Document of The World Bank

FOR OFFICIAL USE ONLY

Report No. 86373-PK

INTERNATIONAL DEVELOPMENT ASSOCIATION

PROGRAM DOCUMENT

FOR A PROPOSED DEVELOPMENT POLICY CREDIT

IN THE AMOUNT OF US$400 MILLION

TO THE

ISLAMIC REPUBLIC OF PAKISTAN

FOR A

FIRST FISCALLY SUSTAINABLE AND INCLUSIVE GROWTH

DEVELOPMENT POLICY CREDIT

April 3, 2014

Poverty Reduction and Economic Management South Asia Region

This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

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GOVERNMENT OF PAKISTAN FISCAL YEAR July 1June 30

CURRENCY EQUIVALENTS

(Exchange Rate Effective as of February 28, 2014) Currency Unit: Pakistani Rupees

US$1.00 = PRs 104.90

ABBREVIATIONS AND ACRONYMS ADB Asian Development Bank AML Anti-Money Laundering BISP Benazir Income Support Program BOI Board of Investment BOP Balance of Payments CCI Council of Common Interest CCOP Cabinet Committee on Privatization CCT Conditional Cash Transfer CIB Credit Information Bureau CFT Counter-Terrorist Financing DFID Department for International

Development (UK) DPC Development Policy Credit EFF Extended Financing Facility EOBI Employees Old-Age Benefits InstitutionFATF Financial Actions Task Force FDI Foreign Direct Investment FSIG

Fiscally Sustainable and Inclusive Growth

FBR Federal Board of Revenue GDP Gross Domestic Product GCC Gulf Cooperation Countries GOP Government of Pakistan GST General Sales Tax IBRD International Bank for Reconstruction

and Development IDA International Development Association IEG Independent Evaluation Group IMF International Monetary Fund ITAMS Integrated Tax Audit Mgment. System

JICA Japan International Cooperation Agency LLP Limited Liability Partnership MFN Most Favored Nation MOC Ministry of Commerce MoF Ministry of Finance MOU Memorandum of Understanding MTB Market Treasury Bill NFC National Finance Commission NISP National Income Support Program NPL Non-Performing Loan NSS National Savings Scheme NTN National Tax Number OSS One Stop Shop PC Privatization Commission PEFA Public Expenditure and Financial

Accountability PIA Pakistan International Airlines PIB Pakistan Investment Bond PFM Public Financial Management PML-N Pakistan Muslim League-Nawaz PPG Public & Private Guarantee PSE Public Sector Enterprise SBP State Bank of Pakistan SECP Securities and Exchange Commission of

Pakistan SEZ Special Economic Zone SME Small and Medium Enterprise SOE State Owned Enterprise SRO Statutory Regulatory Order WTO World Trade Organization

Vice President: Philippe H. Le Hourou Country Director: Rachid Benmessaoud Sector Directors: Ernesto May and Sujata Nitin Lamba Sector Managers: Vinaya Swaroop and Henry K Bagazonzya Task Team Leaders: Jose Lpez-Clix and Mehnaz Safavian

THE ISLAMIC REPUBLIC OF PAKISTAN A PROGRAMMATIC DEVELOPMENT POLICY SERIES FOR A FIRST FISCALLY SUSTAINABLE AND INCLUSIVE GROWTH

DEVELOPMENT POLICY CREDIT

1.INTRODUCTION AND COUNTRY CONTEXT .................................................................................... 12.MACROECONOMIC POLICY FRAMEWORK ..................................................................................... 3

2.1. Recent Economic Developments ....................................................................................................... 32.2. Macroeconomic Outlook .................................................................................................................... 5

3. THE GOVERNMENTS REFORM PROGRAM .................................................................................. 114. THE PROPOSED OPERATION ............................................................................................................ 12

4.1. Link to Governments Program and Operation Description ............................................................ 124.2. Prior Actions, Results and Analytical Underpinnings ..................................................................... 134.3. Link to Country Assistance Strategy and Other Bank Operations ................................................... 214.4. Consultations and Collaboration with Development Partners ......................................................... 22

5. OTHER DESIGN AND APPRAISAL ISSUES ..................................................................................... 235.1. Poverty and Social Impact ............................................................................................................... 235.2. Environmental Aspects .................................................................................................................... 255.3. Public Fnancial Management, Disbursement and Auditing ............................................................. 25

6. SUMMARY OF RISKS ......................................................................................................................... 27Annex 1.Policy and Results Matrix ............................................................................................................ 29Annex 2. Letter of Development Policy ..................................................................................................... 30Annex 3. Bank-Fund Relations Note .......................................................................................................... 37Annex 4. PSIA: Why Protecting BISP Is So Important for the Poor? ........................................................ 38Annex 5. Privatization in Pakistan .............................................................................................................. 41Annex 6. Tariff Simplification and SROs Trade Distortions ...................................................................... 43Annex 7. Plan for Establishing and Virtual One-Stop Shop Registration in Pakistan ................................ 47Annex 8. Doing Business Indicators for Pakistan ....................................................................................... 49Annex 9. Financial Inclusion in Pakistan .................................................................................................... 50Annex 10. Creation of Fiscal Space Through Revenue Mobilization......................................................... 53Annex 11. Pakistan: Debt Sustainability Analysis ...................................................................................... 55Annex 12. Public Financial Management and Procurement ....................................................................... 59Annex 13. Analytical and Advisory Activities: Major Findings and Recommendations .......................... 61Annex 14. Country at a Glance ................................................................................................................... 63 LIST OF TABLES: Table 1. Key Macroeconomic indicators Pakistan FY09/10 to FY17/18 ..................................................... 6Table 2. Key Fiscal Indicators Pakistan FY10/11 to FY 17/18 .................................................................... 7Table 2.1. Total Expenditure Functional Classification ................................................................................ 8Table 3. Pakistan BOP Financing Requirements and Sources FY11/12 to FY 15/16 .................................. 9Table 4. Fiscal Impact Under FSIGs and Power DPCs-supported Actions in FY13/14 ............................. 20Table 5. FSIG-I Prior Actions and Analytical Underpinnings .................................................................... 21Table A4. 1. Budget Execution Performance of BISP, 2008-13 ................................................................ 39Table A4. 2. Funds Requests and Releases for BISP, FY2012-13 ............................................................. 39Table A6. 1. Tariff Rates ............................................................................................................................ 44Table A6. 2. Statutory Duty Rates, FY2002/03 to FY2012/13 ................................................................... 45Table A6. 3. Statistics of Statutory Duty Rates, FY2002/03 to FY2012/13 ............................................... 45

Table A6. 4. Number of Tariff Lines by Type of Goods and Statutory (MFN) Rate, FY2012/13 ............. 46Table A6. 5. Major General and Sector Specific SROs (Rs. Billion) ......................................................... 46Table A7. 1. Preliminary Timeline of Proposed Implementation Plan ....................................................... 48 LIST OF FIGURES:

Figure 1. Pakistan Debt Sustainability Analysis FY08/09 to FY17/18 ...................................................... 10Figure A4. 1. Targeting Performance of Federal Social Programs in Pakistan (%) ................................... 38Figure A8. 1. South Asia Doing Business Rankings .................................................................................. 49Figure A8. 2. Pakistan Ranking Across Doing Business ............................................................................ 49Figure A10. 1. Sequencing of Follow-up Actions in Registering Potential Taxpayers .............................. 54Figure A11. 1. Pakistan Evolution of Public Debt ...................................................................................... 55Figure A11. 2. Structure of Domestic Debt 1999/2000-2010/13 ................................................................ 55Figure A11. 3. Share of MTBs Holdings by Investor ................................................................................. 55Figure A11. 4. Currency Composition of PPG External Debt (including IMF) at End June 2013 ............. 56Figure A11. 5. Public Debt Sustainability Analysis ................................................................................... 57Figure A11. 6. External Debt Sustainability Analysis ................................................................................ 57Figure A12. 1. PEFA Assessment Scores for South Asia ........................................................................... 59

LIST OF BOXES

Box 1. Key Economic Priorities of the Governments Program ............................................................... 11

The Credit was prepared by an International Development Association team consisting of Jose R. Lopez-Calix (Lead Country Economist and Task Team Leader, SASEP); Mehnaz Safavian (Senior Economist and Task Team Leader, SASFP);Vinaya Swaroop (Sector Manager, SASEP), Anthony Cholst (Country Program Coordinator, SARCE); Daria Taglioni (Senior Trade Economist, (PRMTR); Paul Welton (Senior Financial Management Specialist, SARFM);Hanid Mukhtar (Senior Economist, SASEP);Yasuhiko Matsuda (Senior Public Sector Specialist, SASSP);Sarwat Aftab (Senior Private Sector Development Specialist, SASFP);David L. Newhouse (Senior Economist, SASEP);Muhammad Waheed (Economist, SASEP); Guillermo Arenas (Consultant, PRMTR);Saadia Refaqat (Economist, SASEP);Kiran Afzal (Economist, SASFP), Rehan Hyder (Senior Procurement Specialist, SARPS);Sunita Kikeri/Person (Senior Private Sector Specialist, SAFPD), Aijaz Ahmad (Senior Private Sector Specialist, SASFP), ,IrumTouqeer (Analyst, SASGP); Sarmad Sheikh (Research Analyst, SASFP); Mehwish Ashraf (Research Analyst, SASEP); ShabnamNaz (Program Assistant, SASEP); Muhammad Shafiq (Program Assistant, SASEP) and Ehteshamul-Haq(Program Assistant, SAFPD). The team is particularly grateful to Pablo Saavedra (OPSPQ), Satu Kahkonen (ECSP2), Zeljko Bogetic (ECSP2), Manuela Ferro (LCRVP), Peter Mousley (MNSF1) and John Goddard (ESF2) who provided priceless comments and guidance.

