development resources. The throw-forward (Le. the amount o f funds required to complete a l l the ongoing projects in the development portfolio, provided no new project is included in the portfolio) o f the development program of federal ministries and corporations (including WADPA’s non-budgetary program) has doubled during the last three years (from Rs 1.25 trillion in FY06 to Rs 2.5 trillion for 2008/09). Increased throw-forward adds to the rigidities in budgetary decision-making and imposes pressures to increase the size of the development budget to levels inconsistent with the macroeconomic framework.

I n general, development projects should be completed within 4 to 5 years. This implies that the throw-fonvard should be no more than 4 to 5 times the size of the development budget. However, in the present PSDP there are 61 projects which at present level o f allocations wil l take over 100 years to complete. There are 201 projects which may take 10 to 100 years to complete.

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121. Adverse fiscal situation and tight financial market conditions have caused cash f l ow difficulties for a number o f state-owned enterprises (SOEs). This has led to withholding o f payments by these corporations to other SOEs. Over time, this inter-corporate (or circular) debt has increased to a sizeable level. Al though the amounts o f payables and receivables are being disputed among SOEs, cash flow difficulties associated with this debt are already affecting the operations o f these enterprises.

122. In addition, publ ic procurement reforms have proceeded slowly. The Public Procurement Regulatory Authority (PPRA) would need to be strengthened. N o real progress with reforms has been made o n key issues in the past couple o f years. A strong country procurement system wou ld enable Pakistan’s external partners rely o n Pakistan’s o w n systems, rather than prescribe their o w n procurement rules and procedures for use under programs they finance.

123. The preparation apd notification o f the Public Procurement Rules 2004 was a significant first step in the direction o f a transparent and efficient publ ic procurement system. Whi le the rules themselves are consistent with international best practice, an effective appeals process and consultancy rules are s t i l l missing. At present, bidders have no recourse to protest a procurement decision, except an administrative appeal within the same procuring department they have a grievance against.

124. Reform strategy to reach the outcome goals: PRESO wil l support the fol lowing actions, wh ich have been informed by the ongoing Public Expenditure, Procurement, and Financial Management (PEPFM) Review, to improve efficiency o f publ ic spending:

Rationalizing the PSDP portfolio: Under PRESO, Government has rationalized the PSDP portfol io through a thorough review and deletion o f schemes that were unproductive and misaligned with development priorities. This goal was achieved by: (a) re-evaluating the economic and financial viabi l i ty o f schemes that were significantly delayed; (b) cutting projects where the present allocation was less that 10 percent o f the financing needs (that is, throw-forward) and eliminating most o f the new schemes where the allocation was less than 15 percent o f the financing needs; (c) terminating a l l 2008/09 PSDP projects that were n o longer viable o r inconsistent with Government’s development priorities; and (d) reviewing a l l pr ior projects, at par with new projects, for economic and financial viability, pr ior to any re-inclusion in a future development program, in case that i s contemplated. Look ing forward, the PSDP portfol io wi l l be reviewed in 2009110 for further throw-forward reduction to ensure expenditures achieve results. Also, a system to monitor the lapse-time at each processing stage o f government payments will be established and parallel payments done, where feasible. Finally, fiscal impact assessment o f a l l new policies and major development projects i s expected to be made mandatory.

Strengthening budget planning: Under PRESO, the strategic content o f MTBF has been strengthened by: (i) preparation o f a Budget Strategy Paper, wh ich highlights the overall strategy o f the government to achieve i t s budgetary objectives, including the annual PRSP targets; (ii) complementing the “bottom-up” approach o f MTBF with a “top-down’’ component wh ich provides l ine ministries with an indication o f the resources which they can expect to access during the annual and three-year budgeting process; (iii) issuing MTBF consistent with the Budget Cal l Circular along with three-year indicative 2009/10 budget ceilings for each line ministry; and (iv) enhancing the effectiveness o f publ ic expenditure through better linking o f development and recurrent budgets. The 2009/10 budget i s expected to become output-based.

Implementing effective cash management: Under PRESO, cash management has been strengthened by making the use o f assignment accounts by ministries and autonomous agencies fully operational for budget expenditure. This was an important f i rs t step toward a TSA. Look ing forward, cash management wil l be further strengthened by (i) closing a l l other bank accounts o f ministries and autonomous agencies held at commercial banks, and

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the remaining balances wi l l ut i l ized over a period o f time; and (ii) developing a process for aggregating credible and reliable cash f l ow forecasts for a l l ministries and autonomous agencies, covering both development and recurrent expenditure and revenue. Once these measures are fully operational, (i) TSA will cover both development and recurrent spending; (ii) the end-of-week cash balance o f the No. 1 account will be managed in accordance with a target balance, and (iii) cash f l ow forecasts will be produced o n at least a weekly frequency with a weekly granularity, with steps taken toward dai ly forecasts for those entities accounting for 90 percent o f overall cash flows.

Enhancing transparency in public procurement: One key element o f a transparent procurement system i s dissemination o f information to bidders about the outcome o f a bid process. The Public Procurement Rules 2004 require the noti f icat ion o f procurement notices and notices o f award o n i t s website. While procurement notices are advertised on the PPRA website, no procuring entity was posting notices o f award. Under PRESO, the authorities have started to post notices o f contract awards over Rs 50 m i l l i on o n the PPRA website. Going forward, this wil l be extended to include contracts o f a lower threshold.

Posting notices o f award o n a publ ic ly accessible website can be expected to increase the number o f complaints about procurement decisions. For that reason, an independent appeals process i s expected to be established in 2010/11 to further strengthen the transparency o f publ ic procurement.

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Strengthened Government Debt Management

125. Outcome goals: (i) Government borrowing consistent with sound monetary and fiscal policy; (ii) domestic debt-servicing forecast o f N S S instruments differs f rom actual outturn by less than 5 percent; and (iii) public guarantees at or below 2 percent o f GDP.

126. Issues: Government debt in Pakistan was divided roughly evenly between domestic (3 1.2 percent o f GDP) and external (26.2 percent o f GDP) debt in 2007/08. Domestic debt increased in nominal terms by 25 percent in 2007108. As at end-June 2008, domestic debt totaled Rs. 3,264 b i l l i on and consisted o f market wholesale treasury bills and Pakistan Investment Bonds (PIBs), non-market N S S retail instruments, and, above all, borrowings f rom SBP. The maturity prof i le o f domestic debt has become skewed to the short end, and the refinancing risk has further increased due to the early-redemption option embedded in retail instruments.

127. Despite the increase in domestic debt, the government has in effect wi thdrawn f rom market-based funding. This has been made possible by unl imited recourse to central bank financing, the heavy reliance o n N S S retail instruments, and the application o f y ie ld cut-offs in wholesale auctions (thus undermining a commitment to market-based funding costs). The significant r i se in net government borrowing from SBP has undermined the central bank’s abi l i ty to implement a monetary pol icy consistent with macroeconomic stability and l o w inflation. Government has committed not to accumulate any new debt with SBP o n a quarterly basis as o f November 1, 2008, and to retire the stock o f this existing debt over time.

128. On the legal side, the Fiscal Responsibility and Debt Limitat ion L a w (FRDL) provides a framework for support o f fiscal transparency and reform. FRDL was passed by Parliament in June 2005. I t s intent i s to have rules-based policies that establish clear standards o f accountability for fiscal discipline. The rules require, among other things: (i) bringing debt to GDP ratio below 60 percent by 2013; (ii) annual reduction of debt by 2.5 percent o f GDP; (iii) issuance o f guarantees be less than 2 percent o f GDP each year and; (iv) eliminating the revenue deficit (Le. the difference between total current expenditure and total government revenue) by June 30, 2007, and running a surplus thereafter. The law allows Government to depart f rom these provisions with the approval o f the National Assembly under exceptional circumstances, such in the cases o f national security or natural calamity. In the past fiscal

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year, Government could not reach the statutory target for the reduction o f publ ic debt by 2.5 percent o f GDP and the revenue deficit target was also missed. In the current fiscal year, Government i s also expected to miss the revenue deficit target. However, Government i s committed to uphold FRDL f rom 2009/10 onwards.

129. The primary and secondary government securities markets exhibit many shortcomings. The issuance o f wholesale securities i s non-predictable. Whi le treasury bills are issued fortnightly, an issuance calendar for PIBs was introduced only in the current fiscal year and was only recently made fully public. In both T-bill and P I B auctions, bid acceptance i s yield-driven, as opposed to volume-driven (that is , accepting bids sufficient to issue the full announced volume o f the auction). These practices dampen participation in auctions and market-making, as primary dealers are reluctant to commit to trades when they may not be able to acquire bonds. In addition, decision-making rights for P I B issuance were until recently insufficiently defined between the Ministry o f Finance and SBP. The investor base i s not we l l developed, and the secondary market i s thin and illiquid.

130. The retail debt program also suffers f rom serious shortcomings. Government has l imi ted control over the amount o f debt raised and redeemed in any given year. The interest rate and refinancing risks o f the retail debt portfol io are no t managed. Consideration i s not g iven to h o w the retail and wholesale programs, as currently implemented, impact o n each other. Notably, there i s reliance o n manual processes for issuing, recording, reporting, and forecasting o f outstandings and interest payments. Under- forecasting o f debt-servicing costs for the largest scheme, Defense Savings Certificates, a zero-coupon instrument, contributed to fiscal overruns in 2006107 and 2007/08. This arose because the authorities recognize the interest expense o n Defense Savings Certificates only when they are encashed by investors, but they lacked reliable data o n the quantum o f certificates due to mature in those years that remained outstanding or had been encashed early. A project to introduce information technology automation for issuing, recording, and reporting o f NSS instruments i s being piloted.

13 1. In general, debt management in Pakistan i s characterized by institutional weaknesses, and a key factor impeding sound debt management and an effective government securities market i s the absence o f a medium-term debt management strategy. The annual Debt Pol icy Statement currently produced by the Debt Pol icy Coordination Office, whi le outlining a number o f debt portfol io developments, lacks a comprehensive analysis o f the cost and risk implications o f different funding strategies (domestic versus external, wholesale versus retail, tenor m i x and so on) and h o w the funding strategy that i s adopted wi l l contribute to meeting the government’s long-term debt management objectives, as we l l as the development o f the government securities market. N e w instruments have been proposed, in an effort to mobil ize funding. Some initiatives may have a destabilizing effect o n the banking industry, albeit perhaps in only the short term, o r may shift demand away f rom market sources o f funding.

132. Reform strategy to reach the outcome goals: strengthen government debt management:

PRESO wil l support the fol lowing actions to

Debtpolicy and borrowing aligned with sound monetary andfiscalpolicy: T o make room for sound monetary po l i cy implementation, i t i s essential that government borrowing f rom SBP i s curtailed. The Ministry o f Finance has committed to zero net borrowing from SBP f rom November 1, 2008 onwards. Going forward, the authorities expect to develop a sound debt management strategy, including a plan to phase out the stock o f government debt owed to SBP. This strategy will be implemented and improved in 2009110, and i t i s expected that this will involve adjustments to both wholesale and NSS instruments. Also, f rom the 2009/10 budget onwards, Government expects that budgets adhere again to the FRDL law.

Government borrowing conducive to development of the government securities market: As an immediate f irst step under PRESO, a credible calendar for P I B auctions for the remainder o f 2008109, with quarterly updates, has been made publ ic ly available. The

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Ministry o f Finance has also amended rules defining roles and decision-making rights for P I B issuance. Looking forward, Government expects to reform the primary dealer system so as to improve participation and competitive bidding at auctions and development o f the secondary market. This i s expected to enable the government to move fully to volume- based issuance o f PIBs over time, w i th the use o f cut-off yields discontinued.

Improving reliability of debt-servicing forecast: The rel iabi l i ty o f the revised f inal domestic debt servicing estimate for 2007l08 and the budget estimate for 2008109 was strengthened o n account o f efforts by the authorities to gather accurate data o n the Defense Savings Certificates maturing in 2007/08 and 2008109. The authorities are now repeating this exercise on an annual basis.

C. Pillar 11: Enhancing Competitiveness

Reduced Barriers to Competition

133. Outcome goals: Starting-a-business indicator reduced f rom 27 days in 2008 to 22 days in 2009.

134. Issues: Government has supported impl ic i t competition pol icy through open markets for goods and investment as a central part o f i t s pol icy framework. Building on this pol icy stance, a new explicit competition pol icy framework has been pursued through a new Competition Ordinance, promulgated in October 2007. The law emphasizes independence, professionalism, and transparency in the conduct o f the Commission and Government noti f ied an independent CCP in November 2007. Significant progress has been made during the past year to establish the framework and operationalize CCP. CCP has been highly active in terms o f launching the agency, enforcing the l aw and engaging in competition advocacy. Going forward, CCP i s complementing i t s law enforcement activities with a series o f competition impact assessments for key sectors o f the economy and i s producing its first annual report entitled the “State o f Competition in Pakistan.” Through these assessments, CCP will be examining the environment for competition, including those public policies which could be reformed to enhance competition.

135. The legal provisions relating to corporate insolvency, wh ich are currently found in the Companies Ordinance, 1984 (the “Ordinance”) are considered by the authorities to be inadequate for the fluidity o f the modem economy.8 Therefore, the Securities and Exchange Commission o f Pakistan (SECP) established a Corporate L a w Review Commission in 2006 to reform companies’ l aw and along with it the corporate insolvency regime. At the same time, two initiatives by the Banking Laws Review Commission, established by SBP relate to a modern insolvency regime. The f i rs t i s a draft Corporate Rehabilitation A c t prepared in 2004 wh ich speaks to the revival1rehabilitation o f so-called “sick companies.” The second i s a new draft Banking A c t prepared in 2006 to replace the Banking Companies Ordinance, 1962, wh ich has extensive provisions relating to l iquidat iodwinding up o f banks, including special provisions for speedy disposal o f winding up proceedings. Whi le a l l three efforts have been relatively dormant since 2006, they have been revived recently, given the economic difficulties faced by many local companies and the recognized need to have in place a modern system for corporate rehabilitation and liquidation wh ich covers both financial and non-financial corporate.

136. Significant progress was made in the early 2000s in streamlining registration for l imi ted l iabi l i ty companies wh ich reduced the number o f steps and time required f rom over 50 to 24 days. Since 2003, however, the t ime and cost to register a business has remained the same and reliant o n a paper based system. Recently the Securities and Exchange Commission o f Pakistan (SECP) introduced an effort to streamline business registration even further through the introduction o f a nationwide electronic platform,

‘Under the Ordinance, the solution for a company under financial distress, for a l l practical purposes, i s not rehabilitation but liquidation. The Ordinance deals mostly with liquidation o f companies but i s limited with regard to corporate rehabilitation.

