Washington DC February 7 2022: After being on the brink of a severe currency and fiscal crisis, the Extended Fund Facility (EFF) program—approved in July 2019—managed to stabilize the economy by rebalancing the macroeconomic policy mix and helping Pakistan to avoid a disorderly adjustment.
The gains during the first nine months of the program strengthened buffers and allowed Pakistan to weather the unprecedented COVID-19 shock.
However, Pakistan has a long history of stop-and-go economic policies and weak implementation of structural reforms. This has resulted in elevated vulnerabilities and low investment and growth, which weigh on the population, including through high poverty incidence, weak development indicators, and limited progress in achieving the UN’s Sustainable Development Goals (SDGs).
Despite significant efforts to bring the program back on track earlier in the year (which led to the completion of the combined second–fifth EFF reviews in March 2021), the authorities’ efforts shifted toward expansionary macroeconomic policies and reversed some earlier reforms in an attempt to spur growth.
The fiscal relaxation came at a time when economic activity had started to rebound. In FY 2021, real GDP growth strengthened to 3.9 percent, supported by a robust performance of the manufacturing and wholesale and trade sectors, the lifting of lockdowns thanks to contained COVID19 infections, and the authorities’ supportive COVID-19 stimulus package.
Inflation averaged 8.9 percent—down from 10.4 percent in FY 2020—despite the delayed implementation of energy tariff adjustments, reduced petroleum development levy (PDL) to offset rising international oil prices, and a relatively stable, until then, exchange rate. The current account deficit declined to 0.6 percent of GDP, the smallest deficit in 10 years, helped by record remittances. Gross international reserves rose to US$17.3 billion, the highest level in more than 4½ years, while the SBP’s net short swap/forward forex position was reduced to just US$4.9 billion during FY 2021.
As a result of buoyant domestic demand and the terms of trade shock, external imbalances increased rapidly in the early months of FY 2022. The current account in the first quarter of FY 2022 widened to an annualized 4.2 percent of GDP. The combination of a pro cyclical macroeconomic policy mix, a widening trade deficit, exchange rate pressures, and central bank interventions raised the risks of repeating previous boom-bust patterns without a policy correction.
However, the approved FY 2022 budget marked a departure from EFF objectives and contributed to rapidly increasing macroeconomic vulnerabilities. It delivered a significant fiscal relaxation through large spending increases and the unwinding of several EFF tax revenue commitments, notwithstanding the past revenue underperformance. Approved in June, the budget was on track to deliver an adjusted primary deficit of 2 percent of GDP, representing a fiscal loosening of 1.4 percent of GDP compared to the FY 2021 outturn.
On the expenditure side, it allowed for large increases in public wages and allowances, a doubling of subsidies, and an increase in investment of over 50 percent. On the revenue side, it expected unrealistically strong tax revenue growth (from marked improvements in tax administration and strong domestic demand, notably
imports) and high non-tax revenue receipts, thus introducing significant risks of fiscal slippages. In addition, the budget delayed key reforms and reversed some key policies, damaging revenue prospects.