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CREDIT AND PROGRAM SUMMARY: PAKISTAN

FIRST FISCALLY SUSTAINABLE AND INCLUSIVE GROWTH DEVELOPMENT POLICY CREDIT

Borrower Islamic Republic of Pakistan Implementing Agency Ministry of Finance (MoF) Financing Data International Development Association Credit Amount

US$400 million Operation Type Programmatic (1st of 2), single-tranche Main Policy Areas

Private sector development, fiscal management, trade policy and social protection

Program Development Objectives

This is the first in a proposed series of two development policy credits to Pakistan supporting Pakistans fiscally sustainable and inclusive growth enhancing reforms. The proposed DPC operation is central to the Banks engagement in the country in the areas of improved economic governance and human development and inclusion as described in the 2010-2013 Country Partnership Strategy (CPS, and in the 2011 CPS Progress Note. The programmatic Development Policy Credit (DPC) is structured around two development objectives (i) increased private and financial sector development and (ii) expanded social protection and revenue mobilization. The program development objective is also supported by a parallel DPC in the power sector.

Key Outcome Indicators

To measure results, the following outcome indicators will be used: 1. By June 2016, at least five entities privatized through

strategic or equity sale from a baseline of no privatization transactions.

2. By June 2016, consumers will have 100% access to their credit information.

3. By 2016, the simple average statutory Customs tariff rate is at or lower than 10%, and no special (concessionary) Statutory Regulatory Orders (SROs) granting tax exemptions are issued.

4. By June 2016, the number of unconditional cash transfer (UCT) beneficiaries reaches at least 5.5 million.

5. By June 2016, the overall tax collection is at least 11.5 % of GDP.

Overall Risk Rating High

Operation ID P147557

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INTERNATIONAL DEVELOPMENT ASSOCIATION PROGRAM DOCUMENT FOR A PROPOSED CREDIT TO THE ISLAMIC REPUBLIC OF PAKISTAN

1. INTRODUCTION AND COUNTRY CONTEXT

1. This memorandum describes the first Fiscally Sustainable and Inclusive Growth (FSIG-I) single-tranche reform loan for US$400 million equivalent to the Islamic Republic of Pakistan. From the Banks perspective, the proposed loan will be the first of a new programmatic series of loans. The FSIG series has two broad objectives: fostering private and financial sector development to bolster economic growth, and mobilizing revenue while preserving priority use of fiscal space. In this way, the operation contributes to the governments strategy for accelerating economic growth, ensuring fiscal consolidation, increasing investment, and enhancing the openness of the economy to domestic and external competition. A programmatic approach is proposed to carry on reform momentum and strengthen reform incentives during times in which political incentives for reforms are typically high due to election results. Moreover, lessons from other similar operations in Pakistan favor a carefully sequenced and continuous reform approach.

2. Pakistan faces a serious economic situation. Unprecedented floods in 2010 and 2011, coupled with continuing security issues, stalling economic reform, falling investment and external financial inflows, increased devolution of responsibilities to the provinces, and fiscal disarray preceding elections in May 2013 posed critical challenges that have severely affected two major macroeconomic imbalances: by the end of the 2012/13 international reserves were below 1.5 months of imports, and the fiscal deficit (excluding grants) reached 8 percent of gross domestic product (GDP), a very high level for the third year in row. As a result of weak fundamentals, the economy also featured borderline stagflation: modest growth coupled with, until recently, double-digit inflation. As soon as it took office in mid-June 2013, the new Government had to articulate an ambitious emergency response so as to prevent a balance-of-payments crisis, correct fiscal imbalances and put the economy on the road to stabilization and rapid recovery.

3. The first peaceful transition from one democratically elected government to another in Pakistani history has given the incoming administration a solid reform mandate. On May 11, 2013, 86.2 million registered Pakistanisshedding fears of attackcast their vote, with the highest voter turnout in the countrys 66-year existence. The results favored the Pakistan Muslim LeagueNawaz (PML-N) with a majority of seats. PML-N formed a stable government of the center with support from independent candidates and smaller parties. At the provincial level PML-N retained its mandate to govern Punjab. Two opposition parties won mandates as well: Pakistan Tehreek-e-Insaf emerged as the largest party in Khyber Pakhtunkhwa provincial assembly, while the Pakistan Peoples Party, despite losing heavily at the national level, managed to stay the largest political force in Sindh provincial constituent assembly.

4. Barely installed in power, the new government entered into successful negotiations of an Extended Fund Facility (EFF) with the International Monetary Fund (IMF).Approved on September 4th, 2013, the Governments program goes beyond merely rebuilding the reserve position and fiscal consolidation. It also contains a growth-oriented agenda in the areas identified as the major constraints to growthenergy reform, as well as growth, investment, and competitiveness. The overall Bank contribution in IDA budget support to the program is a

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commitment of at least US$1.5 billion over three years, provided the economic program remains on track and the government meets the Development Policy Credit (DPC) conditions. Given the very low level of reserves, the Bank cannot provide lending under International Bank for Reconstruction and Development (IBRD) conditions until creditworthiness (including the level of reserves and debt) recover required levels.

5. Pakistan has important strategic endowments for growth and jobs. A lower middle-income country at the crossroads of South Asia, Central Asia, China, and the Middle East, it is thus the fulcrum of a regional market with a vast population, large and diverse resources, and untapped potential for trade. Pakistans population is about 180 million and gross national income per capita is estimated at US$1,260 in 2013.Agriculture retains a keythough decreasingrole in the economy, with a GDP share of around 22 percent (versus 23 percent for industry and 55 percent for services). Urbanization has been the fastest in South Asia. More rapid and inclusive growth can benefit from and give employment to the increasing proportion of Pakistans working-age population, which requires adequate services and quality jobs, particularly among the rapidly rising share of nonfarm female workers in the labor force.

6. Growth is essential for reducing poverty and improving shared prosperity. Cross-country studies show economic growth as the main determinant of poverty reduction and improving shared prosperity in recent decades and Pakistan is no exception. Despite falling and increasingly volatile per capita growth, poverty declined over the last decade, and Pakistans poverty rate broadly followed the per capita growth trend. The share of the population below the national poverty line fell from 34.7 percent in 2001/02 to an estimated 13.6 percent in 2010/2011. For its part, real per capita consumption of the bottom 40 percent of the populationa measure of shared prosperityalso exceeded that of the top 60 percent in the same period. In addition, Bank analysis shows that growth has been broadly inclusive, with the national Gini coefficient falling from 0.34 to 0.29 between 1998/99 and 2010/11. In this regard, social safety netslike the Benazir Income Support Program (BISP)have had a unique redistributive impact on the poor and vulnerable and have become especially important when growth has become more volatile (Annex 4). BISP has achieved high efficiency, with about 73.5 percent of the program budget reaching the poor.

7. At the request of the authorities, the FSIG-DPC series is designed to support Pakistans fiscally sustainable growth strategy. To this end, it supports enabling the environment for private investment and creating fiscal space. It addresses selected areas like privatization of SOEs, and investment climate reforms around business registration, financial inclusion, and trade competitiveness; as well as strengthening revenue mobilization and protecting priority public spending, . The ambitious reform program is strongly supported by the government, key stakeholders, and donors. Most reforms in Pakistan are contested by vested political interests and it is often difficult for the reform-minded parts of any government to attain their goals. As with other reformsand to varying degreesthe reform program supported by this operation is likely to face resistance. However, by complying with the prior actions of the first operation in this series, the government expects to create a momentum that will help to sustain the reform program. Donors have been involved in preparing this operation since its inception and have taken part in review processes.