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which wil l enable new business to submit registration forms electronically. The plat form enables not only nationwide, convenient access and electronic submission o f the company reports required under the law, but also further streamlining through electronic linkages with FBR, provincial labor departments, and the Employees Old Age Benefits Institution (EOBI) for obtaining a tax ID and registering for sales tax, SSN, and EOBI, respectively.

137. Reform strategy to reach the outcome goals: PRESO will support the fo l lowing actions to reduce barriers to business entry and exit:

Strengthening competition policy framework: Based o n the competition po l i cy emphasizing an independent and professional CCP, under PRESO Government has not i f ied ru les which provide a secure source o f financing for CCP and provide adequate terms and conditions for the appointment o f commissioners. Going forward, competition impact studies wil l be carried out for at least four sectors, with hearings held by end 2009 to discuss and explore the public pol icy issues raised by the work. Fol lowing appropriate vetting o f the recommendations, key actions for at least four sectors wil l be taken by end 2010.

Simplifying business entry: Under PRESO, the Electronic Business registration system was rol led out by end-2008. Going forward, linkages wou ld be established with other agencies, such as FBR and/or provincial labor departments, to streamline further by end 2009. Based on these efforts, a process re-engineering with other agencies, such as provincial social security agencies and EOBI wou ld be pursued in order to collapse the number o f steps required to register a business and therefore reduce the cost and t ime requirements with a target date o f end 2010.

Strengthened Financial Sector

138. Outcome goal: Lending portfol io o f banks diversified over time.

139. Issues: The global financial crisis and, above all, the needed macroeconomic adjustment in Pakistan, can be expected to pu t strain on the financial sector, threatening its soundness and stability. T o l im i t the impact, as well as to strengthen the banking sector so that it can withstand future stresses, the banking sector regulation and supervision wou ld need to be strengthened and made fully compliant with the Basel Core Principles o f banking supervision.

140. At the moment, a significant amount o f credit risk i s borne by the banks due to their large exposure to big groups o f companies. Facilities (both funded and non-funded) o f these groups can account up to 50 percent o f the equity o f banks. This i s because SBP had allowed banks to undertake a high credit risk concentration by keeping the group exposure limit o f banks at 50 percent. The outside limit recommended by the Basel Committee i s 25 percent for a total exposure bo th o n and o f f balance sheet to a single counterparty or a group o f related counterparties.

141. The practice o f extending large facilities to big groups o f companies also limits the banks f rom going after a larger number o f smaller enterprises and SMEs. By limiting the access o f new and smaller companies to bank finance, banks create an entry barrier that i s not conducive to the expansion o f the industrial base o f Pakistan. I t would, therefore, be advisable for SBP to reduce the group exposure limit o f banks from the existing 50 percent to 25 percent in a phased manner.

142. The reduction in group exposure limits wil l not only diversify the port fo l io o f banks and reduce their credit risk exposure, but should also serve to motivate the large groups o f companies to diversify their source o f borrowing as well. This i s expected to induce these groups to issue their o w n bonds in the debt market.

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143. Reform strategy to reach the outcome goal: strengthen the financial sector:

PRESO wil l support the fol lowing action to

Improving banking sector regulation: To reduce the credit r isk concentration o f banks, SBP has amended under PRESO prudential regulations to introduce a phased reduction in the Group exposure limit f rom 50 percent to 25 percent over time.

D. Pillar 111: Protecting the Poor and Vulnerable

Better Targeted Social Safety Nets

144. Outcome goal: Improved targeting and implementation o f cash transfer and safety net programs; measured by increased coverage o f the poorest 25 percent o f the population by the Benazir Income Support Program (BISP).

145. Issues: About a quarter o f Pakistan families are poor, and the poor and non-poor alike remain vulnerable to r isks such as health, disability, and unemployment, and to community-wide shocks such as natural disasters or sharp increases in the price o f food. Fifty-six percent o f the population can be classified as vulnerable (that is, poor or l ikely to become poor in the sho r thed ium term), with vulnerability being higher in rural areas and among the self-employed and those employed in agriculture.

146. The short-term challenge facing Government i s the protection o f the poor f rom the loss o f purchasing power owing to high food price inflation, and f rom impacts o f the necessary economic adjustment measures. Even though Pakistan has a myr iad o f safety net programs targeted pr imari ly at the chronic poor, ranging f rom (unconditional) cash transfers to social care services and microfinance programs, there i s no immediate vehicle available to provide rel ief quickly for a large number o f families. The existing programs have l i t t le impact on poverty and vulnerability. They are fragmented and often duplicative, have l imi ted coverage (about five percent o f the total population), and are poor ly targeted (25 and 32 percent o f resources distributed by the Food Support Program (FSP) and Zakat, respectively, the country’s largest cash transfer programs, accrue to non-poor households). See Annex 10 for a summary o f the social safety net system in Pakistan.

147. In addition, administrative arrangements for cash transfers, especially payment systems, are inadequate, and implementation and monitoring and evaluation (M&E) capacity i s low, wh ich negatively impacts program efficiency and the quality o f service delivery. Among the most common complaints o f FSP beneficiaries are the costs associated with cashing program benefits, and the irregularity and lumpiness o f benefit payments. According to data, one in 10 households experiences di f f icul ty accessing the funds after being approved for assistance.’ FSP beneficiaries on average need to make 1.6 visits to the payment center to obtain their assistance, and more than one in twenty had to go three times or more. Furthermore, one out o f every 10 beneficiaries declared to have paid a br ibe to obtain their benefit at some point, with bribes averaging 10 percent o f the transfer. Finally, weak human and technical capacity at payment centers (that is, post offices) implies that payment reconciliation takes years resulting into delays in updating the beneficiary lists, enhancing the efficiency o f delivery, and producing the results.

148. To strengthen the safety net systems and increase coverage, Government launched the Benazir Income Support Program (BISP) in September 2008, with the objective to provide cash grants to the poorest families in the country. With a budget o f Rs. 34 b i l l i on in 2008109, the program intends to cover 3.4 mi l l ion families and each eligible fami ly i s to receive monthly Rs. 1,000. As such, BISP i s by far the largest social safety net program in Pakistan and could become the core safety net in the country. The

Pakistan Safety Net Report, World Bank, 2007.

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budget committed for the program doubled Federal Government's spending o n social safety nets to 0.6 percent o f GDP in 2008/09.'0 Furthermore, Federal Government intends to expand the BISP budget to Rs. 65 b i l l i on in 2009110 and expand the coverage to about 5 m i l l i on families. In 2010/11, they expect to cover 7 mi l l ion families wh ich comes close to covering 25 percent o f the population-the national poverty headcount rate according to most recent estimates.

149. BISP would need to be improved in many ways to make i t an effective safety net serving the poorest in the country. I t s targeting until recently was a serious concern: beneficiaries o f BISP (female representatives o f families) were in i t ia l ly identified by Parliamentarians (Members o f the National Assembly and Senators), who then submitted an eligible l i s t to the National Database and Registration Authority (NADRA) for validation through i ts database (an ID registry o f the country, which, however, has l imi ted coverage o f potential beneficiaries and does not include indicators that identi fy the poor, wh ich wou ld be essential for validation). The f inal eligible l i s t o f beneficiaries was then forwarded to the Pakistan Post for payments through money orders. In addition, there was n o monitor ing system to track payments, nor a grievance redressal mechanism to correct targeting errors.

150. Since the program has barely begun-as o f February 20, 2009, 1.5 m i l l i on submissions had been received f rom Parliamentarians, and about 1 m i l l i on had been verif ied for e l ig ib i l i ty and payments-there i s room to introduce corrective measures to improve targeting with the help o f an objective instrument and build the necessary institutional capacity to deliver the benefits, and monitor progress and outcomes. The adoption o f an objective targeting instrument-the poverty scorecard-has been the critical f i rs t step to ensure the benefits reach the poor and vulnerable. Once the BISP program i s targeted well, i t wil l form the basis for streamlining and consolidation o f similar cash transfer programs (such as Bait-U1-Maal) and mov ing from a universally targeted wheat subsidy to a targeted one.

15 1. The poverty scorecard i s underpinned by the proxy means testing methodology to improve targeting performance and ensure easy implementation. The scorecard-based targeting will be an improvement over the previous targeting system by providing an objective method for identi fying beneficiaries ensuring: (i) a transparent and fair enrolment process open for all; (ii) transparent criteria for determining eligibility; (iii) adoption o f veri f icat ion tools so that exclusion and inclusion errors are minimized and dealt with in an open and transparent way according to wel l defined rules.

152. Beyond the use o f the scorecard for targeting, institutional arrangements are being designed for managing the program wh ich include building capacity at various levels o f Government; laying out the roles and responsibilities o f various actors to enable accurate information collection and processing; mechanisms for ensuring redress i f there are grievances and complaints; delivering payments to beneficiaries; and auditing and monitoring. The in i t ia l implementation step wi l l be a test phase to build the necessary safeguards that are necessary to realize program objectives.

153. Reform strategy to reach the outcome goal: PRESO will support the fo l lowing actions to initiate a systematic and well-grounded effort to improve targeting and implementation o f BISP, which can then be extended to other cash transfer and social safety net programs:

Improving targeting of BISP: Under PRESO, the Government has adopted a poverty scorecard instrument for targeting and identification o f poor families in the context o f BISP and not i f ied the plan for i t s roll-out. This entailed a clear plan for implementation, o f i t s in i t ia l r o l l out as we l l as modalities for smooth transition out o f the current system to the proposed score-card approach. The retargeting o f B ISP with the use o f the scorecard was

I O In addition, the province o f Punjab i s allocating about 0.2 percent o f GDP to its income suppodcash transfer program in 2008109.

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launched in January 2009. Going forward, the scorecard i s expected to be implemented in al l test districts and rol l-out initiated in al l remaining districts.

Strengthened National Statistical System

154. Outcome goal: More reliable and t imely economic and social data for pol icy analysis and formulation.

155. Issues: Reliable and timely economic, demographic, and social data are central for any successful poverty reduction strategy. Moreover, reliable of f ic ia l statistics are cornerstone o f good pol icy analysis, effective economic management, and informed public debate about outcome and priorities. The Statistics Div is ion o f the Ministry o f Finance i s the main Federal Government institution responsible for collecting, disseminating, and quali ty assurance o f the data. I t consists o f three departments: the Federal Bureau o f Statistics (FBS), the Agriculture Census Organization (ACO), and the Population Census Organization (PCO). This structure has i t s weaknesses as highlighted by statistics users, including government departments, donors, c i v i l society, and multilateral agencies. These include the perception o f a lack o f independence and coordination between the three departments, and concerns about integrity and quality o f some statistics. Addressing them wou ld strengthen the credibility, quality and rel iabi l i ty o f statistics.

156. Reform strategy to reach the outcome goal: strengthen the statistical system:

PRESO will support the fo l lowing action to

Strengthening autonomy of the statistical system: T o improve the functioning o f national statistical system, the Cabinet has approved the new Statistics L a w under PRESO. The new law envisages merging and reorganizing FBS, ACO, PCO, and the Technical Wing into a new Pakistan Bureau o f Statistics (PBS). I t also establishes the legal framework for PBS, specifying governance processes and organizational p lan for the senior management. The a im o f the law i s also to provide for the autonomy o f the new statistical organization.

VI. OPERATION IMPLEMENTATION

A. Poverty and Social Impacts

157. PRESO supports sustainable poverty reduction in a number o f ways. First, the proposed measures address the recent rapid deterioration o f the economic environment which, through lower growth and higher inflation, has adversely affected the living standards o f the poor. By ensuring a recovery o f growth with l o w inf lat ion over the medium term, Government reforms supported by PRESO create the space for development to resume. Second, PRESO will support measures that can be expected to enhance Pakistan’s investment climate and competitiveness. This in turn wou ld facilitate employment creation, economic growth and poverty reduction over time. Third, PRESO supports the development o f a well- targeted social safety net program that delivers cash transfers to the needy. Fourth, PRESO supports mit igation measures to ensure that poor people are shielded f rom major adverse impacts o f price increases.

158. Three poverty and social impact assessments (PSIA) were carried out during PRESO preparation, and they indicate that price increases o f food products on net buyers o f food, and, to a lesser degree, o f fuel products, wou ld be main concerns f rom the poverty impact point o f view. Electricity ta r i f f increases are unl ikely to have any direct adverse impact o n poor people. These analyses are being expanded as part o f the ongoing work o n the Pakistan Poverty Assessment Report and economic sector work on social protection and wheat subsidy programs. A br ie f summary o f the PSIAs carried out i s attached as Annex 11.

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159. Fortunately, the recent decline in international commodity prices makes reductions in domestic food and fuel prices currently more l ikely than increases, which allays the earlier mentioned concerns. The proposed PRESO action o n fuel i s currently expected to benefit a l l households.

160. Fuel price adjustment: The rise in domestic fuel prices o n the back o f international fuel price increases would l ikely reduce the purchasing power o f households and raise poverty. Whi le international domestic fuel prices have decreased over the past few months, they did increase during 2007108 o n the back o f international o i l price increases. Therefore, the PSIA analyzed the impact o f a price increase. Simulations based o n the 200.5106 Pakistan Social and L i v ing Standards Measurement Survey suggest that Pakistan’s domestic fuel price increases between 2005106 and July 2008 might have increased the national poverty headcount by 2.3 to 3.2 percentage points, compared to a situation without any fuel price increases. The lower poverty increase assumes that real household expenditures rose by 6 percent over the period, broadly in l ine w i th macroeconomic indicators; and the higher poverty increase assumes that household expenditures remained constant in real te rms over the period.

16 1 . I t i s important to interpret these findings with caution. First, the analysis captures only the direct impacts o f fuel price increases. The direction o f the indirect effects i s ambiguous. Fuel price increases imply higher input costs for businesses and hence lower household labor incomes. But they also reduce internal and external macroeconomic imbalances, and therefore support a return to sustainable economic growth. In addition, households are l ikely to substitute away f rom fuel consumption, wh ich will mitigate the impact o f fuel price increases o n poverty. Second, a well-targeted and eff iciently implemented welfare program could have eased the poverty impact. The analysis suggests that Government could keep the living standards o f the poor unchanged 011 average by spending just one sixth or less o f the fuel subsidy by adopting a simple p roxy means targeting tool. Given this, Government’s ongoing efforts to improve targeting o f social protection programs are encouraging. Third, domestic fuel prices have started to decline since October 2008 on the back o f fal l ing international prices. Hence, the automatic fuel price adjustment on fortnightly basis, as supported by PRESO, wou ld lead in the current environment to reductions in domestic prices o f petroleum products. Whi le the imposition o f the petroleum development levy (PDL) wil l keep a wedge between landed costs and retail prices, PDL rates are progressive. There are high rates on regular gasoline, high octane gasoline and diesel, wh ich are used by we l l -o f f households, and l o w rates o n kerosene, which i s largely used by poor households.

