The first real test - ANALYSIS

By Sayem Ali The PML-N government faces its first real test in Q4-2013 as it targets difficult structural reforms that are aimed to prevent a balance-of-payments crisis and create fiscal space for higher investment spending. These are benchmark reforms agreed under the new $6.6 billion IMF loan. They include difficult political decisions that previous governments have failed to implement, such as reducing power subsidies, implementing new tax measures and privatising public-sector enterprises (PSEs). The government aims to reduce the fiscal deficit to 5.8 percent of GDP in FY14 (ends June 2014) from 8.8 percent in FY13. However, lower power subsidies and new tax measures are deeply unpopular measures and will test the government’s resolve. The key structural benchmarks to be met during Q4 include raising power tariffs for households and agriculture sector by October 1. Households consuming more than 200 units will face an increase between 30 to 70 percent in tariffs. The government has already notified consumers but is under pressure from courts and the public to reverse its decision. The government has put itself in a difficult position. It risks derailing the IMF programme if it does go ahead with the cut back in subsides. On the other hand, it faces the risk of a public backlash at an early stage of its tenure over an unpopular decision. While the government is right to say that it can no longer finance Rs500 billion in untargeted power subsidies, hiking tariffs is probably the worst possible way to deal with the problem. The PPP government increased tariffs by close to 100 percent in five years but that did not stop the fiscal bleeding of the energy sector. Power and gas theft multiplied exponentially in the last five years. It would have been wiser for the government to tackle the issue of distribution losses and theft as the first step to containing the subsidy bill. The government’s own estimates of distribution and transmission losses stand at 23 percent (approx Rs150bn). According to the Planning Commission, non-payment by the government’s own departments stood at Rs133bn, whereas non-payment from influential industrialist stands at Rs197bn in the end of June 2013. Should the government not clear the power dues by its own departments and these influential industrialists to finance the subsidy bill? Gas theft by the powerful industrialist (including CNG stations) is another major issue with estimated Unaccounted for Gas (UFG) at 12percent, an increase from 4percent in 2008. If this gas theft is eliminated and this gas is supplied to power plants, the government could drastically reduce the cost of producing electricity (and hence the subsidy bill) and also bring over 2,000MWs additional capacity to the national grid. But no steps have been taken to tackle distribution losses and theft and the entire burden of theft, losses and inefficiencies has been shifted to the public. The government has also committed to introduce a new gas levy under the IMF programme that will boost tax revenue by 0.4percent of GDP before end-December 2013. This will be another indirect consumption-based tax on the public, similar to the levy collected on petroleum products. The gas levy will be yet another challenge for the government as provinces claim ownership of gas reserves and will vocally oppose the imposition of the levy. A levy, instead of a tax, will deprive the provinces of a share in revenue collected through this new consumption-based levy. The gas levy will not fall under the divisible pool that the federal government has to share with the provinces. Hence, it will be very difficult for the PML-N to carry out this key reform agreed under the IMF programme. Another challenge will be obtaining the approval of the Council of Common Interest (CCI) for its plans to privatise 30 PSEs by the end of September. This is yet another commitment with the IMF. However, opposition parties are strongly against the privatisation program and will not allow the CCI to give approval for the privatisation programme. In addition to the structural benchmarks, the next disbursement of the IMF loan will depend on the government meeting strict performance benchmarks to limit the fiscal deficit, reduce borrowing from the State Bank of Pakistan (SBP) and build up foreign exchange reserves. Below-target tax revenue collection and higher-than-targeted borrowing from the SBP will make this difficult. During Q3-2013, the government borrowing from the SBP surged to Rs786bn (3 percent of GDP). It will have to retire this amount during the fiscal year to meet IMF targets. The good news is that the government is on track to achieve the fiscal defictit target for Q3. Provisional data for Q3 shows fiscal deficit during Q3 was Rs374bn (1.5percent of GDP), which is in line with the IMF performance benchmark. The PML-N government requested the $6.6bn Extended Fund Facility (EFF) at the IMF’s September 4 board meeting. The EFF is a three-year concessional loan facility, with a three percent interest rate and a repayment period of up to 10 years. Disbursement is contingent upon the government successfully meeting performance and structural benchmarks. The government sought IMF assistance to “forestall a balance-of-payments crisis”. A widening current account deficit and large debt repayments have led to a sharp drawdown of the SBP’s forex reserves. Markets are concerned about this sharp decline, as well as growing risks of rising global oil prices and Pakistan’s large external debt repayments on the horizon. Despite the release of the first tranche of the IMF loan, the SBP’s forex reserves have entered crisis level territory at $3.9bn, enough to cover less than one month of import payments and the lowest level since the 2008 balance-of-payments crisis. The Pakistani rupee is also under immense pressure due to depleting official forex reserves. It has declined 10percent year to date to 106 (end-September). Delays in the release of the next IMF tranche due in December would have serious implications for the balance of payments and outlook for the rupee. The SBP hiked policy rates by 50bps to 9.5percent at its September 13 policy meeting to support the weak rupee and alleviate rising inflation concerns. Headline inflation accelerated sharply to 8.55percent in August from 5.9percent in June due to a weaker rupee and government measures to reduce subsidies and raise taxes. The SBP raised its FY14 inflation forecast to 11-12 percent, a sharp revision from the eight percent projected in June 2013. The SBP has hinted at further measures to stabilise the rupee and keep inflation in check. In our view, it will hike rates by a further 50bps in November. Other measures that the SBP is considering include restrictions on import forwards, and higher cash margins for importers. The government is also looking at increasing customs duty on non-essential imports. These steps are necessary to stabilise the rupee; otherwise we are likely to see further pressure on the currency in the coming weeks. The writer is an expert on economic policy