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2. MACROECONOMIC POLICY FRAMEWORK

2.1. Recent Economic Developments

8. Pakistans economy is at a turning point. Pakistan had not fully recovered from the slowdown in economic growth since the global and twin balance-of-payments crises of 2008/09 when the country was hit by a mix of large fiscal deficits, accommodative monetary policy and financial outflows; thus leaving it with few buffers to absorb shocks and little fiscal space to foster investment. As a result, real economic growth has averaged 3 percent over the last five years, which is about half the rate of the 1960s. Bank estimates also point to increased GDP volatility in past years, accompanied by slowing gains in poverty reduction, job creation and social indicators. Emerging growth constraints are shortage of electricity supply, falling productivity growth, poor business climate, a difficult security situation and poor macroeconomic management. Business climate rankings have also worsened. Out of 189 countries, Pakistans Doing Business indicators with lowest scores are: getting electricity (171), paying taxes (162), enforcing contracts (155), registering property (135), issuing construction permits (109) and starting a business (98). Pakistan's ratings on the World Economic Forum (WEF) Global Competitiveness Index are also poor. To change the growth trajectory, the new authorities adopted an ambitious growth enhancing package, supported by the EFF and the two proposed DPC series. The authorities approved a substantial increase in, and protection of, the amount of targeted transfers to the poorest with aims to compensate for the effects of fiscal consolidation and rationalize social spending. The DPC described here addresses the electric power sector, and the Fiscally Sustainable and Inclusive Growth DPC series is aimed at reforms to state owned enterprises, (SOEs), trade policy, business climate and financial inclusion.

9. Economic activity is gradually improving. Preliminary data for FY13/14 show growth picking up mainly driven by services and manufacturing. They grew 5.7 and 5.2 percent, respectively, in the first quarter of FY13/14, supported by some decline in electricity shortages and unscheduled load-shedding. Over the past year, the growth in services has remained stable due to the offset of the slowdown in telecoms and transport with an improved performance by wholesale and retail trade, and by finance and insurance. There has been strong large-scale manufacturing performance, including of agro-based industries, enhanced capacity in iron and steel, some improvement in construction, and better external demand for cotton yarn and fabrics. Agriculture grew at a modest 2.5 percent in the first quarter of this year and continues to show significant variation in its contribution to growth owing to changing weather conditions, little use of new technologies, and few seed varieties. On the demand side, growth continues to be driven by private consumption, strongly supported by workers remittances. Private investment is low and declining: its share of GDP dropped to 10.3 percent in FY12/13 from 14.5 percent in FY06/07. Much of this stems from a shortage of private sector bank credit, whose growth was nil in FY12/13 owing to depressed demand, large excess capacity in manufacturing linked to persistent energy shortages, and to scarce supply due to massive placement of government paper with commercial banks. In FY13/14, credit to the private sector has started to rebound and posted year-on-year nominal growth of 5.6 percent. Public investmentconstrained by lack of fiscal spacewas also low at 3 percent of GDP in FY12/13 and remains contained this year due to fiscal constraints.

10. A significant correction of a loose fiscal stance is taking place to ensure sustainability. Pakistan is on track to meet a fiscal deficit target of 5.8 percent of GDP in FY13/14. This is

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remarkable as the country has had large fiscal deficits exceeding the budget target over the last six years, with a widening gap stemming from recurrent revenue shortfalls, and expenditure overruns mainly due to unbudgeted power subsidies. These problems stood out sharply in FY12/13: Federal Board of Revenue (FBR) revenue was about 1.9 percent of GDP below target due to low collection of the general sales tax (GST) and income taxes. Energy-related subsidies reached 1 percent of GDP in FY12/13, and circular debt continued to accumulate due to below cost recovery tariff rates, and delays in tariff determination and fuel cost adjustments. The government cleared 1.5 percent of GDP of this circular debt in June 2013 and an additional 0.6 percent of GDP in July 2014.

11. Public debt remains high as large fiscal deficits have been financed mainly through domestic borrowing, crowding out private sector credit. As external financing available to the government has become scarce, the government has had to borrow increasing amounts from the banking system to finance the budget. This has left very little commercial bank credit available for private investment, directly hurting recovery prospects. In addition, because T-bills are the preferred instrument, there are in high rollover/refinancing risks and high interest payments for the government equivalent to 4.3 percent of GDP. Since FY11/12, public debt has been above the 60 percent limit mandated by the Fiscal Responsibility and Debt Limitation Act of 2005.

12. The external position is extremely fragile. The current account deficit was small at around one percent of GDP by end-FY12/13 and remains so. In contrast, net official foreign exchange reserves declined to the equivalent of 1.5 months of imports at the end of June 2013 (and to 0.8 month of imports by the end of December 2013). The overall balance of payments is under severe stress due to weak financial inflows coupled with high debt repayments, especially to the IMF. Net foreign direct investment (FDI) was a modest 0.5 percent of GDP in FY12/13 and is muted in the present fiscal year. In response, monetary and exchange rate policies have moved from being accommodative to a tightening stance on monetary policy as needed to assure reserve accumulation and price stability. Last year, strong intervention by the State Bank of Pakistan (SBP) kept the Pakistan Rupee to U.S. Dollar exchange rate stable. As a result, the rupee suffered only a mild depreciation of 4.5 percent in FY12/13 and of 6 percent against the dollar since end-June. Since the second quarter of this year SBP has started to purchase dollars on the spot market, turning decisively toward rebuilding the external position. The relative stability of the rupee in nominal terms left the real effective exchange rate roughly unchanged during the past year. On a longer view, and following the steep correction the real effective exchange rate had in the aftermath of the 2007 - 2008 crisis, the rupee remains overvalued by some 3-6 percent.

13. Inflation has been in double digits over the last four years, but more recently returned to single digits. The average headline rate declined to 7.4 percent in FY12/13, down from 17.0 percent in FY08/09. In FY13/14, headline inflation has been in single digits supported by the fall in food prices and core inflation. Some favorable supply and demand factors explain its recent decline: good weather has helped improve food supply; and nonfood and non-energy core inflation - a proxy measure of underlying inflationary expectations - declined from 11.5 percent in June of FY11/12 to 7.8 percent in June of FY12/13. Consistent with the recent tightening of monetary policy to address balance of payment concerns and support the deflationary move, SBP increased the policy rate by 50 basis points in September and November 2013.

14. The financial sector appears reasonably provisioned, but vulnerable to further slowdown in the economy and overexposed to government securities. Banking profitability

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has been broadly positive over the last few years but slipped in an environment of monetary policy easing last year. The past years decline in interest rates reduced returns of banks placements in government securities and, coupled with lower loan volumes, curtailed banks profitability, which was further dampened by higher provisioning charges in January to June 2013. In broad terms, the sectors liquidity and solvency positions remain strong, backed by sluggish growth in advances and a sizable concentration of the asset portfolio in government securities which carry low risk weightings. As banks risk appetite remains cautious for private sector credit amid weak but stabilizing credit quality, nonperforming loans (NPLs) slightly declined to around 15 percent of the overall loan portfolio in June 2013 and to 14.3 percent in December 2013. NPLs in small and medium enterprises (SMEs) are still high at 36.9 percent of total loans, followed by those in agriculture (18.5 percent) and the consumer sector (15.6 percent). The largest share of credit to the private sector is the corporate sector (64.6 percent) where NPLs are 15.8 percent, mainly concentrated in textile firms.

15. Pakistans Emerging Markets Bonds Index Plus (EMBI+) risk spread has declined significantly since the arrival of the new administration. The spread had been affected by continuous political instability, security concerns, and the lackluster performance of the fiscal and external sectors over the past two years. Market confidence in the Governments program is bearing fruit as the EMBI+ spread has almost halved from 1,011 basis points in March 2013 to around 560 basis points in February 2014. According to Caa1 (Moodys) Pakistan's foreign- and local-currency bonds are high risk. The Government intends to return to the international markets with the placement of a US$500 million Eurobond in April 2014.

2.2. Macroeconomic Outlook

16. The economic cornerstone is the bold economic program of measures anchored on Pakistans EFF and the proposed DPCs. The medium term macroeconomic framework FY13/14-FY17/18 projects gradual growth recovery-cum-low inflation, supported by fiscal consolidation and rebuilding of the external position. The program tackles the key identified growth constraints: power load-shedding, cumbersome business environment, low access to finance and macro risks embedded in past stagflations. Under a baseline scenario, higher growth rates are expected to be reached gradually and inflation is expected to remain low and declining.