162. Electricity tariff adjustment: Concerns about the adverse impact o f electricity ta r i f f adjustments on poor people are unwarranted for three reasons. First, poor households are adequately covered by the provision o f a l i fel ine tariff. Electricity tariffs are progressive. Tarif fs o f the lowest slab, for consumption between zero to 50 kWh, are very low, and have remained unchanged for at least f ive years. Average electricity consumption in the lowest tar i f f slab i s about 19 kWh per month, providing enough power for four light bulbs and one fan, which i s typical for households in the lower consumption quintile. Any further tar i f f increases are not expected to change the l i fel ine tariff. Furthermore, the poorest o f the poor have n o access to electricity at all. According to the 2006107 PSLM, some 13 percent o f Pakistani households, and 19 percent o f rural Pakistan households, have no access to electricity. Second, the main beneficiaries o f keeping electricity tariffs below cost recovery levels are non-poor consumers. They accrue the bulk o f the power sector subsidy, in part because a l l households benefit f r om the l o w rates on the f irst tar i f f slabs, irrespective o f the overall electricity consumption. Finally, in light o f the decline in international energy prices, the elimination o f power subsides by end June 2009 i s l ikely to require only moderate, i f any at all, electricity ta r i f f increases.

163. Mitigation of wheat price increases: The average fami ly in Pakistan spends about ha l f o f total household expenditure on food. The domestic price o f wheat, the main staple food crop in Pakistan, rose 73 percent between August 2007 and July 2008, although it remained below the level in neighboring countries. Government uses the wheat subsidy program to stabilize the domestic market prices o f wheat f lour and to ensure consistent supply o f wheat f lour at a lower price to the poor through specific outlets,

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such as stores o f the federal u t i l i t y stores cooperation. Other interventions in 2007/08 included the imports o f additional wheat, a complete ban on wheat exports, a ban on intra-provincial wheat movement to curb smuggling, and an increase in the procurement price o f wheat to create an incentive for farmers to sell to the domestic market and to discourage smuggling and hoarding. During the first seven months o f 2008/09, Federal Government had not spent any money on wheat subsidies.

164. Since the budget share o f wheat i s larger than that o f fuel expenditure, the impact o f wheat price increases on the poor can be expected to be more significant than fuel price increases, even though it wou ld boost household incomes o f net producers o f wheat, many o f wh ich are living in rural areas. According the Bank’s preliminary estimation based on PSLM 2005106, the wheat price increase between August 2007 and July 2008 increased the national poverty headcount rate by 3.5 percentage points. However, the impact varied across different groups o f people. The loss in purchasing power was particularly severe among urban residents, landless and marginal landholders, whereas i t increased among medium and large landholders in rural areas. This analysis does not account for the provision o f subsidies wheat through utility stores, although in any case there are concerns about the effectiveness o f this intervention in reaching poor households.

165. A well-targeted social safety net program wou ld be the most cost-effective way to mitigate the impact o f wheat price increases o n the poor. Wheat reserve fund operations could be l imi ted to a minimum required to achieve the fund’s original objective o f smoothening seasonal price differences and ensuring emergency food security. In the design o f the safety net scheme, i t wou ld be important to take into account that wheat price inf lat ion affects pr imari ly people who are net buyers o f wheat. Also, the support provided should be temporary and flexible to reflect the temporary nature o f price shocks.

B. Fiduciary Aspects

166. Overall Fiduciary Environment: The overall fiduciary risk associated with the proposed operation i s rated as substantial. Government’s commitment to publ ic financial management reforms is, however, exemplified by actions already taken. Progress has been made in terms o f the accuracy, comprehensiveness, reliability, and timeliness o f financial and fiscal reporting; enhanced accountability and transparency; the use o f financial information for informed decision-making; and oversight o f the use o f publ ic monies through risk-based audits. However, a number o f weaknesses remain and the key areas for reform, highlighted also in the Government’s PRSP-11, include the modernization o f the legal and institutional public financial management framework; updating o f the financial and treasury rules; strengthening o f publ ic accountability practices; and further improving and ro l l ing out o f the public audit and oversight functions at sub-national levels o f government. In public procurement, several challenges remain, including the establishment o f an effective appeals process and an effective monitoring and evaluation system. Since enhancing accountability, transparency, and reducing opportunities for corruption are core elements o f improved governance and reduced fiduciary risks, publ ic financial management and public procurement reforms are supported by a number o f donor-funded initiatives.

167. Public Financial Management System: The Pakistan Country Financial Accountability Assessment (CFAA) o f December 2003 highlighted improvements in expenditure reporting and monitoring, and stated that budget support operations disbursed and managed through Government’s financial management systems have satisfactory outcomes. However, it also underscored the need for building institutional and human resource capacity to support the transition to full reliance on government systems, controls, and financial reporting. I t revealed weaknesses in data reliability, particularly at the sub-national level. In accounting and financial reporting, challenges that remain to be addressed are: (i) the creation o f internal audit units in departments to improve internal controls; and (ii) finalization o f the Controller General o f Accounts’ (CGA) control over organization, staffing, and training arrangements w i th clearly defined roles and responsibilities for staff reporting.

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168. Public Financial Management and Accountability Assessments (PFMAA) for the provinces o f Balochistan, Punjab, and N W F P were completed in M a y 2007, and identi f ied deficiencies in internal audit and controls, and budget credibility. These assessments were based o n the Public Financial Management Performance Measurement Framework, which was used to rate the existing arrangements against international best practice. Reform strategies are being formulated to bridge these gaps. A federal-level P F M A A i s also planned. A federal level P F M A A i s also ongoing.

169. In addition, a PEPFM review has been recently carried out. The review concluded, inter alia, that expenditure effectiveness would be fostered by a concerted review and revision o f government business processes to eliminate redundant procedures in expenditure commitment and payments, particularly for the development budget.

170. Government has taken action to enhance accountability and effectiveness o f publ ic expenditures. For better accounting and financial reporting, the Project for Improvement to Financial Reporting and Auditing (PIFRA) has supported a new accounting model, wh ich has introduced an IMF GFS-compliant Chart o f Accounts (CoA). As o f 2007/08 the federal, provincial, and district governments have prepared their budgets based o n the new CoA. An automated budget compilation, accounting, and financialifiscal reporting system i s being implemented country-wide. The financial management systems o f the federal government and N W F P and Punjab provinces, including the district accounts and finance offices, have been fully automated. Sindh and Balochistan are expected to complete the automation during 2008109. The next step wil l be to provide system connectivity to al l 140 l ine departments to support the monitoring o f budget execution o n a real t ime basis.

171. Government has taken action to enhance accountability and effectiveness o f publ ic expenditures. For better accounting and financial reporting, the Project for Improvement to Financial Reporting and Auditing (PIFRA) has supported a new accounting model, wh ich has introduced an IMF GFS-compliant Chart o f Accounts (CoA) for the general government. As o f 2007/08, the federal, provincial, and district governments have prepared their budgets based o n the new CoA. An automated budget compilation, accounting, and financial/fiscal reporting system i s being implemented country-wide. The financial management systems o f the federal government, NWF, Sindh, and Punjab provinces, including the district accounts and finance offices, have been fully automated. Implementation in Balochistan i s currently in progress, and completion o f the automation process i s expected during 2009/10. The next step also being taken i s to provide system connectivity to a l l 140 l ine departments to support the monitoring o f budget execution o n a real t ime basis as we l l as cater for the financial management requirements for the 133 district headquarter Tehsil Municipal Authorities (TMAs).

172. Timeliness o f end-year financial reporting has improved at the federal level and in a l l provinces and districts owing to the introduction o f the automated budget management system. Within 12 to15 days of the end o f each month, c iv i l accounts are prepared and presented to the Ministry o f Finance. The rel iabi l i ty o f these reports has also improved with material reductions in un-reconcilable differences and the elimination o f suspense accounts. Reconciliation levels, except in Balochistan, wh ich i s yet to adopt computerization, have improved to about 97 and 98 percent for receipts and expenditures, respectively, and 99 percent for suspense and inter-governmental accounts. Year-end financial statements have been prepared on the IPSAS basis by the federal government and a l l provinces. Distr ict governments are also transitioning to this fo rm o f reporting as part o f Government’s international financial reporting regime. Pakistan i s mov ing ahead we l l in compliance with international standards and the timeliness and readiness o f annual financial statements for audit has improved to an average o f eight months after the end o f the fiscal year compared to more than 15 months pr ior to 2006/07.

173. To enhance effectiveness o f external audit, a risk-based audit methodology compliant with international standards has been rol led out. I t was applied to federal government accounts in 2005/06, and to the financial statements o f provinces and some districts in 2006/07. The 2007/08 financial

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statements o f provinces are currently under audit and may be certified by the Auditor General and presented to their respective Governors w i th in 9- 10 months o f the end o f the fiscal year, compared to 18- 24 months in pr ior years. Introduction o f an Audit Management Information System i s also underway to enhance the efficiency, effectiveness, and control o f audit processes.

174. Legislative oversight across the federal and provincial governments has been mixed, largely due to absence o f Public Accounts Committees (PACs), weak capacity, and non-functioning o f the Z i la Accounts Committees at the district level. With a large audit backlog o f un-reviewed audit reports and audited accounts due to recurring interruption o f legislative oversight and the poor quality o f audit reports, efforts to strengthen the capacities o f PACs and streamline their review process have been initiated. After elections, strong PACs have emerged at federal level, Punjab, N W F P and Sindh, and are working to reinforce accountability through regular reviews o f audit reports and audited accounts. Institutionalization o f the oversight function in district governments, however, remains a key challenge in the medium t e r m to ensure enhanced accountability at the sub-provincial level.

175. Procurement: The 2000 Pakistan Country Procurement Assessment Review (CPAR) highlighted a weak regulatory framework governing public procurement, and called for institutional and procedural reforms. CPAR revealed that Pakistan does not have a coherent law that establishes standards and an effective legal system that protects against collusion and corruption in the award o f government contracts. CPAR recommended the establishment o f a new and modern procurement rules conforming to international best practice.

176. A Public Procurement Regulatory Authority (PPRA) was created in 2002 with powers to formulate publ ic procurement legislation applicable to federal government l ine departments, state-owned enterprises, and semi-autonomous organizations. N e w public procurement rules were noti f ied in 2004, and they depart f rom the o ld system in two important ways: they require posting o f a l l bid notices o n the PPRA’s website, and prohibit post-bid negotiations. M o v i n g forward, the development o f monitoring and reporting mechanisms, and the creation o f an effective appeals procedure to handle complaints in a t imely and transparent manner will be critical for effective implementation o f PPRA rules. PPRA rules are widely recognized as the rules to fo l low for procurement, and Sindh and Balochistan have adopted the rules to apply to al l procurements o f the provincial and district governments. Punjab i s in the process o f implementing a procurement reform strategy, and technical assistance i s being provided to N W F P on amendment o f i t s existing procurement law and making it consistent with international best practice.

177. Safeguards Assessment of the Central Bank: An IMF Safeguards Assessment o f the State Bank o f Pakistan was conducted in 2001. I t highlighted significant vulnerabilities, in particular relating to SBP’s financial statements and disclosure policies wh ich fel l short o f acceptable central bank standards. However, since 200 1 the risks associated with foreign exchange management control have been mitigated. SBP i s currently producing financial statements consistent w i th international accounting standards and formats. An independent review o f SBP’s internal audit function has been completed and the recommendations implemented. SBP has also established a process o f reconciling data reported to the IMF, and implemented guidelines to prohibit operations that pledge or encumber reserves, o r place restrictions on, o r otherwise impair the availability of, foreign exchange reserves outside the authorized framework.

C. Disbursement and Audit

178. Borrower and Credit Agreement: The proposed Credit wou ld be made to the Islamic Republic o f Pakistan, represented by the Federal Ministry o f Finance. The IDA credit proceeds, amounting to the equivalent o f US$500 mil l ion, wou ld be transferred to the Federal Government in accordance with the terms o f the Financing Agreement (FA).

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179. Funds Flow Arrangement: The Government o f Pakistan wil l ident i fy a Foreign Exchange Account with SBP, wh ich forms part o f the country’s off icial foreign exchange reserves, into which the proceeds o f the Credit wil l be disbursed on a single tranche basis upon Credit effectiveness. The Rupees equivalent o f the funds in the Account will, within two working days, be transferred into the Consolidated Fund o f the Government o f Pakistan (Account No . 1-Non-Food) held with SBP, wh ich i s used to finance budgetary expenditures.

180. Disbursements: Disbursements f rom the Consolidated Fund for activities to be financed under the program by the Government o f Pakistan wil l not be l inked to any specific purchases, and n o special procurement requirement shall be needed. The proceeds o f the Credit shall, however, not be applied to finance expenditures in the negative l i s t as defined in Appendix 1 o f the FA. If any port ion o f the Credit i s used to finance ineligible expenditures as so defined in the FA, IDA wil l require the Government to promptly, upon notice f rom IDA, refund the amount equal to the amount o f the said payment to the IDA. Amounts refunded to IDA upon such request wil l be cancelled f rom the credit.

18 1. Accounting and Assurance Requirements for the Credit: SBP, o n behal f o f Government, wil l continue to maintain an appropriate accounting system in accordance with generally accepted accounting principles. For this Credit, since n o special fiduciary arrangements are required, n o additional assurance requirements in the fo rm o f a formal audit wil l apply, in the light o f the f iduciary environment as established with the management o f foreign exchange reserves by SBP as we l l as continuing improvements in the financial management systems in government. However, within 45 days o f disbursement o f the credit by IDA, the Finance Secretary, Ministry o f Finance, will provide a written confirmation to IDA cert i fying the receipt o f the Rupees equivalent o f the credit into the Consolidated Fund Account o f the Government o f Pakistan, the date o f the receipt, and the exchange rate applied to translate the credit currency into Rupees.

D. Environmental Aspects

182. The policies and measures supported by the proposed operation could be potentially associated with both positive and negative environmental effects. The reduction in fuel subsidies could lower the demand for petroleum products and thereby improve air quality and subsequently human health. A reduction in power sector subsidies could create fiscal space to invest in fuel-efficient physical infrastructure with attendant positive environmental effects. However, poor households could respond to increases in fuel prices by shifting towards the use o f biomass as fuel, which has a documented causal relation with respiratory illnesses, particularly among poor children and women.

