Bottom line: For FY11E (Jul-Jun), our view that fiscal and external account would lead macro and monetary improvements is intact. After a cyclical rebound in economic activity in FY10 (4.1%); we are yet again at the point where the recovery momentum largely hinges on (i) external & fiscal account and (ii) IMF’s endorsement. On the fiscal front, expansionary budget (4.0% deficit) for FY11E should support the ailing economy, at least on face value. On monetary policy, we expect the Central Bank (SBP) to loose the pedal (current policy rate 12.5%) once inflation moderates ie 2HFY10. However, we believe external inflows and the IMF hold the key, in particular, to execution of these desired policy actions & economic recovery – to be exact. Our base case GDP growth target for FY11E is 4.0%.
Fiscal improvements: A must…
The federal government has announced budget outlay of PRs3.3trn and an estimated fiscal deficit of 4.0% for FY11E. On face value, we do acknowledge that this would support growth in FY11E; however, we remain cognizant of the risks and key developments on the horizon. Topping concerns in our view is the financing of fiscal deficit. Secondly, the government is yet to confirm on potential taxation changes for increasing revenue. And lastly, energy supply and likewise quasi fiscal situation related to power sector subsidy. If these concerns play out negatively, we see risk to fiscal targets and economic growth. (see table 1)
….and external financing imperative
While fiscal reforms (higher taxes and lower subsidies) are must, they also carry near term associated costs ie inflation & burden on private sector where external flows come in as the indirect pacifier. That said, we believe external flows are now critical than ever in FY11E – for FAI recovery, domestic liquidity & Fx reserves. In FY10 (Jul-Jun) govt. targeted ~50% of deficit financing through external flows; however actual numbers depicted a rather grim picture, ~20%, hence recourse to domestic sources & crowding out of private sector coupled with a decline in Inv-to-GDP to 16.6% – 10 yrs low (see table 2).
IMF: Targets, structural reforms and support
IMF holds equal importance as it would help in securing donor’s funding/external inflows and in turn in execution of the desired policy actions (monetary and fiscal) and economic recovery in our view. While key quantitative targets are likely to be met for June-10, the govt. remains somewhat short on progress over structural reforms related to fiscal and quasi fiscal account – value added tax (VAT), energy subsidies and single treasury account (STA). We foresee June-10 IMF review and conformity on external support by donors to be the key signpost that would improve economic growth visibility and shape up policy response.
5 July 2010