17. On the supply side, growth will be driven by the services and large-scale manufacturing sectors, which have benefitted from decreased power load-shedding and improved business climate. On the demand side growth drivers will be a mix of consumption recovery, partly supported by remittances, with strengthened private investment and renewed export dynamism and, to a lesser extent, increases in public investment. Fiscal consolidation is expected to reduce borrowing needs and create some fiscal space for public investment while reducing public debt. Scheduled banks liquidity is in turn expected to increase, helped by reduced crowding out, falling NPLs and increased provisioning, which is now above 70 percent. Relatively stable or declining international commodity prices, are also expected to help reduce inflationary pressures. Ongoing recalibration of policy toward monetary tightening, but in a context of falling inflation rates, should help rebuild reserves. Aided by a gradually improving security situation, structural reforms are expected to spearhead productivity growth, lower country risk, attract foreign and domestic investment linked to the sale or restructuring of state-owned enterprises and foster competition in the banking, telecom and commercial service sectors. Strong remittances and recovery of private sector credit are also projected to support

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consumption. In sum, successful fiscal consolidation and gradual rebuilding of the external position, supported by satisfactory implementation of the EFF, are expected to ensure complementary donor external financing and enable the business environment to stimulate financial inflows. The Baseline macro projections are shown in Table 1 and explained below.

Table 1. Key Macroeconomic indicators Pakistan FY09/10 to FY17/18

FY09

/10 FY10

/11 FY11

/12 FY12

/13 FY13

/14 FY14

/15 FY15

/16 FY16

/17 FY17

/18 Actual Projections

Real economy (Percentage change; unless otherwise indicated) Nominal GDP at market prices (in bn. of rupees) 14,867 18,285 20,091 22,909 26,139 29,485 33,171 37,217 41,795 Real GDP growth (at factor cost) 2.6 3.7 4.4 3.6 3.6 4.0 4.4 4.7 5.0 Contributions:

Agriculture 0.1 0.4 0.7 0.7 Industry 0.7 1.0 0.6 0.7 Services 1.8 2.2 3.1 2.1

Per Capita GDP (current US$) 6/ 1,025 1,214 1,257 .. Unemployment rate 1/ 5.6 6.0 6.0 6.0 6.0 6.0 5.9 Consumer prices (period average) 10.1 13.7 11.0 7.4 10.0 9.2 8.4 7.3 7.0 Consumer prices (eop) 11.8 13.3 11.3 5.9

Fiscal sector (In percent of GDP; unless otherwise indicated) Expenditures 20.2 18.9 21.5 21.0 19.9 19.9 19.6 19.8 19.8 Revenue 14.3 12.3 12.8 13.0 14.1 14.5 15.1 15.4 15.4 Overall balance (excl. grants) -5.9 -6.5 -8.8 -8.0 -5.8 -5.4 -4.5 -4.4 -4.4 Total public debt 61.3 59.4 63.7 63.0 64.2 63.5 62.1 59.5 58.0

Foreign currency public debt 2/ 30.0 26.5 25.7 21.4 23.1 22.7 22.0 20.0 18.0 Domestic currency public debt 31.3 32.9 38.0 41.6 41.1 40.8 40.0 39.5 40.0

Monetary Sector (Percentage change; unless otherwise indicated) Broad Money 12.5 15.9 14.1 15.9 Credit to non-government 3.9 4.0 7.5 -0.6 Interest (key policy interest rate) 12.5 14.0 12.0 9.0

Balance of payments (In percent of GDP; unless otherwise indicated) Current account balance (incl. transfers) -2.2 0.1 -2.1 -1.0 -1.0 -0.8 -1.0 -1.4 -1.6

Exports of goods & services 14.0 14.6 13.2 13.3 14.9 15.0 15.0 14.8 14.5 Imports of goods & services 21.5 20.4 21.6 20.1 22.5 23.1 23.3 23.3 23.3

Capital and financial account 3.0 1.1 0.6 0.3 2.4 2.4 1.5 1.6 1.5 Foreign direct investment, net 1.2 0.7 0.3 0.5 0.6 1.2 0.9 1.3 1.5

Gross official reserves (in US$ million, eop) 3/ 13,112 15,662 10,852 6,047 8,427 13,142 16,641 17,562 17,419 Gross official reserves (in months of imports of G&S) 4/ 3.6 3.9 2.7 1.4 1.8 2.6 3.0 2.9 2.8 Total external debt 5/ 34.7 31.0 29.1 25.3 26.5 26.4 25.7 23.6 21.6 Rupees per U.S. dollar (period average) 83.9 85.5 89.2 96.8 Memo:

Nominal GDP at market prices (in US$ billion) 177.4 213.9 225.1 236.6

GDP, PPP (current international $) 6/ 442.8 464.1 491.1 .. 1/ National estimates. Estimated for FY12/13 as published in the Economic Survey of Pakistan 2012/13. Staff assumptions for projection years. 2/ Includes medium and long term PPG debt as well as short-term external debt and IMF debt (budget and balance of payments support). 3/ SBP Gross Reserves exclude Cash Reserve Requirement, gold and foreign currency deposits of commercial banks held with SBP. 4/ Total external debt is inclusive of medium and long term PPG debt as well as short-term external debt, IMF and private debt. 5/ Source; WDI.

Growth and inflation. GDP growth is expected to be 3.6-4 percent in the current fiscal year and it should pick up from 4 to 5 percent from FY14/15 onwards. Inflation is expected to decline as a result of stabilization. This will result from the Government tackling its key growth constraints addressed by the reform agenda supported by both Bank DPCs: and tackles with macroeconomic instability (mainly addressed by the EFF). At the sector level, the economic expansion will be supported by services and recovery of the large-scale manufacturing sectors, fostered by less load-shedding and better private sector credit conditions ensuing from fiscal consolidation and hence lower borrowing requirements. On the demand side, consumption will be supported by resilient remittances that are expected to show positive, albeit declining growth

7

rates. Manufacturing exports of goods and services are expected to grow at 6 to 7 percent, their past decade average. Better external demand growth is expected due to GSP plus enhanced trade preferences for 75 new major export products entering in the European market, U.S. recovery and opening of new markets in South and East Asia and trade normalization with India. Services are projected to expand with telecom, fostered by new 3G/4G services, power and transport services. Official figures place inflation in single digits by end-fiscal 2014, despite some pressures related to hikes in administered prices such as oil, electricity and gas that might bring about a 10 percent end-year rate. As fiscal consolidation and monetary tightening proceed, average inflation is expected to approach its medium-term target of 7 percent.

Fiscal accounts. The fiscal deficit excluding grants is projected to decline from 5.8 percent of GDP in FY13/14 to about 4.4 percent of GDP by FY17/18. Provinces are expected to generate small fiscal surpluses. About half of the fiscal consolidation effort is expected to come from revenue increases and the other half from reducing untargeted power subsidies and recurrent spending. Recurrent expenditure cuts and gradual reduction of power subsidies would lead recurrent expenditures to decline from 16.0 percent of GDP in FY12/13 to 14.2 percent in FY17/18. The tax strategy should support an increase of at least three percentage points of GDP in tax revenue over this period, from 9.6 to 12.6 percent of GDP. About two thirds of such efforts are expected to come from the federal level and one-third from provinces. Part of such fiscal space generated would allow development spending and protect social safety net. BISP outlays will increase to around 5.6 percent of GDP by FY17/18, significantly higher than the 3.7 percent average during the last three years. Public debt to GDP ratios are expected to increase to 64.2 percent of GDP in FY13/14, but to decrease to below 60 percent of GDP by FY16/17, as projected fiscal consolidation will require smaller amounts of financing (Tables 2 and 2.1).