183. The environmental effects o f tax pol icy reform are ambiguous and wou ld depend o n the treatment provided by the reformed tax po l i cy to environmentally benign goods and services relative to environmentally damaging goods and services. I t i s not anticipated that the tax reform, which aims at reducing exemptions, wou ld provide incentives that favor the consumption o f environmental “bads”. On the other hand, the inclusion o f “green taxes” could be associated with posit ive environmental effects. The direction and magnitude o f the tax reform’s environmental effects will be better understood once the details o f the tax reform are more clearly defined.

184. Pakistan’s legislative, regulatory, and environmental management frameworks are largely in place to improve environmental performance. The Pakistan Environmental Protection A c t 1997 i s the cornerstone o f the country’s environmental legislation, while the National Environmental Pol icy (NEP) adopted in 2005 provides the overall framework to promote sustainable development. However, the enforcement and implementation o f existing policies and regulations needs to be strengthened.

185. A Strategic Country Environmental Analysis (SCEA) o n Pakistan was prepared by the Bank in 2006. According to it, Pakistan’s ma in environmental challenges are l inked to environmental health,

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particularly outdoor and indoor air pollution. Since the program’s supported policies are expected to be associated with positive and negative environmental effects, the Bank i s undertaking technical assistance and analytical work aimed at enhancing the institutional capacity o f environmental agencies, particularly the Ministry o f Environment, the Pakistan EPA, and the provincial environmental protection departments.

E. Implementation and Monitoring

186. Coordination of Reform Program Implementation: Successful coordination o f the proposed program wil l require effective coordination among various ministries, SBP and agencies, and between the authorities and the Bank. The Ministry o f Finance will coordinate the PRESO agenda within Government. The Governor o f SBP wil l lead the pol icy agenda applicable to SBP. Further, Secretaries o f ministries and heads o f agencies involved in PRESO wil l be responsible for coordinating reforms in each ministrylagency.

187. Bank’s Monitoring Arrangements: The reform program sets out qualitative and quantitative benchmarks and targets for 2008/09. The Bank team wil l monitor and fol low up on progress, carry out regular consultations with the executing federal ministries, and assess implementation o f pol icy measures. The fol low-up and monitoring wil l be done in the context o f quarterly macroeconomic assessments, and a possible separate programmatic operation to support the latter two fiscal years o f the medium-term pol icy framework o f the authorities.

F. Risks and Risk Mitigation

188. The risks to the proposed operation are high. Political, economic, implementation, and security risks could results in prolonged economic instability:

0 Political risks: Attaining a sharp reduction in the fiscal and current account deficits wil l require commitment f rom the poli t ical leadership. The scale and speed o f the required economic pol icy response to the macroeconomic imbalances could intensify social tensions in part o f the population, but no adjustment wou ld ult imately impose even greater economic and social costs. The sustainability o f the program could also be undermined by disagreement among Pakistan’s main pol i t ical parties o n other issues, including judicial reform and the war on terror. The authorities’ draft medium-term pol icy framework attached to this package mitigates this risk and the risk o f pol icy reversals by signaling the authorities’ upfront commitment to a medium-term adjustment path.

Economic risks: On the external side, a renewed rise in international energy and commodity prices, a reduction in foreign remittances especially f rom the countries o f the Middle East, and a further deterioration in the wor ld economy and international financial markets could weaken the export sector, reduce household transfers, lower capital inflows, limit economic growth and reduce flexibility for pol icy reforms. Owing to these reasons, the external imbalances may continue to widen despite the short-term measures taken. On the internal side, the inabi l i ty o f Government to restore fiscal and external balance as agreed could reduce business and consumer confidence. This could cause a fundamental shift in market expectations and a loss o f confidence at home and abroad, leading to a sudden reversal o f financial assets held in Pakistan stock and bond markets. This could generate a vicious cycle between weakening financial markets, stalling economic activity, and a worsening fiscal position. The IMF Stand-By Arrangement wi l l mitigate these risks by committ ing the authorities to fiscal and current account defici t targets.

Implementation risks: Stringent implementation o f the reforms will be critical for success. The implementation o f reforms may be slower than planned because o f significant institutional capacity constraints. Other projects and initiatives financed by the Bank and

0

41

development partners have supported the strengthening o f a number o f institutions which mitigates the risk, including SBP, the Auditor General o f Pakistan, the Controller General o f Accounts and PPRA. FBR reform initiatives are supported through the Bank’s Tax Administration Reform Project and Tax Policy Program.

Security risks: There i s a risk o f deterioration in the security and law and order situation, wh ich could shift Government’s focus from economic matters. This risk cannot be directly mitigated. P E S O wou ld rely o n the Government’s commitment to improved security, as confirmed by the renewed efforts to end mil i tancy in tribal areas.

42

Schedule 1

Shaukat Tarin Adviser to Prime Minister on Finance, Revenue, Economic

Affairs & Statistics

ISLAMABAD February 3 , 2009.

POVERTY REDUCTION AND ECONOMIC SUPPORT OPERATION: LETTER OF DEVELOPMENT POLICY

Dear Mr. Zoellick,

1. I am writing to request, on behalf o f our Government o f the Islamic Republic of Pakistan (Government), the Poverty Reduction and Economic Support Operation (PRESO) of US$SOO million to support the implementation of Pakistan’s Second Poverty Reduction Strategy Paper (PRSP-II). This Letter of Development Policy sets out our Government’s key economic policy actions under PRSP-I1 over 2008/09 to be supported by PRESO, as well as our planned medium-term reform path through 20 1 O/’ l1 .

2. The overarching objective of PRSP-I1 i s to steer Pakistan back on the path of sustained and broad-based economic growth, to create jobs and to reduce poverty. This requires a prolonged period of macroeconomic stability, financial discipline and consistently transparent policies that place poverty reduction at the centre of the country’s overall economic policies. These policies are based on a three- pronged approach: regaining and maintaining macroeconomic stability; enhancing competitiveness; and protecting the poor and vulnerable.

3. We aim to achieve the following overall outcomes: (i) the fiscal deficit reduced from 7.4 percent of GDP in 2007/08 to 4.2 percent of GDP in 2008/09, 3.3 percent o f GDP in 2009/10 and 3.0 percent in 2010/11; (ii) the current account deficit reduced from 8.4 percent o f GDP to 6.5 percent o f GDP in 2008/09, 5.7 percent of GDP in 2009/10 and 4.6 percent of GDP in 2010/11; (iii) improved doing business indicators; and (iv) improved access to social safety nets for the poorest 25 percent of the population. Our reform plans to reach these outcomes are outlined briefly in the following paragraphs.

Regaining and Maintaining Macroeconomic Stability:

4. After a consumption lead strong economic performance for about five years, Pakistan experienced a significant terms of trade shock in 2007/08 in the form o f increased international oil and food commodity prices. Owing to inadequate policy response to this shock, the economic situation deteriorated rapidly and fiscal and balance of payments imbalances widened substantially. Our incoming Government recognized the need for strong resolve to correct the macroeconomic imbalances and to smooth the adjustment process and to avoid unnecessary cost to the economy and Pakistan’s population. I n response to th i s severe challenge, we put in place a home-grown stabilization program and accomplished adjustment actions including revisions in petroleum prices and

1

R Continuation Sheet

electricity tariffs to reduce burden on the budget; the increase in the standard rate o f the General Sales Tax by one percentage point to 16 percent; significant streamlining o f public expenditures to curb public subsidies and wasteful public expenditures; and monetary policy tightening to fight inflation. Our main priority for PRSP-I1 i s to continue the policies required for macroeconomic stability. It i s on the basis of a sound macroeconomic framework that assumptions and targets of all policies will be set. Regaining and maintaining macroeconomic stability entails a focus on these outcomes: increased revenue mobilization, adjusted fuel prices and electricity tariffs, improved efficiency o f public spending, and strengthened government debt management.

5. Increased revenue mobilization: A sustainable improvement in our resource envelope has to come through higher tax revenue mobilization. Pakistan’s tax collection stands only at around 10 percent of GDP, which i s below many o f Pakistan’s peer emerging economies. To ensure adequate public funding for our development priorities, we aim to increase overall tax collection by 0.6 percent of GDP in 2008/09, 0.8 percent of GDP in 2009/10, and 0.9 percent of GDP in 2010/11. The rise in tax collection has to go hand in hand with improvements in the structural properties of the tax system. This includes making the tax system buoyant, fair and broad-based, with minimum distortions and exemptions. Achieving these objectives requires reforms of both tax administration and tax policy.

6. Regarding tax administration, our Government has approved the establishment o f a new integrated tax administration on functional basis, and FBR has implemented the related top management changes. In addition, FBR has established task forces to pursue unregistered entities, non-filers and stop filers, and has launched the preparation of risk-based compliance strategies. Furthermore, FBR has selected the Large Taxpayer Unit in Lahore as pilot site for the new Integrated Tax Systems based on System 2009. Going forward, FBR will adopt a comprehensive business process re-engineering strategy and adjust all business processes fully consistent with the new integrated organization. The business processes will make effective use o f the System 2009, which wil l be fully deployed in headquarter and all field offices of FBR, and modified on an ongoing basis in line with changes in business processes and tax polices. We will also increase significantly risk-based audit coverage, ensuring rigorous quality assurance, coupled with application o f punitive measures in case o f tax evasion. These compliance measures will ensure significant increases in business registration, reduction in stop fi lers and reduction in arrears.

7. Complementing changes on tax administration, our Government is committed to pursue substantial reforms on tax policy. The main untapped potential for tax collection lies with the General Sales Tax (GST). Our Government has approved the policy proposal to amend legislation of domestic indirect taxes to ensure a comprehensive taxation of goods and services in the form of a Value Added Tax (VAT). To ensure adequate tax collection for the current fiscal year, FBR will start taking measures in February 2009 to limit revenue leakage. In June 2009, our Government wi l l legislate amendments of domestic tax laws for 2009/10. They include reductions in exemptions and zero-ratings o f the Sales Tax Act, and simplifications in the tax rate schedules, rationalization of withholding taxes, and reductions in exemptions of the Income Tax Act. Tax definitions and procedures for income tax, sales tax and federal excises will also be harmonized.

8. In parallel to this effort, we will draft a new VAT law. In March 2009, we will review the options to deal with the treatment of services under a new VAT regime. Subsequently, we will present some o f the options to the provinces for their evaluation and concurrence. We expect to obtain approval o f the new, comprehensive VAT law in time for operation for the 2010/11 Budget. We also intend to consider incentives for the sub-national government to increase their own-source revenue bases. Our

2

Continuation Sheet

Government also intends to make the revenue division of the Ministry o f Finance fully functional to facilitate sound fiscal policy making.

9. Adjusfmenf of fuel prices and power far@: The elimination o f public subsidies for fuel and electricity i s a central part o f moving Government’s finances onto a sustainable footing. Strengthening the financial health of the energy sector through cost-recovery pricing wi l l also help to attract the much needed private investment into the sector. Our Government already eliminated fully petroleum subsidies by December 2008. In January 2009, Government has introduced the monthly automatic adjustment of consumer fuel prices to pass through changes in international prices, while at the same time safeguarding the collection o f a minimum level o f petroleum development levies to compensate for tax revenue shortfalls on the back of lower fuel prices. Going forward, our Government will not introduce any fuel subsidies.

10. Our Government will also eliminate fully electricity subsidies by end-June 2009. To achieve this objective, we have adopted and started to implement a plan in January 2009 consistent with the 2008/9 budget. Our Government has already introduced the monthly determination o f the fuel adjustment surcharge in electricity tariffs, and wi l l from January 2009 onwards notify the new consumer tariffs within 15 days o f their determination or re-determination, By end March 2009, our Government will adopt a plan for eliminating the inter-corporate circular debt. Going forward, no power sector subsidies wil l be introduced. Our Government i s fully committed to protecting the poor from negative impacts of price increases.

1 1. Improved efficiency of public spending: Strengthening the efficiency of public spending i s an important aspect of the fiscal reforms. One pillar for sound fiscal policies i s the Fiscal Responsibility and Debt Limitation Law (FRDL). Due to the adverse situation in 2007/08 and 2008/09, Government could not comply fully with this Law. Going forward, we wil l comply fully with all provisions o f FRDL, including maintaining a revenue deficit o f zero, and maintaining annual social and poverty-related public spending at no less than 4.5 percent of GDP.

12. We have already consolidated our public sector development program (PSDP) by 20 percent to ensure consistency of the development priorities o f our new Government, and to reduce the size of the PSDP throw-forward in 2008/09 by at least 9 months. To facilitate the timely completion of development schemes and increase the space for the adoption o f new development priorities, we intend to review the PSDP portfolio for further consolidation going forward. Our Government also envisages additional measures to enhance the quality of public expenditures. Any projects that were deferred as part of the 2008/09 PSDP consolidation wil l only be re-included into the PSDP if projects with similar financial outlays are dropped.. A system to monitor the lapse-time at each processing stage o f government payments will be established and, where feasible, parallel payment processing implemented. Fiscal impact assessments of all new policies and development projects wil l be made mandatory from 20 10/11 onwards.

3

Continuation Sheet

13. Our Government intends to strengthen public financial management by adopting medium-term budget planning. Such a Medium-Tern Budget Framework (MTBF) wil l provide ministries the space and flexibility they need to formulate, plan, and implement policies that focus on public service delivery or output. After testing the system successfully in selected ministries on a pilot basis, our Government has expanded the MTBF to a l l federal ministries, and provided each line ministries with a revised Budget Call Circular along with three-year indicative ceilings as part o f the 2009/10 budget preparation. We also plan to make the 2009/10 budget output-based.

14. Another ingredient to sound public financial management is reliable cash flow forecasting and efficient cash balance management. To achieve this objective, we have made the use of assignment accounts by ministries and autonomous agencies fully operational for budget expenditures. During 2009/10, our Government envisages to close any other bank accounts and to sweep the remaining balances to Account No. 1. By 2010/11, the treasury single account i s expected to be fully operational for development and recurrent spending, the end-week cash balance managed in accordance with the target balance, and daily forecasts initiated for those entities account for 90 percent of overall cash flows. In addition, our Government intends to clear inter-corporate debt involving state-owned enterprises in 2009/10, and prevent the accumulation o f new arrears in 2010/11.

15. Public procurement i s an important part of good governance and transparency in the use of public funds. Our Government has already amended the public procurement rules to ensure that contract awards over Rs. 50 million are posted on the website of the Public Procurement Regulatory Authority.

16. Strengthened Government domestic debt management: Prudent debt management policy was one key factor behind Pakistan’s economic recovery early in this decade. And the imprudent large-scale Government borrowing from the State Bank of Pakistan (SBP) was one key factor behind the economic crisis in 2007/08. Our Government is committed to reduce the stock of government debt to SBP and to ensure public borrowing i s consistent with sound monetary and fiscal policy. We wil l ensure that the 2009/10 and 2010/11 budgets are consistent with the FRDL. This includes, among other provisions, that annual public guarantees be at or below 2 percent of GDP, and public debt as percent of GDP i s reduced annually by 2.5 percent from 2009/10 onwards. To achieve these objectives, a comprehensive medium- term debt strategy wil l be adopted in 2009/10, and implemented subsequently, including a plan to phase out debt owed to SBP.

17. Despite the increase in domestic debt in 2007/08, our Government relied litt le on market-based funding, which indicates important shortcomings of the government securities market. In order to improve the credibility and predictability of the Pakistan Investment Bond (PIB) market, the Ministry of Finance amended rules defining roles and decision-making rights for PIB issuance and issued related instructions to SBP. In addition, our Government published in early January 2009 a credible calendar for PIB auctions for January to June 2009. We intend to adhere to this calendar, and provide an update in April for the last quarter o f this fiscal year. Such published annual calendars with quarterly updates will be continued in the next fiscal years. Going forward, we envisage reforming the primary dealer system to improve participation and competitive bidding at auctions and the development of the secondary market, with the ultimate objective to move to market-based PIB issuance.

18. Our Government i s also conscious of the need to reform the retail debt program. After an inadvertent under-forecasting of debt-servicing cost by the Central Directorate of National Savings (CDNS) during 2006/07 and 2007/08, we have now gathered complete data on outstanding and early encashment of Defense Savings Certificates due to mature in 2008/09 and 2009/10. Similar data will be

4

Continuation Sheet .\

collected in the next fiscal years. The reliability of debt-servicing forecasts will also be strengthened through the introduction o f information technology.

Enhancing Competitiveness:

19. Improving the competitiveness of an economy requires action on many fronts. The country must ensure a stable macroeconomic environment, upgrade its infrastructure, strengthen its human resources, make its institutions responsive to changing requirements, and take other steps to reduce the cost o f doing business. As part of this agenda, our Government’s strategy for building a more competitive economy aims at reduced barriers to competition, better functioning o f labor markets, and a strengthened financial sector.

20. Reduced barriers to competition: Government set up in 2007 the Competition Commission o f Pakistan (CCP) in order to monitor the state o f competition, weed out practices that interfere with contestability, and generally ensure that the economy continues to develop in line with market-based principles. To ensure the adequate functioning of the CCP, the Government notified CCP rules in early January 2009 providing the terms and conditions o f CCP members, and an automatic source of financing. One sign for the rising reputation o f CCP as an independent and even-handed agency will be the number o f the investigations conducted and concluded by it. Going forward, our Government will be holding hearings on sectoral competition assessments by CCP, and implement actions to promote competition in these sectors based on the findings o f the assessments.

2 1. Many domestic companies are affected by today’s difficult economic climate. This highlights the need to adopt a modern system for corporate rehabilitation and liquidation. By end 2009, the Government intends to submit to Parliament the Insolvency Act, which includes rehabilitation. Going forward, we expect to submit to Parliament the Companies Act to establish a modem corporate law infrastructure.

22. Ease o f business entry i s an important aspect o f competitive markets. Recently, the Security and Exchange Commission Pakistan (SECP) rolled out an electronic platform for the business registration system. Going forward, we intend to link this platform to other agencies, such as FBR, and undertake a business re-engineering to reduce substantially the number of steps and time required to register a business.

23. Better functioning labor markets: A competitive economy requires a well-functioning market for labor. Yet, labor regulation in Pakistan is more pervasive than the ones in neighboring countries and peer emerging economies. As a consequence, Pakistani employers tend to rely more on temporary workers and few formal jobs are created with economic growth. Our Government intends to pass and implement the Employment and Service Conditions Act (ESCA) aimed at consolidating a number of related laws and increasing flexibility in the labor market. We will also notify rules and regulations for ESCA and the Occupational Safety and Health Act and issue to provinces model regulations for inspections.

24. Strengthened financial sector: The global financial turmoil and difficult domestic economic situation has increased the vulnerabilities to the soundness and stability of the banking sector. In view of the need for improved banking sector regulation, SBP has amended prudential regulations to introduce a phased reduction in the group credit exposure limit from 50 percent to 25 percent over time, which i s the outside limit recommended by the Basel Committee. The group exposure limit will be reduced to 45 percent by December 2009, and further reduced to 40 percent by December 2010, 35 percent by

5

Continuation Sheet

December 201 1, 30 percent by December 2012 and 25 percent by December 2013. By supporting the diversification o f the lending portfolio of banks, this measure i s expected to reduce their credit risk.

Protecting the Poor and Vulnerable:

25. About a quarter of Pakistan’s households are poor, and they remain vulnerable to the elevated level in prices o f food and other basic consumption items. To mitigate the adverse impact o f high cost of living on the poor and vulnerable, our safety nets would need to be strengthened and expanded.

26. Better targeted social safety net: Pakistan has a number o f safety net programs, ranging from cash transfers to social care services and microfinance programs, but these programs have little impact on poverty and vulnerability. They are fragmented and often duplicative, have limited coverage (about five percent of the total population) and are poorly targeted. With the aim to provide relief to the poor and vulnerable in the face of high prices o f the essential commodities, we have launched in autumn 2008 the Benazir Income Support Program (BISP) with an initial allocation o f Rs. 34 billion to be disbursed amongst the target families. The program envisages cash grant of Rs. 1,000 per month (about USD13) to each qualifying family. BISP i s intended to compensate economically vulnerable families for the erosion o f their purchasing power and to ameliorate their conditions by supplementing their sources of income through direct cash assistance. To ensure that the public resources allocated for BISP reach the poorest 25 percent o f the population, an objective, reliable and simple targeting instrument i s critical. Our Government has adopted the scorecard as the new targeting instrument for BISP and notified the roll-out plan. We envisage that the scorecard will be implemented in a l l test districts and its roll-out initiated in all remaining districts during 2009.

27. Strengthened National Statistics: In order to assess whether our poverty reduction strategy i s successful, and to make appropriate adjustments in the strategy, we require reliable and timely economic and social data for policy analysis and formulation. Our Cabinet Division i s processing a new Statistics Law aimed at strengthening the autonomy and functioning of the national statistical system.

28. I n conclusion, I would like to reiterate the commitment o f our Government to all these reforms, and I trust that this request for World Bank support for their implementation will receive your favorable consideration.

The roll-out was launched in end January 2009.

Yours sincerely,

- (Shaukat Tarin)

Mr. Robert Zoellick President International Bank for Reconstruction and Development 1818 H Street, N.W. Washington DC, 20433

6

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Page 1 of 3 11/14/08

1 --9--GDP ~ GDP per capita

Annex 1- Pakistan at a glance

Key Development Indicators

(200 7-08)

Population, mid-year (millions) Surface area (thousand sq. hi) Population growth (“A) Urban population (% of total population)

GNI (Atlas method, US$ billions) GNI per capita (Atlas method, US$) GNI per capita (PPP, international e)

GDP growth (%) GDP per capita growth (%)

(mosl recent estimale, 2000-2008)

Poverty headcount ratio at $1.25 a day (PPP, %) Poverty headcount ratio at $2.00 a day (PPP, %) Life expectancy at birth (years) Infant mortality (per 1.000 live births) Child malnutrition (% o f children under 5)

Adult literacy, male (% o f ages 15 and older) Adult literacy, female (% of ages 15 and older) Gross primary enrollment, male (“h of age group) Gross primary enrollment, female (% of age group)

Access to an improved water source (% ofpopulation) Access to improved sanitation facilities (% ofpopulation)

Pakistan

165.8 796 2.1 36

140.2 860

2,570

6.0 3.7

65 78 31

64 35 94 73

90

South Asia

1,520 5,140

1.4 29

1,339 880

2,537

8.5 6.9

40 74 64 62 41

70 46

111 104

87 33

Low income

1,296 21,846

2.1 32

749 578

1,500

6.5 4.3

57 85 29

72 50

100 89

68 39

Net Aid Flows

(US% millions) Net ODA and official aid Top 3 donors (in 2006):

United States Japan United Kingdom

Aid (Oh of GNI) Aid per capita (US$)

Long-Term Economic Trends

Consumer prices (annual % change) GDP implicit deflator (annual % change)

Exchange rate (annual average, local per US$) Terms o f trade index (2000 = 100)

Population, mid-year (millions) GDP (US$ millions)

Agriculture Industry

Services

Household final consumption expenditure General gor’t final consumption expenditure Gross capital formation

Exports of goods and services Imports of goods and services Gross savings

Manufacturing

1979-80

1,181

42 112 44

4.6 14

9.1

9.9

82.7 23,690

29.5 24.9 15.9 45.6

83.1 10.0 18.5

12.5 24.1 13.7

1989-90 1999-00

1.127 692

167 88 194 280 54 24

2.7 0.9 10 5

10.6 4.8 6.5 24.9

21.4 51.7 103 100

108.0 138.1 40,010 73,952

(% of GDP) 26.0 25.9 25.2 23.3 17.4 14.7 48.8 50.7

73.8 75.4 15.1 8.6 18.9 17.2

15.5 13.4 23.4 14.7 20.9 20.1

2007-08

2,147

478 225 203

1.7 14

I 2 0 13.4

62.3 150

165.8 I68,2 76

20.4 26.6 19.1 53.0

79 7 8.8

21.6

12. I 22. I 20.8

Age distribution, 2007

Female

75-79

60-64

45 49

30-34

15-19

0 4

I 15 10 5 0 5 10 15

percent

Under-5 mortality rate (per 1,000) 1 I 4 0 -

1990 1995 2000 2006

0 Pakistan DSouth Asia

1 Growth of GDP and GDP per capita (%)

T 8

6

4

2

0

95 05

1980-90 1990-2000 2000-07 (average annual growth %)

2.7 2.5 2.3 6.3 3.8 5.8

4.0 4.4 3.4 7.7 4.1 7.7 8.1 3.8 9.6 6.8 4.4 6.3

4.3 4.9 5.3 10.3 0.7 8.2 5.8 1.8 6.9

8.4 1.7 8.3 2.1 2.5 8.7

Note: Figures in italics are for years other than those specified. 2007-08 data are preliminary. .. indicates data are not available. a. Aid data are for 2006.

Development Economics, Development Data Group (DECDG).

Page 2 of 3

Pakistan

Balance o f Payments and Trade

(lis$ mi//iOnSJ Total merchandise exports (fob) Total merchandise imports (a0 Net trade in goods and services

Current account balance as a % o f GDP

Workers' remittances and compensation o f employees (receipts)

Reserves, including gold

Central Government Finance

(?%of GDPJ Current revenue (including grants)

Current expenditure

Overall surplus/deticit

Highest marginal tax rate (%)

Tax revenue

Individual Corporate

External Debt and Resource Flows

IUS8 millions) Total debt outstanding and disbursed Total debt service Debt relief (HIPC, MDRI)

Total debt (% o f GDP) Total debt service (%of exports)

Foreign direct investment (net inflows) Portfolio equity (net inflows)

1999-00 2007-08

8,191 20.122 9,602 35.417

-2,275 -21.602

-217 -14,036 -0.3 -8.3

1,075 5,998

1,510 9,385

13.7 14.3 10.2 10.0 16.7 17.7

-5.6 -7.4

35 35 37

32,781 40,623 2,854 2,828

- -

44.3 24.1 26.7 8.9

308 4,273 35 1,152

Composition of total external debt, 2006-07

Short-term 2233 -IBRD, 2086

US$ millions

Private Sector Development

Time required to start a business (days) Cost to start a business (% o f GNl per capita) Time required to register property (days)

Ranked as a major constraint to business (% o f managers surveyed who agreed)

Access toicost o f financing Tax administration

Stock market capitalization (% o f GDP) Bank capital to asset ratio (%)

ZOO0 2008

- 24 - 12.6 - 50

2000 2008

47.5 46.0

8.9 49.2 4.9 8.8

Governance indicators, 2000 and 2007

-9 Voice and accountability

Political stability -2

Regulatory quality -

L Rule of law

Control of corruption

25 50 75 100

12007 Country's percentile rank (0-100) 12000 higher vsiues rmpfy beder rafmgs

Source: Kaufmann-Kraay-Mastruui, World Bank

Technology and Infrastructure

Paved roads (% o f total) Fixed line and mobile phone

High technology exports subscribers (per IO0 people)

(YO o f manufactured exports)

Environment

Agricultural land (% o f land area) Forest area (% o f land area) Nationally protected areas (% o f land area)

Freshwater resources per capita (cu. meters) Freshwater withdrawal (% o f internal resources)

C02 emissions per capita (mt)

GDP per unit o f energy use (2005 PPP $ per k g o f oil equivalent)

Energy use per capita (kg o f oil equivalent)

World Bank Group portfolio

(US$ millions)

IBRD Total debt outstanding and disbursed Disbursements Principal repayments Interest payments

IDA Total debt outstanding and disbursed Disbursements Total debt service

IFC f iscal year) Total disbursed and outstanding portfolio

Disbursements for IFC own account Portfolio sales, prepayments and

repayments for IFC own account

o f which IFC own account

MICA Gross exposure New guarantees

zoo0

56.0

2

0.4

35 2.7

323.3

0.77

4.2

463

2000

3,093 159 227 182

3,828 141 93

718 455

2

52

Ill 0

2007

64.7

52

1.4

35 2.5 9.5

336

0.83

4.5

490

2007

2,086 175 284 1 I 4

9,075 1,001

197

219 214

69

55

82 36

Note: Figures in italics are for years other than those specified. 2007-08 data are preliminary. .. indicates data are not available. -indicates observation i s not applicable.