Table 2. Key Fiscal Indicators Pakistan FY10/11 to FY 17/18

FY10 /11

FY11 /12

FY12 /13

FY13 /14

FY14 /15

FY15 /16

FY16 /17

FY17 /18

Billion PKR Actual Projections Revenue and grants 12.6 13.1 13.3 14.3 14.7 15.3 15.5 15.5

Total Revenue 12.3 12.8 13.0 14.1 14.5 15.1 15.4 15.4 Tax revenue 9.3 10.2 9.6 10.3 11.2 12.0 12.5 12.6 Taxes on goods and services 4.2 4.7 4.2 Direct Taxes 3.3 3.6 3.2 Taxes on international trade 1.0 1.1 1.0 Other taxes 0.8 0.8 1.1

Nontax revenue 3.0 2.6 3.4 3.8 3.3 3.1 2.9 2.8 Grants 0.3 0.3 0.3 0.2 0.2 0.2 0.1 0.1

Expenditure 18.7 21.2 21.0 19.9 19.9 19.6 19.8 19.8 Current expenditure 15.9 17.5 16.0 15.5 15.2 14.4 14.3 14.2

Interest payments 3.8 4.4 4.3 4.7 5.1 4.5 4.3 3.9 Superannuation allowances & pension 0.6 0.7 0.8 Transfers (other than provinces) 1.3 1.1 1.0 Others 5.7 4.5 5.1 5.7 4.9 4.6 4.5 4.8 Provincial 4.4 6.8 4.8 5.2 5.2 5.4 5.6 5.5

Development expenditure & net lending 2.8 3.7 5.0 4.4 4.7 5.2 5.5 5.6 Statistical discrepancy 0.2 0.3 0.1 0.0 0.0 0.0 0.0 0.0 Overall balance (excluding grants) -6.5 -8.8 -8.0 -5.8 -5.4 -4.5 -4.4 -4.4 Overall balance (including grants) -6.2 -8.5 -7.7 -5.6 -5.2 -4.3 -4.3 -4.3 Financing 6.5 8.8 8.0

External 0.6 0.6 0.0 Of which : privatization receipts 0.0 0.0 0.0

Domestic 5.9 8.1 8.0 Memo: Primary balance (excluding grants) -2.5 -4.0 -3.6 -1.1 -0.3 0.0 -0.1 -0.5 Primary balance (including grants) -2.2 -3.7 -3.3 -1.0 -0.1 0.2 0.0 -0.4 Source: World Bank Staff estimates

8

Table 2.1. Total Expenditure Functional Classification (In percent of GDP; unless otherwise indicated)

2011/12* Actual

Federal Punjab Sindh KP Balochistan General services 11.1 0.5 0.3 0.2 0.1 Defense 2.5 0.0 0.0 0.0 0.0 Public order and safety 0.4 0.4 0.2 0.1 0.1 Economic affairs 0.7 0.4 0.3 0.2 0.2 Health 0.1 0.3 0.2 0.1 0.0 Education 0.3 0.8 0.4 0.3 0.1 Community services 0.0 0.4 0.1 0.1 0.1 Social protection 0.0 0.0 0.2 0.0 0.0 Others 1/ -0.6 0.0 0.0 0.0 0.0

Source: World Bank Staff calculations and estimates. * Does not include net lending. 1/ This category pertains to other social services in case of provincial governments. For federal government, this category is a balancing entry to reach at the Ministry of Finance published aggregate number on development expenditure using the Accountant General Pakistan Revenues disaggregated data (on account of data discrepancy).

Revenue mobilization. The baseline assumes a marked improvement in FBR performance, allowing tax revenues to rise from 9.6 percent of GDP in FY12/13 to 12.6 percent by FY15/16, and consolidated total revenue and grants from 13.3 percent of GDP in FY12/13 to 15.7 percent of GDP by FY15/16. In general increased revenue mobilization will be aided by tax buoyancy resulting from a revival of economic growth, a pickup in imports as well as the authorities own efforts to revamp and reform tax policy and tax administration. Thanks to its tax reform strategy, Government has a menu of tax policy priorities aimed to broaden the tax net and reduce the tax gap by strengthened compliance focused on five areas: (i) minimization of tax expenditure (including those which are SRO-related); (ii) upward revision of sales and general excise tax rates; (iii) upward revision of capital gains tax on securities and immovable property; (iv) revision of threshold taxes for sales tax registration; and (v) identification of new sectors for expanding the net of domestic taxes. The impact for FY13/14 is projected to be positive at about 0.7 to 0.8 percent of GDP, and next year estimated fiscal impact is expected to be again at least 0.7 percent of GDP. Of this, removal of SRO supported tax exemptions estimated at 0.35 to 0.4 percent of GDP has already been identified. This also assumes a mild decrease of nontax revenues, which over the forecast period are projected to fall from 3.8 percent of GDP in FY13/14 to 2.8 percent of GDP, mainly because of reduced US Coalition Support Funds offset by small increases on SOE profits resulting from their expected reform and privatization.

External accounts. The current account deficit is projected to average a modest 1.2 percent of GDP between FY13/14 and FY17-18, with a positive trend in tandem with expected gradual growth recovery that will require additional imports (including oil). Export recovery, strong dynamism of remittancesdespite some negative spillovers expected from expatriate workers returning from Gulf Cooperation Council (GCC) countries and imports initially favored by low international oil prices will support the current account balance. Higher financial inflows attracted by lower country risk, privatizations, new cooperation and trade relations with neighbors and the opening of special economic zones, especially attractive to China and Japanese investors, and multilateral flows will support the financial account. Official foreign exchange reserves are expected to build from US$6.0 billion by the end of FY12/13 to about US$16.6 billion by the end of FY15/16, equivalent to 3 months of imports. This will be the outcome of a significant effort to close the financing gap in the initial years. Balance of payments (BOP) financing requirements are shown in Table 3.

9

Table 3. Pakistan BOP Financing Requirements and Sources FY11/12 to FY 15/16

Actual Projections In million US Dollars FY11/12 FY12/13 FY13/14 FY14/15 FY15/16 Financing requirements 8,028 7,983 8,350 5,809 5,021 Current account deficit 4,658 2,530 2,311 1,988 2,717 Maturing short-term debt 100 391 147 100 100 Amortization of medium- and long-term debt 3,270 5,062 5,892 3,721 2,203

To IMF 1,155 2,540 3,089 1,272 57 To other official creditors 1,477 1,881 2,203 1,849 1,941 To private creditors 638 641 600 600 205

Financing sources 8,031 7,983 8,350 5,809 5,021 FDI and portfolio investments (net) 600 1,273 2,250 3,724 2,690 Capital grants 180 241 202 165 235 Other net capital and financial inflows -370 -793 -200 400 -200 Short term debt disbursements 0 256 300 300 250 Long term debt disbursements 3,191 2,454 8,230 5,936 5,444

From IMF 0 0 2,207 2,207 2,207 From other official creditors 2,633 2,089 5,336 2,912 2,756 From domestic private creditors 558 365 687 817 481

Change in reserves (decrease = +) 4,430 4,556 -2,433 -4,715 -3,399 Source: World Bank Staff calculations and estimates

Financing gap. Gross financing requirements from the balance of payments are expected to decrease significantly once the bulge of the IMF amortization in FY13/14 and, to a lesser extent, FY14/15 passes. They are projected to decrease from US$7,983 million in FY13/14 to US$5,021 by FY15/16. In closing the financing gap, the role played by front-loaded multilateral financing during the early stages of the EFF program is expected to decline, partly offset by a back-loaded increase in FDI attracted by privatization and private sector participation. In the critical initial year of FY3/14, the main projected sources of official financing are: Saudi Arabia (US$1.5 billion), the Coalition Support Fund (US$1 billion), Bahrein (US$0.5 billion); IMF (US$2.2 billion), World Bank (US$1 billion), Asian Development Bank (ADB) and Japan International Cooperation Agency (JICA)(US$500 million each) and DFID (US$100 million). Pakistan Telecommunication Company Ltd. Privatization (US$800 million), and sales of third-generation telecoms licenses (US$1 billion) and placement of Eurobonds (US$0.5-1 billion) are also expected to contribute to the early rebuilding of the foreign reserves position. Given the difficult security conditions only slow increases in Foreign Direct Investment (FDI) flows are projected from 0.5 percent of GDP in FY12/13 until they reach the average level of 1.2-1.3 percent of GDP of the 2000-2009 period. This projection accounts for a privatization program that can despite facing some early successes, may face some implementation delays and a gradual return of investors appetite for investing in Pakistan only when key structural reforms get sustained momentum.

Public Debt. Pakistans public debt to GDP ratios are projected to peak in FY13/14 and then decline. Fiscal consolidation coupled with enhanced debt management and revenue from privatization proceeds will help reduce public debt levels. Public debt is projected to fall from 64.2 percent of GDP in FY13/14 to around 58 percent by FY17/18. Stress tests of a debt sustainability analysis show that the debt path is highly sensitive to exchange rate depreciation shocks and, to a lesser extent, the materialization of a contingent liability from power circular debt or SOEs losses which might put the level of public debt above threshold of 60 percent of GDP. Debt sustainability analysis is shown in Figure 1 and discussed further in Annex 11.

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Figure 1. Pakistan Debt Sustainability Analysis FY08/09 to FY17/18

18. The macroeconomic framework is appropriate for the proposed DPC operation. Economic activity is showing clear signs of pick-up, inflation is declining, and fiscal imbalances are narrowing. Moreover, on the external front, imbalances are at a point of inflexion, the current account remains modest and foreign exchange reserves have started to rebuild.