Development Economics, Development Data Group (DECDG)

11/14/08

Mil lennium Development Goals

80 - 50 -

40 -

30 -

20 -

Page 3 of 3

Pakistan

With selected targets to achieve between 1990 and 201 5 (estimate closest to date shown, +/- 2 years)

Secondary school enrollment (gross, %) Youth literacy rate (% ofpeople ages 15-24)

Women employed in the nonagncultwal sector (% of nonapcultural employment) Proportion o f seats held b y Nomen in national parliament (“A)

Infant mortality rate (per 1,000 live births) Measles immunlzation (proportion o f one-year olds immunlzed, %)

Binhs attended b y skilled health staff (% o f total) Contraceptire prevalence ( X ofwomen ages 15.49)

Incidence of tuberculosis (per 100,000 people) Tuberculosis cases detected under DOTS (“A)

Access to an improved water source (“A o f population) Access to improved sanitation facilities (% o f population) Forest area (Yo o f total land area) Nationally protected areas (% of total land area) C 0 2 emssioiis (metnc tons per capita) GDP per unit o f energy use (constant 2005 PPP $ per kg o f o i l eqmvalent)

Mobile phone subscribers (per I00 people) Iiitemet users (per 100 people) Personal computers (per 100 people)

Education indicators (%)

loo 1

50 7 5 1 0 1

ZOW 2002 2004 2005

-+-Primary ret enrollment ratio

-0-Rat io of girls to boys in primary 8 secondary education

Measles immunization (%of I-year olds)

loo 75 1 1

1990 1995 2000 2006

0 Pakistan USouth Asia

;1 1 2000 2002 2004 2006

0 Fixed + mobile subscribers Internet users

Note: Figures in italics are for years other than those specified. .. indicates data are not available.

Development Economics, Development Data Group (DECDG).

11/14/08

Annex 2 - Pakistan Social Indicators

Latest single year Same regionhncome group

POPULATION Total population, mid-year (million)

Urban population (% o f population) Total fertility rate (brths per woman)

POVERTY (% o f population) National headcount index

Urban headcount index Rural headcount index

Growth rate (% o f annual average o f period)

INCOME GNI per capita (US$) Consumer price index (2001=100) Food price index (2000=100)

INCOME/CONSUMPTION DISTRIBUTION Gini index Lowest quintile (% o f income or consumption) Highest quintile (% o f income or consumption)

SOCIAL INDICATORS Public expenditure

Health (% o f GDP) Education (% o f GDP) Social security and welfare (% o f GDP)

Net primary school enrollment rate (99 of age group)

Total Male Female

Access to an improved water source (99 ofpopulation)

Total Urban Rural

Immunization rate &of children ages 12-23 months)

Measles DPT

Child malnutrition (% o f under 5 years) Life expectancy at birth (Years)

Total Male Female

Mortality Infant (per 1,000 live births) Under 5 (per 1,000 live births)

Male (per 1,000 population Female (per 1,000 population

Adult (15-59)

Maternal (modeled, per 100,00 live births)

1980-85

94.8 2.7

29.3 6.5

370.0 29.9

38.0 30.0

57.4 56.9 58,O

105.0 142.0

282.5 290.9

1990-95

122.4 2.5

31.8 5.2

28.6 17.2 33.4

490.0 68.4 69.6

30.3

2.6

33.3

86.0 95.0 82.0

47.0 58.0 39.0

60.9 59.9 61.9

93.0 118.0

232.3 230.0

2000-06 South Asia Low-Income

3 1 n 40 8 41 1

159.0 2.1

35.3 3.9

800.0 137.4 139.2

31.2

2.1 2.6

65.6 73.5 57.3

91.0 96.0 89.0

80.0 83.0 31.3

65.2 64.7 65.8

77.8 97.2

176.9 145.2 320.0

1,499.4 1.6

28.8 2.8

767.9 132.2

4.5 2.2

85.1 87.6 82.4

84.5 93.6 81.4

65.5 64.2 41.0

64.2 63.0 65.5

62.0 83.2

250.7 172.5 500.0

2,419.7 1.8

30.4 3.5

649.2 144.6

4.6 3.1

78.4 81.2 75.5

75.0 88.1 69.4

68,9 68.3 35.3

60.4 59.3 61.7

74.2 112.3

285.5 222.7 650.0

Births attended by skilied health s ta f f (%) 18.8 .. ..

Note: Immunization: refers to children ages 12-23 months who received vaccinations before one year o f age

2008 World Development Indicators, World Bank.

Annex 3 - Pakistan Selected Economic Indicators

A c t u a l Pro ject ions 2006/07 2007108 2008/09 2009/10 2010/11 2011/12 2012/13

Output and prices Real GDP at factor cost Consumer prices (period average) Pakistani rupees per U.S. dollar (period average)

Saving and Investment Gross national saving Gross capital formation 11

Public finances Revenue (including grants)

Tax revenue

Non-tax revenue Grants

ofwhich : Central Board of Revenue

Expenditure (including statistical discrepancy) :2 Current expenditure 13

Interest Other federal 13 Provincial

o f which: one-off-outlays 4/ Development expnditure 13

Net lending

Statistical discrepancy

Overall balance Underlying (excluding grants and one-off-outlays) Excluding grants Including gants

Financing External

Domestic off which; privatization receipts

Total government debt External government debt Domestic government debt

Monetary sector Net foreign assets Net domestic assets Broad money Private credit Six-month treasury bill rate (period average; in %)

External sector Merchandise exports, U.S. dollars (growth rate; in O h )

Merchandise imports, U.S. dollars (growth rate: in %) Current account including official current transfers (as Oh o f GDP) Gross official reserves (in millions o f U.S. dollars) /5 In months of next year's imports o f goods and services

Memorandum Items: Real effective exchange rate (annual average; percentage change) 16 Real per capita GDP (percentage change) 17 GDP at market prices (in billions o f Pakistani rupees)

6.8 7.8 1.3

18.1 22.9

15.2 10.9 9.7 3.9 0.3

20.6 15.8 4.2 6.9 4.6 4.9 0.5

-0.1

-1.4

-3.9 -4.3 -4.0

4.0 2.0 0.6 2.0

54. I 24.2 29.9

8.1 11.3 19.3 17.2 8.8

4.4 8.0

-4.8 14,302

3.8

0.5 5.1

8,723

5.8 12.0

13.2 21.6

14.6 10.4 9.6 3.9 0.3

21.8 17.7 4.7 8.9 4.2 4.0 0.2

-0.3

0.1

-7.3 -7.4 -7.1

7.1 I .2 0.0 6.0

57.4 26.2 31.2

(Annuul chunges; in percent) 2.5 4.0 5.0

20.0 6.0 5.5

(In percent of GDPi 14.2 20.1

15.4 11.3 10.0 3.9 0.2

19.3 16.1 4.8 7.3 4.0 3.2 0.2 0.0

0.2

-4.1 -4.3 -4.2

4.2 1.4 0.0 2.8

56.9 27.8 29.1

15.6 19.9

16.0 12.0 10.6 3.8 0.2

19.2 15.2 4.7 6.3 4.2 4.0 0. I 0.0

0.0

-3.3 -3.4 -3.2

3.2 1 .o 0.2 2.2

55.3 26.2 29.1

17.3 21.6

16.8 12.8 11.5 3.7 0.4

19.4 14.2 3.5 6.4 4.3 5.2 0.0 0.0

0.0

-3.0 -3.0 -2.6

2.6 1.5 0.2 1.1

54.1 26.2 27.9

(dnnuul chunges; in percenfl -7.8 -3.4 -1.4 23.2 11.8 12.1 15.3 8.4 10.6 16.4 8.3 14.2 9.6

16.5 -5.5 1.5 6.2 31.2 -14.5 -5.5 6.8 -8.4 -5.9 -4.3 -4.3

8,591 9,091 10,591 11,091 2.7 3.0 3.3 3.2

-0.8 4.1 0.9 2.4 3.4

10,478 12,970 14,298 15,838

6.0 5.5

18.6 23.0

17.4 13.5 12.3 3.5 0.4

19.7 14.1 3.1 6.6 4.4 5.7 0.0 0.0

0.0

-2.7 -2.7 -2.3

2.3 2. I 0.4 0.2

52.1 26.2 25.8

8.0 7.0

-4.3 11,891

3.2

4.4 17,712

6.5 5.5

19.7 23.9

17.7 13.9 12.7 3.4 0.4

19.6 14.0 2.8 6.7 4.5 5.6 0.0 0.0

0.0

-2.3 -2.3 -1.9

1.9 1.9 0.1 0.0

49.9 26.3 23.6

8.0 7.6

-4.2 11,891

3.0

4.9 19,901

GDP at market prices (in billions o f U.S. dollars) 144.0 167.6 162.6 171.0 180.8 193.1 207.4 11 Including changes in inventories. Investment data recorded by the Federal Bureau o f Statistics are said to be underreport t rue activity. 12 Expenditure on social assistance in 2008109 i s budgeted at 016 percent o f GDP. The program wi l l target an additional 0.3 percent o f 13 Projection for 2007108 includes as development expenditure 0.2 percent o f GDP corresponding to items classified as current

14 Spending related to the 2005 earthquake. 15 Excluding gold, foreign deposits o f commercial banks held with the State Bank o f Pakistan 16 An increase is a real appreciation. 17 The Real per capita GDP for years FY 11, FY 12, and FY 13, the population growth rate i s assumed to be 1.6% Sources: Government o f Pakistani and WB staff estimates and projections.

expenditure in earlier years. Reclassification is maintained in all projection years.

GDP.

Annex 4 - Pakistan Key Exposure Indicators

Actual Projections Indicator 2006 2007 2008 2009

Total debt outstanding and disbursed (TDO) (US$m)a e

Public and Publicly guaranteed debt (PPG) e

Net disbursements (USSm)a

Total debt service (TDS) (US$m)a e

Debt and debt service indicators ("/I

TDOiXGSb TDOiGDP TDSiXGS

Interest paymentsiGDP

IBRD exposure indicators (%) IBRD DSipublic DS Preferred creditor DSipublic DS (%)c

IBRD DSiXGS

35,655

32,579

1,871

3,608

166.5 24.8 16.8

0.7

17.7

1.6

38,699

35,290

2,502

3,608

163.2 23.1 15.2

0.8

16.7

1.5

44,467

40,243

2,692

5,265

194.9 27.3 23.1

0.7

15.2

1.8

51,452

423 16

2,378

4,681

222.0 30.1 20.2

0.7

11.3

1.5 IBRD TDO (US$m)d 2,143 2,086 1,807 1,605

a. Includes public and publicly guaranteed debt, private nonguaranteed, use o f IMF credits and net short-term capital b. "XGS" denotes exports o f goods and services, including workers' remittances. c. Preferred creditors are defined as IBRD, IDA, the regional multilateral development banks, the IMF, and the

Bank for International Settlements. d. Includes present value o f guarantees.

h Y) Y

5 U m

I m

c

3 u

Annex 6 - Pakistan Pakistan

Committed and Disbursed Outstanding Investment Portfolio As o f 10/31/2008

(In USD Millions)

Committed

- FY **Ouasi Partici Approval ComDany Loan Equity Eauitv *GT/RM Partici pant *GT/RM pant

199511996 1996 2008 199319710 1 2004 2006 2003 2007 2007 1996 2006 1990192 2008 1995 2006 2008 0103108 2007 1995 2002 199612006 2006 94195105107 I983102 2001 2008 , 2006108 2007 2004107 1996 2005

AES La1 Pir AES Pak Gen Airblue Pvt. Ltd. Crescent Bahuman Ltd. CSIBL Dewan Petroleum Ltd. Dewan Salman Fiber Ltd. Engro Asahi Polymer Ltd. Engro Energy Pvt. Ltd. Gul Ahmed Energy Ltd. Habib Bank Ltd. IGI Investment Bank Ltd. IIL Jahangir Siddiqui Invest. Ltd. JSPE Fund Kashf Micro Finance Bank Terminal KESC Kohinoor Energy Ltd. First Micro Finance Bank Orix Investment Bank Ltd. Orix Leasing Pakistan Ltd. Packages Ltd. Pakistan Petroleum Ltd. Sarah Textiles Ltd. Saudi Pak Bank Tameer Bank Islamabad Sareena Hotel TRG Pakistan Uch Power Pvt. Ltd. UTP - Large CF

0.0 3.9

22.0 0.0 6.5

13.5 17.5 30.0 56.9

1.4 0.0 0.0

12.0 0.0 0.0 0.0

25.1 0.0 0.0 0.0 3.5

15.5 30.0

0.0 1.1 0.0 3.7 0.0 0.0 0.0 0.0

9.5 9.5 0.0 0.5 0.0

12.0 0.0

18.7 2.8 3.9 0.0 0.1 0.0 0.3

20.0 2.0 0.0 0.0 6.3 2.0 0.0 0.0 5.8 4.6 0.0

24.0 0.5

16.0 1.9 0.0 3.5

0.0 0.0 0.0 0.0 0.0 0.0 2.4 0.8 0.0 0.0 0.0 0.0 5.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

50.0 0.0 0.0 0.0 6.4 0.0 0.0 0.0 0.0 0.0 0.0 0.0 1.5 0.0

125.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 16.0 0.0 0.0

0.0 0.0 0.0 1.5 0.0

21.4 0.0

30.0 0.0 0.5 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

0.0 0.0 0.0 0.8 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

0.0 0.0 0.0 1.5 0.0

21.4 0.0

15.0 0.0 0.5 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Total Portfolio: 242.5 143.9 190.3 16.8 53.4 0.8 38.4

* Denotes Guarantee and Risk Management Products. ** Quasi Equity includes both loan and equity types.

Annex 7 - Pakistan Selected Indicators* o f Bank Portfolio Performance and Management

As Of Date 11/19/2008

Indicator 2006 2007 2008 2009 Portfolio Assessment

Average Implementation Period (years) 2.6 3.0 3.2 3.6 Percent of Problem Projects by Number 0.0 5.0 13.6 13.6 Percent of Problem Projects by Amount ' I , 0.0 5.0 6.7 6.7 Percent of Projects at Risk by Number '' 0.0 5.0 18.2 18.2 Percent of Projects at Risk by Amount ' L 0.0 5.0 7.1 7.1 Disbursement Ratio (%) e 77.4 37.5 33.8 6.9 Portfolio Management CPPR during the year (yesho) - Supervision Resources (total US$) Average Supervision (USSiproject)

Number of Projects Under Implementation " 19.0 20.0 22.0 22.0

Memorandum I tem Since FY 80 Last Five FYs

Proj Eval by OED by Amt (US$ millions) 12,101.1 1,882.4 % o f OED Projects Rated U or HU by Number 23.5 8.3 % o f OED Projects Rated U or HU by Amt 31.1 14.5

Proj Eval by OED by Number 149.0 12.0

a. As shown in the Annual Report on Portfolio Performance (except for current FY). b. Average age o f projects in the Bank's country portfolio. c. Percent of projects rated U or HU on development objectives (DO) andor implementation progress (IP). d. As defined under the Portfolio Improvement Program. e. Ratio of disbursements during the year to the undisbursed balance of the Bank's portfolio at the

beginning o f the year: Investment projects only. * A l l indicators are for projects active in the Portfolio, with the exception of Disbursement Ratio,

which includes a l l active projects as well as projects which exited during the fiscal year.

Annex 8 - Pakistan IFC and MIGA Program, FY 2005-2008

2005 2006 2007 2008

IFC Commitments (US$m)

Sector (%) Prviate Equity & Funds Financial Markets General Manufacturing Health & Education Infrastructure Information & Telecommunications Oil, Gas, Mining Total

Investment instrument(%)

43.3 124.7 286.4

11.5 16.2 58.4 0.0 0.0

13.9 0.0

100.0

29.7 0.0 0.0

12.5 57.7 0.0

100.0

5.9

0.0 61.0 4.0 0.0 6.4

28.1 0.5

100.0

Loans QE-Loan QE-Equity Straight Equity (including Fund) Guarantees Other (Client Risk Management) Total

MIGA guarantees (USSm)

MIGA guarantees for 2008 are until March 2008

52.1 40.1

0.0 5.3 2.4 0.0

100.0

9.6

7.0 4.4

16.1 1.2

43.6 0.9

26.9 100.0

27.5 43.6 0.0

24.6 4.3 0.0

100.0

_ _

178.4

0.0 55.8 0.0 0.0

44.2 0.0 0.0

100.0

44.2 0.0 0.0

33.6 22.1

0.0 100.0

36.9

Annex 9

INTERNATIONAL MONETARY FUND

Pakistan-Assessment Letter for the World Bank

March 2,2009

This note provides the IMF staf fs assessment o f Pakistan’s macroeconomic developments and prospects as background for the Poverty Reduction and Economic Support Operation policy loan being considered by the Executive Board o f the Wor ld Bank on March 26. The assessment i s based on the findings o f the February 2009 IMF mission to Islamabad and Dubai that conducted the discussions with the Pakistani authorities on the First Review under the Stand-By Arrangement (SBA) and the 2009 Article IV Consultation.

Recent Developments and Performance under the SBA Program

Economic developments in Pakistan since the SBA was approved on November 24,2008 have been favorable.

The exchange rate has been broadly stable, with the State Bank o f Pakistan (SBP) intervening on the buying side o f the interbank foreign exchange market. As a result, the international reserves position has strengthened significantly (gross reserves amounted to $6.7 bi l l ion on February 23).

There was a strong positive response from the T-bill market to the 200-basis points increase in the central bank discount rate in mid-November, allowing the government to retire some o f i t s debt to the SBP. T-bill auctions through end-February have been consistently oversubscribed, with wide participation o f banks, and interest rates on T-bills came down from 14 percent (weighted average) in mid-January to 12.98 percent at the most recent session (February 25).

There has also been a gradual reflow o f deposits into the banking system.

Headline inflation declined markedly to 20.5 percent in January, due to lower food and energy prices, but year-on-year core inflation remains high at 19 percent, despite a decline in the month-on-month core inflation rate.

In mid-December, the authorities removed the stock market price floor which had been in place for 3% months. Subsequently, stock prices dropped sharply, but the decline moderated in early January. Since then, the market has fluctuated in line with economic prospects and developments in international equity markets.

All the quantitative performance criteria through end-December 2008 were observed.

2

Through December, the budget registered a revenue shortfall that was compensated by expenditure restraint.

0 Despite the improved confidence, credit and broad money growth have been slower than expected. Specifically, private sector credit growth, at 13 percent on an annual basis, has been lower owing to both lower demand from corporates and an increase in lenders’ risk aversion.

0 Structural conditionality has generally been observed, although there i s scope for improvement in some areas.

A contingency plan for handling problem private banks has been prepared.

0 A committee to review the operational autonomy o f the SBP has been established.

0 A tax administration reform plan has been prepared which comprises key reforms, such as the integration o f the income tax and sales tax departments and the replacement o f the current general sales tax with a broad-based VAT. The authorities have requested technical assistance from the Fund to help with the design o f the VAT law, the revisions in the income tax legislation, and the possible introduction o f a carbon tax.

0 Electricity tariffs have been reviewed (with the Wor ld Bank) and it has been agreed that a 4 percent increase, to be implemented between February and June, would suffice to reach the cost recovery level, given the recent substantial drop in the price o f furnace oil.

The SBP has stopped the direct provision o f foreign exchange for furnace o i l on February 1,2009, as agreed under the program.

0 Progress has also been made toward the end-March 2009 benchmarks under the program.

0 The fiscal program includes additional spending on the social safety net.

In late January, the authorities and the Wor ld Bank agreed on reforming the Benazir Income Support Program and introduce a scorecard for the identification o f poor households.

0 The authorities have accelerated the preparation o f a plan to deal with the circular debt issue (inter-corporate debt in the energy sector).

3

Outlook

Since the SBA program was agreed in October, the wor ld economic outlook has deteriorated significantly. This deterioration i s likely to affect Pakistan’s economy through several channels:

Domestic activity i s likely to be weaker than originally envisaged in the program. Large-scale manufacturing output has dropped, and there has been a significant decline in exports. Preliminary projections for agricultural output in 2008/09 show that increases in rice and cotton crops, and the prospects o f a large wheat crop, would offset a decline in sugar cane production.

Lower activity i s having an adverse impact on fiscal revenue.

Falling food and energy prices and the lower economic activity should continue to exert downward pressure on headline inflation. Under conservative assumptions, year-on-year headline inflation would decline to 10 percent by end-2008/09 (compared with 20 percent in the program), and to 6% percent by end-2009110.

The external current account has also improved, but the outlook i s fragile owing to the recent decline in exports. The projected outcome for the external current account through end-2008109 i s slightly better than envisaged in the program because a marked decline in imports i s expected to outweigh the weaker export performance. The financial account surplus i s now expected to be somewhat lower than originally projected, due mainly to lower than envisaged inflows o f private capital. The overall external balance for 2008/09 i s now projected to be better than programmed by about $500 mill ion. This outlook, however, i s subject to significant downside risks, especially if the drop in exports continues and remittances decline.

Key Challenges and Policy Issues

As noted above, the downturn in the world economy poses significant downside risks to economic activity and the external position. The authorities recognize that, given financing constraints, the scope for countercyclical policies i s l imited and that consolidating economic and financial stability remains the principal challenge faced by the authorities. The fiscal program and the monetary policy stance remain the key pol icy tools to consolidate stability.

The fiscal outlook for the remainder o f 2008/09 i s l ikely to be affected by shortfalls in revenue and foreign budget financing. The authorities remain committed to the program target o f a deficit o f Rs. 562 billion, equivalent to 4.3 percent o f the revised GDP for 2008109. The tax revenue shortfall i s expected to be partly offset by higher collections f rom the Petroleum Development Levy, as well as stepped-up auditing, and the authorities are committed to restraining expenditures, as needed, to achieve

4

the budget deficit target. External budget financing in 2008/09 i s now projected to be lower than expected, mainly reflecting a shortfall in external privatization proceeds.

Pakistan needs additional external resoirces in order to create fiscal space for higher development and social spending. A donor conference, tentatively scheduled for MarcWApril2009, wi l l provide an opportunity to seek additional external assistance.

The cumulative 500-basis points discount rate hike in 2008 has resulted in tighter monetary conditions. As inflation remains elevated, it i s premature at this stage to reduce interest rates, but rates may be lowered later in the year, provided that inflation continues to decline and the government avoids SBP financing o f the budget.

The exchange rate should remain flexible, with market intervention largely aimed at meeting the international reserves targets.

Pakistan’s banks have weathered the crisis well so far, but there are increasing risks from the deteriorating economic outlook. Non-performing loans have r isen to 9.1 percent in December 2008, f rom 7.7 percent in June. Stress tests by the FSAP update mission and by the authorities show that the a deterioration in credit quality i s the main risk. Accordingly, the authorities need to continue to monitor developments in the banking system very closely.

Medium-term outlook

A significant increase in revenues as a share o f GDP remains the cornerstone o f the medium-term framework, but the economic downturn has led to a revision o f the medium-term path for fiscal and external adjustment. Growth i s projected to recover gradually to 4.0 percent next year and 7.0 percent by 2013/14. Headline inflation i s expected to decline rapidly to 6% percent by 2009/10. The external current account deficit i s envisaged to narrow to 4% percent o f GDP in 2009/10 and to decline fbrther to more sustainable levels by 2013/14. A significant increase in the revenue-to-GDP ratio wi l l create fiscal space for higher public investment and sustainable growth. However, the room for increasing the public investment-to-GDP ratio may be more limited than previously assessed, as there i s a need to ensure that the outlook allows for an adequate increase in outlays on poverty reduction.

Status o f IMF Relations

As noted, a SDR 5.169 bi l l ion ($7.6 billion) SBA was approved on November 24,2008. The staff has just completed the discussions on the First Review o f the SBA and the 2009 Article IV Consultation, which are scheduled to be considered by the IMF Executive Board in late-March 2009.

5

Table I. Pakistan: Selected Economic Indicators, 2005/06-2009/10 I/ (Population 160 9 million (2007108))

(Per capita GDP US$1 042 (2007108)) (Poverty rate 23 9 percent (2004105))

2005106 2006107 2007108 2008109 2009110 Prog Pro) Prog Pro]

Output and prices Real GDP at factor cost Partner country demand (WE0 definition) Consumer prices (period average) Consumer prices (end of period) Pakistani rupees per U.S dollar (period average)

Saving and investment Gross saving

Government Nongovernment (including public sector enterprises)

Government Nongovernment (including public sector enterprises)

Gross capital formation 21

Public finances Revenue and grants Expenditure (including statistical discrepancy) 3/ Budget balance (including grants) Budget balance (excluding grants) Primary balance Total government debt

External government debt Domestic government debt

Monetary sector Net foreign assets Net domestic assets Broad money Private credit (percentage change) Six-month treasury bill rate (period average, in percent) 41

External sector Merchandise exports, U S dollars (percentage change) Merchandise imports, U.S. dollars (percentage change) Current account including official current transfers (in percent of GDP)

External public and publicly guaranteed debt Debt service Implicit interest rate (in percent) 51

Gross reserves (in millions of U S dollars) 61 In months of next year's imports of goods and sewices

Memorandum items. Real effective exchange rate (annual average, percentage change) Terms of trade (percentage change) Real per capita GDP (percentage change) GDP at market prices (in billions of Pakistani rupees) GDP at market prices (in billions of U.S. dollars)

7 0 4 8 9 0 9 1

15 5 0 0

15 5 17 7 3 6

14 1

13 2 16 8 -3 6 -4 3 -0 6 53 3 25 2 28 0

6.8 4.5 7 8 7.0 1.3

18.1 1 .o

17.1 22 9

5.0 17.9

15.2 19 2 -4 0 -4.3 0.2

54.1 24 2 29.9

(Annual percentage change)

5 8 3 4 4 5

1 2 0 230 21 5 2 0 0

(In percent of GDP)

13.2 13 5 -2.8 -1.1 1 6 0 14.5 21.6 20.0 4.3 3.0

17.2 17.0

14.6 15 1 21.7 19.1 -7 1 -4.0 -7.4 -4.2 -2.5 0.6 57.4 54.6 26 2 26.9 31 2 27.7

2 5 5 0

2 0 0 1 3 0 1 0 0 6 0

1 4 2 156 - 0 9 0 8 1 5 1 1 4 9 201 2 1 3

3 2 3 8 1 6 9 1 7 5

1 5 4 1 6 1 1 9 6 192 -4 2 -3 1 -4 3 -3 3 0 6 1 6

5 6 9 524 2 7 8 2 7 1 2 9 1 254

(Annual changes in percent of initial stock of broad money, unless otherwise indicated)

5 4 8.1 -7.8 -4.9 -3.4 1.8 13.9 11.3 23.2 15.7 11 8 14 1 19.3 19 3 15.3 1 0 8 8.4 1 5 9 217 172 1 6 4 252 8 3 1 9 6

8 2 8 8 9 6 1 2 7

1 6 4 4 4 16.5 12.0 -5.5 1 1 0 1.1 -14.5 5.7 162 8.0 31.2

-2.2 -4.8 -8.4 -6.5 -5.9 -5 7

(In percent of exports of goods and services, unless otherme indicated)

4 0

6 0 6 5

1 5 6 0 8

14 8 1 9 9 4 0

1 5 9

16 0 19 2 -3 2 -3 4 1 5

55 3 26 2 29 1

-1 4 12 1 10 6 14 2

1 5 -5 5 4 3

177.3 164.8 169.7 160.0 186.2 154.2 189.0 14.2 16 8 15.2 1 6 9 2 3 1 1 5 4 202

2 8 5.0 2.4 2.4 3 2 2.4

12,006 14,302 8,591 8.591 9,091 11,291 10,591 4.5 3 8 2.7 2.1 3.0 2 6 3 3

0.5 -0.8 -2.6 -3.7 -10.2 5 0 5 1 4 1 1 6 0.9 3.3 2.4

7,659 8,123 10,478 13.384 12,970 15,880 14,298 127.5 144.0 167.6 . . .

Sources Pakistani authorities and Fund staff estimates and projections

11 Fiscal year ends June 30 21 Including changes in inventories Investment data recorded by the Federal Bureau of Statistics are said to underreport true activity 31 Expenditure on Social assistance in 2008109 is budgeted at 0 5 percent of GDP The program will target an additional 0 3-0 5 percent of GDP 41 2008109 average for Jun -Dec 2008 51 Calcuiated as interest payments in percent of the end-of-period debt stock of the previous year 61 Excluding gold and foreign deposits of commercial banks held with the State Bank of Pakistan

ANNEX 10. Overview of Social Protection in Pakistan

Public Programs and Expenditures

Until recently, overall public social protection expenditures remained l o w and biased toward social security in Pakistan. Currently, the country spends about 1.4 percent o f GDP on social protection (comprising safety net and pension/social security spending, but excluding subsidies such as the wheat subsidy), compared to 4.7 percent o f GDP in India and 3.1 o f GDP percent in Sr i Lanka. Some 80 percent o f Pakistan’s social protection expenditures are devoted to pensions and social security, which often benefit the non-poor and those w i th access to formal jobs, while on ly 20 percent o f social protection spending and 0.3 percent o f GDP i s spent on safety nets. This i s much lower than other countries in the region and other countries with Pakistan’s income level spend. However, wi th the launch o f the Benazir Income Support Program (BISP) in September 2008, Government intends to increase social assistance spending significantly. The BISP budget allocation for 2008/09 i s Rs 34 billion, or about 0.3 percent o f GDP. Government has also announced its intention to increase the BISP budget by another Rs 34 b i l l ion in the near future. Whi le the spending increase i s welcome, there are concerns about the effectiveness o f the social safety nets in reaching the poor, as will be discussed below.