19. Downside risks to the macroeconomic outlook are high. Pakistan remains vulnerable to internal and external shocks that could derail the entire program. First, the country is exposed to natural disasters that might require significant fiscal resources. Second, the economy is vulnerable to terms-of-trade shocks, especially for oil. A US$10 increase per barrel in oil price raises the import bill by about US$600 million. Third, remittances growth might fall faster if tougher migration policies in labor-recipient countries such as Saudi Arabia, the United Arab Emirates, and other GCC countries stop or reduce migration. Fourth, the consolidation of the global economic recovery could take longer than projected, due to the impact of US Federal Reserve tapering or new unfavorable events in European or major emerging economies. Fifth, expected FDI might not materialize as expected, especially if the domestic or regional conflict in neighboring countries continues or even gets worse. Last, but not least, the IMF program might run off-track because, for example, lower revenues are collected at the federal and/or provincial levels or both; or power subsidies are reduced more slowly than projected due to political opposition; or no or slow progress on State Owned Enterprises (SOEs) privatization. If any of this happens, the mitigation response would depend on the nature of the shock, once it materializes. The summary results of a worst case scenario are included in Annex 11 and, compared with the baseline, they can be summarized as: lower growth, return to double digit inflation, larger fiscal deficits, and higher external current account deficits. While the reserve position would show initial improvements, these would reverse in later years. In a similar vein, public debt ratios would barely show marginal decreases.

External Debt Composition, 2012/13USD(mn)

Share of total debt

% of GDP

Monetary authoriities 4,981 8% 2.1%

General Government 45,194 76% 19.1%

Banks 1,554 3% 0.7%

Other sectors 8,050 13% 3.4%

Of which intercompany lending 2,829 5% 1.2%

Total External debt 59,779 100% 25.3%

Long term 56,256 94% 23.8%

Short term 3,523 6% 1.5%Sources: Pakistan authorities

50

55

60

65

70

75

80

20

08/0

9

20

09/1

0

20

10/1

1

20

11/1

2

20

12/1

3

20

13/1

4

20

14/1

5

20

15/1

6

20

16/1

7

20

17/1

8

Actual 0 0 0 0 Projections 0 0 0 0

In p

erc

en

t of

GD

P

Public Debt Sustainability Analysis

Contingentliabilities 1/

Combined 2/

ER depreciation3/

Baseline 4/

Source: World Bank staff est imatesNotes: 1/ One time 10 percent of GDP increase in other debt creating flows in 2014/152/ Combination of three shocks: i. Real GDP growth is at baseline minus one-quarter standard deviation, ii. Primary balance is at baseline minus one-quarter standard deviation, iii. Real interest rate is at baseline plus one-quarter standard deviation3/ One time 30 percent real depreciation in 2014/154/ Country team projections

10

20

30

40

20

08/0

9

20

09/1

0

20

10/1

1

20

11/1

2

20

12/1

3

20

13/1

4

20

14/1

5

20

15/1

6

20

16/1

7

20

17/1

8

Actual 0 0 0 0 Projections 0 0 0 0

In p

erc

en

t o

f G

DP

External Debt Sustainability Analysis

Current account 1/

Combined 2/

ER depreciation 3/

Baseline 4/

Source: World Bank staff estimatesNotes: 1/ Non-interest current account is at baseline minus one-half 10-year historical standard deviat ions2/ Combination of three shocks: i. Non-interest current account is at baseline minus one-quarter standard deviation, ii. Real GDP growth is at baseline minus one-quarter standard deviation, iii. Nominal interest rate is at baseline plus one-quarter standard deviation3/ One time 30 percent real depreciation in 2014/154/ Country team projections

11

2.3. Relations with the IMF

20. This FSIG-I operation is prepared in close coordination with the IMF-EFF. This has required an extraordinary amount of bilateral technical dialogue, coordination of views, and joint missions between both institutions and officials. The EFF mainly focuses on the short-term stabilization program and on selected structural reforms in tax administration, SOE reform, and power sector reform. The Banks DPCs bring depth and complementarity to key structural efforts over the medium term in those areas as well; while introducing new measures in tax administration, trade competitiveness, the business climate, and access to finance. The Bank also has parallel technical assistance work identifying institutional capacity and providing assistance to areas where it has proper technical and financing expertise, such as tax policy and administration, trade, private participation in basic infrastructure, and social safety nets. Finally, close collaboration with the IMF is ongoing in (a) power sector reform through the Banks preparation of a DPC on power; (b) financial sector reform, including joint efforts to prepare a Financial Sector Assessment Program; and (c) debt management through joint missions and preparation of a Medium-Term Debt Strategy.

3. THE GOVERNMENTS REFORM PROGRAM

21. Upon taking office, the Sharif government introduced a comprehensive reform program. Under this program, the government is committed to adopt strong stabilization measures to eliminate the countrys critical macroeconomic imbalances and initiate major growth-oriented structural reforms needed for a more efficient economy (Box 1).The government also issued a new energy policy last August.

Box 1. Key Economic Priorities of the Governments Program

The government envisages stabilizing the economy, bringing inflation down to the 67 percent range, and achieving growth rate targets of 67 percent by 2017/18 or earlier. To do this, it has set the following major goals: Stabilization Moving to fiscal consolidation. Reducing the fiscal deficit from 8.0 percent of GDP in 2012/13 to 3.5-4 percent in 2016/17 by

increasing revenues over 1 percent of GDP annually; eliminating tax exemptions; imposing austerity in expenditure management based on reductions in ministries nonwage current expenditures; protecting the priority safety net (BISP); and carrying on active public debt management.

Rebuilding the external position and tightening monetary policy. Scaling back monetary accommodation of fiscal deficits and setting up policy rates to keep positive real interest rates; strengthening the central banks independence; and protecting the external position by repurchasing reserves to cushion against major shocks.

Growth-enhancing reforms Comprehensive power sector reform. Reducing power subsidies; restructuring boards of power distribution and generation

companies; making new investments; strengthening the power sector regulator; and expanding alternative sources of energy. Reforming SOEs. Privatizing or restructuringthe latter requiring professional chief executives and board members with a

corporate structure in line with Public Sector Companies (Corporate Governance)Rules 2013. Improving trade competitiveness. Simplifying tariffs to return to the 2003 tariff framework, with four slabs and 025 percent

rates, and phasing out trade-distortive statutory regulatory orders (SROs) on some 4,000 products. Normalizing trade relations with India. Extending most-favored nation status to it; shifting to the sensitive list under the

South Asian Free Trade Area regime to facilitate regional trade; and taking full advantage of trade preferences available from the European Union.

Enhancing the investment climate. Establishing a virtual and physical OSS for registering limited liability companies; and strengthening of the Board of Investment in facilitating implementation of investment-friendly special economic zones.

Expanding access to finance. Deepening the SBPs Financial Inclusion Program to enhance access of SMEs to financial services through regulatory reforms, product innovation, financial literacy, and consumer protection.

12

4. THE PROPOSED OPERATION

4.1. Link to Governments Program and Operation Description

22. The proposed FSIG-I single-tranche credit, under a two-phase framework, will support key reforms of the growth-enhancing components of the governments program described above. In particular, it will address the following: privatization of SOEs, improving the investment climate, mobilizing revenue and protecting priority social expenditure. Measures are encapsulated in four core areas of actions: (a) reforming state-owned enterprises with private sector participation; (b) promoting access to finance and business registration; (c) expanding social protection; and (d) mobilizing revenue. Most measures are in fact interrelated. For instance, SOE privatization and the creation of fiscal space will contribute to fiscal consolidation and smooth the social costs of adjustment both in this operation and in a parallel power sector operation. As the growth elasticity of Pakistans poverty rate is among the highest in the world, by the expected impact on growth acceleration, the operation is also expected to contribute to poverty reduction and shared prosperity.

23. The first phase of the program addresses critical institutional and regulatory changes required to have a solid jumpstart of reforms. The second phase of the program consolidates and deepens reforms required to reach the major outcomes of the reform process. However, the first credit is mostly based on self-standing policy measures implemented by the government before Board presentation.

24. Pakistan is considered as a low-performing country at implementing policy-oriented operations. Therefore, past operations provide valuable country-specific lessons for designing this DPC series that have been closely followed in its preparation.

The 2011 Country Partnership Strategy Progress Report notes that deep reform progress supported by development policy lending should be aware of the slow pace of structural reform and the permanent risk of an earlier than anticipated closing of the IMF program. Evidence from past reform programs in Pakistan, undertaken by both the Bank and ADB, suggests that multi-sector operations fail. A recommendation from an IEG Project Performance Assessment Report on four structural adjustment loans in Pakistan dated December 19, 2005 states three lessons: (i) "Complex or politically difficult sector reforms are best supported through dedicated sector operations. A multi-sector operation can play only a secondary or facilitating role when dealing with ... deep-rooted reluctance to reform (as in power)..."; (ii) power sector reform programs require sustained intervention over the long term but must be designed with flexibility to allow assessment of progress and adaptation as the reform evolves, including leaving open the option to change indicative triggers or bring other instruments into play; and (iii) precise definitions of actions and when they are considered complete are needed to avoid delays or failures to achieve objectives, and these cannot always be described in the policy matrix alone. ADB's equivalent of IEG, which had a series of program loans which completed in about 2008 or 2009 drew much the same conclusion: "ADB must pursue structural reforms through sector-specific initiatives using a programmatic approach. Reforms in various sectors should not be lumped together into one large program."

The Tax Administration Reform Project indicates that given the policy, legal, and institutional complexities involved in mobilizing revenue, an investment operation alone

13

strictly focusing on improving tax administration is unlikely to increase the tax ratio on a sustained basis. Hence, tax administration reform should be complemented by upfront adopted tax-policy measures.

The last 2007/08Poverty Reduction and Economic Support Operation underscores the importance of (a) aligning the program with the relevant levels of government, that is federal or provincial; (b) avoiding dispersion and being selective on the most critical areas of reform; (c) addressing capacity issues with timely technical assistance; (d) undertaking robust and comprehensive prior analytical work; (e) being aware that institutional reforms take time and need multiyear support; and (f) having flexibility to respond to new developments.

4.2. Prior Actions, Results and Analytical Underpinnings

Fostering Private and Financial Sector Development

Under Action 1.1 of DPC-I, The Privatization Commission has launched the Privatization Program, including (a) taking to market one strategic sale of an SOE, including calling for expressions of interest from prospective investors; and(b) issuing requests for proposals and calling for expressions of interest in connection with the procurement of financial advisors to advise on: (i) another SOE strategic sale, and (ii) the offering of equity in three SOEs in domestic and international capital markets. Under Action 2.1 of DPC-II, one SOE strategic sale and one capital market SOE privatization transaction will have been completed.

25. The current Government is keen on reviving the Pakistans privatization program that had been stalled for over eight years (Annex 5). Pakistans SOEs are a heavy burden on already strained fiscal resources, deliver poor services, and create market distortionsall of which hold back economic growth and suppress private investment by providing poor services and crowding the private sector out of major markets. Pakistan still has more than 100 SOEs operating in a wide range of economic sectors, many of which have weak managerial and corporate governance and cost-ineffective service delivery, and rely on considerable direct subsidies (to cover financial losses or to pay for operational costs) and contingent liabilities (guarantees) to sustain their operations. The new government is taking urgent steps to generate revenues from the privatization of suitable SOEs. On October, 2013, the Cabinet Committee on Privatization (CCOP) approved a list of 31 priority projects to be implemented in a phased manner. These projects were selected from the list of 65 SOEs approved by the Council of Common Interest (CCI) for privatization. On December 18, 2013, the government appointed a full-time professional (from the private corporate sector) Chairman of the Privatization Commission and constituted a new Privatization Commission (PC) Board on December 26, 2013, consisting of leading private sector professionals. The PC Board has already selected a priority list of at least 10 SOEs, from the approved list of 31 SOEs, in the oil and gas, banking and insurance, and power sectors for block sales, and primary or secondary public offerings. It also approved an implementation roadmap for these 10 SOEs including: key objectives, identification of appropriate privatization modalities, sequencing prioritization, broad timeframes, and stakeholder communication. The expected support of financial advisors will

14

allow PC to offer minority shares in two or three companies in domestic or international markets and one strategic sale subject to investor interest and global market conditions.

26. Results: The prior action and indicative trigger will help restart the privatization process in Pakistan, with the completion of the first 2 equity and strategy sales. And as the privatization process gains momentum, it will indirectly achieve an increased private sector investment, improved performance at service delivery by SOEs, reduced fiscal losses and by the same token, improved public sector resource allocation.

Under Action 1.2 of DPC-I: The MoF has submitted the Credit Bureaus Bill, 2014 to the National Assembly for approval.

Under Action 2.2 of DPC-II: National Assembly will have approved the Credit Bureau Act.

27. Credit information is a key component of a strong business environment and a key indicator in the Doing Business report. Among the most productive reforms to promote financial inclusion are those which reduce the underlying risks by strengthening creditors rights through reforms in credit information and in secured transactions. Credit bureaus are essential parts of the financial infrastructure that facilitate access to formal finance, and when well designed with the proper legal framework, they reduce information asymmetries, increase access to credit for small firms, lower interest rates, improve borrower discipline, and support bank supervision and credit risk monitoring. The State Bank of Pakistan established the electronic-Credit Information Bureau (e-CIB) system with mandatory membership for all banks and financial institutions, which are either regulated by SBP or the Securities and Exchange Commission of Pakistan (SECP) (43 nonbank financial companies, 38 banks, 9 development financial institutions, and 7 microfinance banks). Access to information from this database is restricted to members. Public and private credit bureaus provide credit information on only 7 percent and 2 percent, respectively, of the population. Significant gaps are that borrowers and third parties do not have access to their own credit information, positive information is not included in public bureau credit reports, and credit histories do not include information from nonfinancial institutions. Furthermore, there is no direct legislation governing credit information. The government recognizes the need for reforms in credit information.

28. Results. This action will fundamentally change the way the credit information system functions in Pakistan by making it fully transparent. Following extensive consultations in its preparation, the new Act consolidates the regulatory framework under the State Bank of Pakistan (including credit rating agencies), includes critical consumer protections which have been missing, and increases the scope of information available to consumers, while expanding the coverage and quality of their credit information.

Under Action 1.3 of DPC-I, the Securities and Exchange Commission of Pakistan has approved the Securities and Exchange Commission (Micro-insurance) Rules, 2014.

29. Opening insurance markets is critical for an inclusive growth agenda. It lowers risks for enterprises, households, and individuals. International experience has shown that insurance can play an important role in helping the poor manage their risks by protecting the assets and incomes of low-income households when financial losses occur. The market for micro-insurance in Pakistan remains severely underdeveloped due to the lack of awareness about the potential

15

benefits of micro-insurance among micro-entrepreneurs, small and landless farmers, women, and low-income households, and due to the lack of effective mechanisms and targeted products to provide micro-insurance services and address the existing or potential demand. Moreover, most of the activities in this sector remain broadly unsupervised due to the inexistence of a specific regulatory framework. The SECP has finalized draft rules for micro-insurance that were published in June 2013 in the official gazette of Pakistan for seeking public comments. The rules were waiting to be finalized and officially communicated. In Pakistan, where insurance penetration is just 2-5 per cent of the population, and there is the potential to increase the number of micro-insurance holders from 5 million to 30 million, it is anticipated that this initiative will help in creating a transparent and enabling environment thereby increasing the insurance density and affordable outreach to low-income people.

30. Results. These rules will open up the insurance market in Pakistan by introducing insurance products that benefit lower income households and small farmers.

Under Action 2.4 of DPC-II, SECP, FBR and Employees Old Age Benefit Institution (EOBI) will have established (a) a virtual One-Stop-Shop (OSS) for business registration and (b) a physical OSS in one province, and developed a plan for introduction of the concept of limited liability partnerships (LLPs).

31. One of the most important elements for doing business is business registration. When an entrepreneur wants to start a business in Pakistan, the business has first to be registered with many different public agencies and the person behind the business has to be aware of the range of different reporting obligations that may apply. This process is cumbersome and a deterrent for starting a business. Indeed, a new business is often not registered with all the required agencies, and in many cases the business does not register at all, and therefore unregistered businesses expand the already large informal sector, with negative consequences for business activity and tax collection. Businesses themselves may be hurt, as on average informal businesses grow more slowly and stay smaller than those in the formal sector. Under DPC-I, solid steps have been taken. FBR, EOBI and SECP launched the establishment of OSS by finalizing the design of the integrated business registration software and, to do this they signed a memorandum of understanding (MOU). The MOU defined roles, responsibilities, actions, costs, and timeframe to initially establish a virtual OSS for limited liability companies; established the Project Management Committee; finalized the technical requirements for hardware and software development; and finalized the blueprint for the design of the virtual (and physical) OSS.

32. Results. This action will reduce the number of steps and days to register a business from 10 and 21 to at least 8 and 18 respectively.