Most social protection programs in Pakistan are administered and financed at the federal level. Provincial governments contribute only marginally to pol icy formulation and/or program administration and monitoring. The main exceptions to this are the Punjab Food Support Program and c iv i l service pensions.

Safety Nets

Pakistan has a myriad o f safety net programs targeted primari ly to the chronic poor and ranging f rom (unconditional) cash transfers to social care services and microfinance programs. There are no workfare programs, although such programs existed in the past, or other public schemes aimed directly at vulnerable households for mitigating, or copying with, risks.

Safety net programs are fragmented and often duplicative. In addition to the recently announced BISP, Bait-ul-Mal (public expenditures at 0.05 percent o f GDP) and Zakat (expenditures through private donations at 0.1 percent o f GDP) are the other major federal programs. Bo th Bait-ul-Mal and Zakat are ineffective in targeting the poor: only 46 percent o f total expenditures o f Bait-ul-Mal, and 43 percent o f Zakat expenditures, reach the poorest 40 percent o f the population. The only significant provincial program i s the Punjab Food Support Program, launched in autumn 2008 and endowed with a budget o f Rs. 22 bil l ion. To date, no systematic evidence i s available to assess i t s targeting performance.

1

In this context, the rapid introduction o f BISP manifests Government’s commitment to protect the poor and vulnerable from the impact o f the economic crises, although plans for consolidation o f cash-transfer programs are not formalized at this stage. The current BISP design has some positive elements. In particular, the decision on final eligibility for benefits i s handled separately f rom the collection o f relevant data to determine eligibility. However, Government i s committed to reforming the program so that i t conforms to international best practices. This includes the need to: (a) ensure a targeting and beneficiary enrolment process that i s objective, transparent, and minimizes the risk o f major inclusion and exclusion errors to safeguard its credibility; (b) adopt an objective and up-to-date targeting tool such as a poverty scorecard that i s derived using the Proxy Means Test methodology in l i eu o f the existing targeting scheme that relies on information collected by Members o f National Assembly together with the data in National Database and Registration Authority (NADRA) which suffers from several weaknesses: i t has incomplete coverage o f poor households, incomplete information on relevant proxies for poverty, and in part obsolete data; and (c) design and implement effectively the institutional arrangements for managing the program w i th adequate capacities to engage with the different tiers o f Government. When the reform o f BISP i s completed it will serve as a platform to: (a) consolidate other similar programs l i ke Bait- ul-Maal and similar provincial program to avoid duplication and improve efficiency; (b) move universal subsidies such as wheat toward a targeted one pegged to BISP; and (c) innovate other programs that complement a basic cash transfer programs like BISP to help the poor to graduate into income generation opportunities.

Social Security

There are several schemes providing insurance against o ld age, disability, death and/or survivor benefits. The most important o f these are c iv i l service pensions, followed by schemes provided by private employers in the formal sector. Social security programs have l o w coverage (that is, fewer than one in ten workers are covered by any scheme that protects their households against major life-cycle shocks such as sickness, mortality and o ld age) and are focused on the non-poor because o f the strong link between coverage and access to formal employment; benefits levels are relatively l o w and their value in real terms has declined in recent years due to lack o f indexation. Current administration systems are highly fragmented, which translates into relatively high administrative costs. Finally, the main schemes are fiscally unsustainable in their current format. There are large unfunded liabilities under the c iv i l service pension system, estimated at about 25 percent o f GDP, and recent estimates project important shortfalls for the Employees Old Age Benefits as it matures over the next few decades.

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ANNEX 11: Summary findings from Poverty and Social Impact Assessments (PSIAs) on Fuel Price Increases and Food Price Inflation

Recent global food and fuel price inflation severely affected the world economy, and how to mitigate the adverse impact on people's welfare had been among the most important policy agenda o f governments around the world. Pakistan was no exception. The global food and fuel price inflation hit the economy, particularly the poor and vulnerable in the country. The government's interventions like food and fuel subsidies no doubt helped people cushion the adverse impact, but also further worsened the fiscal position o f the government.

The World Bank conducted two PSIAs to see the distributional impact o f the recent food and fuel price inflation and assess how the government's interventions, particularly fuel and food subsidies, performed at the height o f the recent inflation. Also, these studies conducted an ex ante assessment o f whether and under what conditions the new social safety net program, the Benazir Income Support Program (BISP), would have worked to mitigate the impact o f economic shocks o f this magnitude.

Despite recent dramatic downturns in global food and o i l prices, both PSIAs focus on the impact o f the price increases till July 2008 - the peak o f international food and o i l price inflation - for two reasons. First, this was the time when the trade-off between mitigation o f the adverse welfare impact o f inflation and the resulting fiscal distress was the most evident. Careful studies on th i s period provide valuable lessons for the government and other stakeholders to prepare for a possible resurgence o f either food or fuel price inflation in the future. Second, the experience o f this period drove the government to create a new social safety net program - the BISP. The ex ante assessment o f possible contributions o f the BISP would benefit the ongoing reform on the social safety net in Pakistan.

Prices o f domestic o i l products were

According to Oil and Gas Regulatory Authority (OGRA), the ex-depot sale

percent and that of light diesel O i l

broadly stable until February 29, 2008.

prices of motor spirit declined 4 6

increased only 5.2 percent between

This annex summarizes findings from the PSIAs. All analyses were conducted using PSLM 2005-06 data. Since some key socio-economic parameters have likely changed since 2005-06, as soon as PSLM 2007-08 data become available, it i s recommended that all results here be re-evaluated with the new data.

I. A PSIA on the fuel price inflation'

Recent trends of domestic and international fuel prices

date

lntl o I (USD) - - - - MS _ _ _ _ _ LDO lntl oil (Rs) - _-

Source OWQ. website

htlr, /&2tOCld doc e o \ / d n ' i \ / ~ e ! / p ~ ~ ~ ~ ~ ~ ~ o - ~ _ ~ htni -AI] countries

IfltllJ ~2 p ~ / i r n , ~ ~ . c \ i ~ ~ / _ d ~ ~ ~ i i l ( ~ ~ i d ~ / I 220364185jxil, and Energy Information Administration website

Spot Price FOB eeighted bq estimated export bolume (US$/Barrel)

Figure 1: Oil price indices (100 for April 14,2006)

84

' Ful l results are available in Yoshida and Sho (2008).

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Apri l 2006, while the ex-depot price o f motor spirit increased 54 percent, HOBC, 53 percent, Kerosene, 78 percent, and LDO, 82 percent (Table 1).

tariff adjustments on poor people are unwarranted for two reasons. Poor households are adequately covered by the provision o f a lifeline tariff.

no access to electricity at all. According to the 2006/07 PSLM, about 13 percent

o f rural Pakistan households, have no access to electricity.

The impact on poverty incidence i s measured by a gap between poverty

increases. In other words, the

the fuel prices did not increase. The impact of the price increases varies depending on how much household income grows between 200546 and July 2008. Therefore, the impact i s estimated

Furthermore, the poorest o f the poor have

o f Pakistani households, and 19 percent

estimates with and without the price

counterfactual i s the poverty estimate if

As shown in Figure 1, the international o i l prices peaked around July 2008 and declined rapidly since then. As o f January lst, 2009, the international o i l prices (in Pakistan Rs.) declined 25 percent since Apr i l 2006. Domestic fuel prices, on the other hand, did not decline yet over the same period. For example, as o f January 1, 2009, the ex-depot prices o f both Kerosene and LDO are s t i l l higher than those o f Apr i l 2006. Adjustments o f prices o f Motor Spirit and HOBC were slightly better, but both prices on January Is', 2009 are s t i l l

Figure 2: Comparison of the national poverty rates with and without the fuel/oil price increases

I R - --. I.

---\

$- <.\. .--. 5

$ 8 -

p ~ -

p.

--- --I.

--- ---. .-. .. -.. -. --.. .. . -.- -- .-. -. W - -.

gz -

0 I 2 3 4 5 6 7 8 9 I O % Increase in Household Exp per Adult Equivalent since 05-06.

No change Match Int I price

~ TtII Julv 2008 _ _ _ Source Staff estimation using PSLM 2005-06 Note The x-axis represents the percentage increase in real household expenditure per adult equivalent between 2005-06 and Jul) 2008 The red line (6 0) indicates the projected growth rate o f household expenditure per adult equivalent between 2005-06 and Jul) 2008

higher than those in April 2006.

Estimation of the impact on the national poverty headcount rate

The PSIA projects the poverty impact o f the recent fuel price increases between April 2006 and July 2008 using PSLM 2005-06 data - the latest available PSLM data. The PSIA was conducted for the two scenarios: (i) the impact o f domestic price increases registered as o f July 2008; and (ii) the impact if domestic prices had risen to match the rise in the international o i l prices.

To assess the impact o f fuel price increases, some assumptions are made. First, the second round effects o f the fuel price increases are not assessed here. Second, the budget shares o f all goods are assumed not to change since 2005-06. This i s admittedly a strong assumption. And this i s one reason why the impact o f inflation should be re- evaluated using P S L M 2007-08 data once they become available. Third, electricity prices also increased recently. However, concerns about the adverse impact o f electricity

Table 1: Fuel price increases since April 2006 (%)

I July21, 1 Jan 1, I 2008* 1 2009**

Motor Spirit I 54 I 2 HOBC 53 15 Kerosene LDO International

~ 156 ~ -25 crude oil (PKR) Source: OGRA Petroleum Prices notification dated Jul. 21,2008 and January 1,2009. and Energy Information Administration website: M p : // ton Lo. ei a d oc. t ? o v / d n a v l p e l i i ~ l ~ ~ - i - ~ ~ . - ,

weighted by estimated export volume (US$/Barrel). Data on exchange rates are drawn from IFS till Oct. 2008 and the website

- A l l countries Spot Price FOB

crude oil price i s estimated using the price o f July 18, 2008. **The inflation rate for the international crude oil price i s estimated using the price o f Dec. 26,2008.

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If household income did not grow at all, the fuel price increases would have raised the national poverty headcount rate by 3.2 percentage points. If the household income grew uniformly by 6.0 percent - a projected growth rate between 2005-06 and July 2008,* the impact on the poverty headcount rate at the national level would have been 2.3 percentage points. The increase in poverty rate i s in general limited, ranging between 2.3 and 3.2 percentage points.

Poverty rates would have risen even more significantly, if the domestic fuel prices had been raised further to match the international oil price increases as o f July 2008. If the household income had not grown at all, it would have raised the national poverty rate drastically by 5.7 percentage points, implying roughly 7.6 million people would have become poor due to the fuel price increases. If the household income had grown by 6.0 percent, the poverty rate would have increased by 5.0 percentage points.

Subsidy Saving vs. Social Safety Net

Fuel price increases, or cutting fuel subsidies, wi l l certainly reduce the fiscal burden of the government, while they wil l worsen the living standards by reducing purchasing power of consumers and increase the poverty incidence. One way to mitigate the poverty impact o f subsidy cuts i s to transfer part of subsidy saving to the poor through a social safety net program such as BISP. We examine which of these two alternatives i s more cost-effective: fuel subsidies or a social safety net program.

Any targeting program involves a certain level of mistargeting, i.e., exclusion o f the poor and inclusion of the non-poor. According to the World Bank’s analysis, even if a reasonably good targeting mechanism (a proxy means testing approach) i s adopted, the targeting errors are not negligible. To make this evaluation more realistic, some targeting imperfection was also taken into account.

Despite the imperfection of targeting mechanism, simulations based on PSLM 2005-06 data indicate that the government could keep the living standards of the poor unchanged on average by spending just one sixth or less o f the fuel subsidy by adopting a simple proxy means targeting tool. This suggests that a social safety net with a good targeting mechanism i s a far more efficient instrument for poverty alleviation than fuel subsidies. However, it i s worth noting that the efficiency hinges on how accurately the program can identify the poor. Experience of other countries shows that fuel subsidies outperform a safety net program if its targeting i s weak.

11. A PSIA on the food price inflation

This PSIA assesses the poverty impact of wheat price increases. Wheat prices in Pakistan rose 73 percent between August 2007 and July 2008 at the national level, despite various measures to limit the increases. While the sharp decline in international wheat prices since and prospects for a wheat bumper crop suggests that domestic wheat prices might decline sometime in 2009, they remained elevated in Pakistan throughout 2008.

The impact o f the wheat price increase differs from that of fuel price increases in the following ways. First, wheat price increases have much larger impact on poverty than fuel price increases, since wheat consumption comprises a far larger budget share among the poor than fuel consumption. For example, according to PSLM 2005-06, the budget share o f wheat consumption i s nearly 10 percent at the national level and nearly 15 percent among the poorest 20 percent of the population.

Second, wheat price increases do not necessarily reduce purchasing power of households, particularly farmers, who do not only consume but also produce wheat. If a farmer produces

This projected growth rate i s likely to be on the very high side and needs updating as soon as new estimation becomes available, since it has not taken into account the economic downturn since late 2007.

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much more wheat than he/she consumes, a wheat price increase raises hidher purchasing power, resulting in a welfare gain.

According to the Bank’s preliminary estimation based on PSLM 2005/06, the loss in purchasing power due to the wheat price increase between August 2007 and July 2008 appears to be almost nil on average. However, the impact varies largely across different groups in the population. For example the loss in purchasing power i s particularly severe among (i) urban residents, (ii) landless and marginal landholders, and (iii) the poor. On the other hand, rural residents (as a whole), medium and large landholders in rural areas, and the r ich increased their purchasing power as a result o f the wheat price increase. Reflecting the fact that welfare losses concentrate among the poor and landless/marginal landholders, the poverty impact i s significant despite the lack o f impact on the purchasing power registered on average at the national level. According to the Bank’s projection, the national poverty headcount rate i s 3.5 percentage points higher than the counterfactual, i.e., if the inflation did not O C C U ~ . ~

A role of a socialsafety netprogram

Since the poor are among the biggest victims o f the wheat price inflation, a well-targeted social safety net program for the poor i s likely to be cost-effective. And wheat reserve fund operations can be limited to a minimum required to achieve the fund’s original objective o f smoothening seasonal price differences and ensuring emergency food security. However, the analysis indicates that the design o f a social safety net program should take into account two aspects. First, unlike most o f the chronic poor, the victims o f the wheat price inflation concentrate in the urban areas, although even among rural inhabitants, the net buyers are likely to suffer from the adverse impact. Second, price shocks can be temporary. A permanent and rigid prograin can outlive price shocks, and thereby i ts rationale.

This analysis did not include the impact o f economic growth since 2005-06.

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