Under Action 2.3 of DPC-II, MoF will have obtained approval by Parliament of a budget 2014/15 including the application of 6 statutory tariff slabs under the tariff simplification program and the Plan to achieve 4 slabs in 3-years, within a range of 0 to 25% for all tariff lines, with very few exceptions and tariff peaks allowed just to address sensitive goods or special sectors will be finalized.

33. A poor investment climate has also negatively affected by a complex tariff regime that reduces trade competitiveness. Tariff simplification would stimulate growth by boosting exports and increasing Pakistans ability to compete globally, at the same time increasing

16

consumer welfare. A decade ago Pakistan was among the most open economies worldwide, with four statutory tariff rates in the range of 525 percent, and few exceptions (Annex 6). However, the tariff structure of imports seems to have started growing more complex after 2004, with the introduction of new statutory duty rates, the use of statutory regulatory orders (SROs) and additional duties. The number of standard statutory rates doubled from only four (5, 10, 15, and 25 percent) in 2002/03 to eight (0, 5, 10, 15, 20, 25, 30, and 35 percent) in 2012/13. As a result, the performance of Pakistanis export growth has deteriorated since 2004, reflecting an increasing complexity of the tariff regime and the use of SRO exemptions. Firm level export data clearly show that the ability of firms to innovate and select high growth products is greatly diminished. Tariff dispersion also increased from 67 percent to 81 percent over the last decade. Tariffs reform should aim to reduce the average rate, while preserving selected tariff peaks mainly of sensitive tariff lines, namely alcoholic beverages and auto industry products, whose elimination seems politically more difficult in the near term, but feasible in the medium term. The reduction in the average duty rate, which should be applied with priority to capital and intermediate goods, will result in increased competitiveness for Pakistani producers, stemming from cheaper access to imported inputs and machinery unavailable in Pakistan. The simplification of the tariff regime to fewer slabs will enhance transparency, and cut the administrative, menu and information costs associated with the current complexity of the tariff structure. As an initial step, the Federal Government already approved a Tariff Rationalization Plan to reduce, and make effective following approval of budget 2014-15, the number of slabs in statutory (MFN) Customs tariff rates from 8 to 6, in the range of 0 to 25 percent, for all tariffs lines currently below 50%, with a very limited number of exceptions for sensitive goods and special sectors.

34. Results. The simple average statutory tariff rate will be reduced to below 10% by June 2016, from its present average of 14.4 % in June 2013.

35. Other measures to create a more enabling investment climate. Competitiveness is instrumental to growth, and Pakistan needs to address it in a broader way, through productivity-enhancement measures, particularly around the business environment which can create incentives to increase private sector investment. Whereas some key areas affecting the business environmentregistering contracts and dealing with construction permitshave been transferred to provincial governments, there are still important initiatives to be done at the federal level (see below).

Business environment Special Economic Zones. The creation of Special Economic Zones (SEZ) in Pakistan has been advanced through the recently approved SEZ bill of 2012. While the law should catalyze the creation of industrial clusters, increasing productivity and competitiveness, implementation has stalled due to lack of clarification for private investors and capacity constraints at the Board of Investment (BOI) to process the applications received to date. The BOI, after consultations with the provincial governments and concerned SEZ authorities, is charged with framing the rules and regulations necessary for implementation of this act. BOI Committee already approved the first SEZ application. In this case, it was submitted by the Sindh provincial authorities on Khairpur and approved it following clarification of tax benefits under the SEZ regulatory framework for developers and provincial authorities. By mid-this year, BOI Committee intends to approve at least two SEZ applications.

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Access to finance AML/CFT. Pakistan has taken substantial steps towards improving its Anti Money Laundering (AML/CFT) regime, including by issuing a Statutory Regulatory Order that addresses the definition of terrorism and an Anti-Terrorism Amendment Ordinance to establish procedures for the identification and freezing of terrorist assets. The Financial Actions Task Force (FATF) has commended Pakistan for the issuance of the AML/CFT Ordinance, which came into force on 12 October 2013 and allows Pakistan to begin implementing its UNSCR 1373 obligations immediately. However, the FATF had concerns regarding the temporary character of this ordinance, which needs to be converted into permanent legislation through the parliamentary process, and urged Pakistani authorities to take the necessary steps for swift ratification of the ordinance by its legislature. The Ministry of Interior already submitted the ratification of the AML/CFT amendment to Parliament and National Assembly approved it. The amendment responds to FATF requirements towards ensuring Pakistan is fully compliant, and is a substantial progress towards ensuring Pakistans country rating reflects these achievements to date.

Several trade and transit-related actions have put the country on a course towards enhanced regional competitiveness. The GOP has set the stage for increasing the number of goods that can be imported through its main land border with India at Wagah and at Karachi port. It has granted India (the main country with which Pakistan maintains significant trade barriers) full non-discriminatory access to its market over 3 years, which will allow a significantly expanded list of items to be imported from India via Wagah and Karachi, and extended Wagah border hours of operation from the current 8 hours to at least 12 hours per day, 7 days a week (with a schedule to extend to 24/7). Through tangible progress in implementing the Afghanistan-Pakistan Trade and Transit Agreement, Pakistan has also allowed goods from India destined for Afghanistan to also enter through Wagah, which up until now could only enter Pakistan through Karachi; thereby increasing transit volume and collected fees, reducing transportation costs and enhancing consumer welfare in Afghanistan, an important action for both countries' growth and stability. Additional regional measures include the signing of power purchase agreements with Tajikistan and Kyrgyz Republic (and a transmission services agreement with Afghanistan) which will allow Pakistan's National Power Transmission Corporation to import 1000 MW of summer-time electricity supply; and adoption of a Pakistan-India framework under which the electricity transmission systems of the two countries can be connected within the next 12-18 months, with Pakistan's private sector importing at least 200 MW of competitively priced electricity from India.

Expanding Social Protection and Revenue Mobilization

Under Action 1.4 of DPC-I, the Ministry of Finance has strengthened the pro-poor orientation of the BISP through: (a) raising the basic benefit under BISP to PKRs.1,200 per family per month; (b) issuing a notification guaranteeing timely and full quarterly budget releases to BISP; and (c) obtaining the endorsement of the Chief Secretaries of the Provinces of memoranda of understanding between BISP and the Provinces to extend conditional cash transfers (CCTs) for primary education to at least twenty (20) districts.

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Under Action 2.5 of DPC-II, MoF will have (a) obtained approval by Parliament of a budget 2014/15 increasing BISP allocation to at least PRs. 80 billion increase the benefit amount in line with inflation; start activities to expand CCTs for primary education in no less than 25 districts with a benefit of Rs.250 per month per child attending school; and seek an agreement with provinces on a cost-sharing arrangement for CCTs included in budget 2014/15.

36. Protecting the safety net by expanding social protection. The government is committed itself to minimize the potential negative impact of fiscal adjustment and structural reforms on the poor and vulnerable. The rigorous fiscal adjustment requires protecting those programs with demonstrated effectiveness in benefiting the poor while curtailing less productive expenditures. For example, the planned reduction of the untargeted power subsidies, could disproportionately affect the poorest. Although these subsidies are not particularly well targeted for the poor, their significant reduction could increases the prices of consumption goods in general. To mitigate these risks, the Benazir Income Support Program (BISP) is the countrys primary pro-poor federal expenditure program.

37. The Governments move to increase the cash benefit amount, within a constrained fiscal space, is a step in the right direction in enhancing the BISP basic cash transfers impact on poverty. Furthermore, the Government is considering ways to index the cash transfers amount so as to protect it from possible erosion from inflation. Budget releases to BISP tended to be insufficient in amount and were characterized by lack of predictability in timing. This forced BISP to ration benefit payments, which resulted in a sizable portion of the eligible beneficiaries not receiving the full annual benefit amount they were entitled to. For the current fiscal year, the Government has taken cognizance of this problem and has improved the budget releases. For the first two quarters of the FY2013-14, the Finance Division released the full quarterly amount (PRs. 18.75 billion) and allowed BISP to make full payments to all eligible beneficiaries. However, in both quarters, releases arrived late. To prevent recurrence of these problems, the Finance Division has decreed a special procedure committing to release exactly one quarter of the annual appropriation by the 15th of the middle month of each quarter. BISP will also expand modern, debit-based technology-based payment methods. Finally, BISP has successfully piloted a co-responsibility cash transfer (CCT) scheme in 5 districts and will expand it to additional 15 districts throughout the nation. Management of the schools systems is a provincial responsibility assigned in the Constitution and therefore the verification of the CCT co-responsibility requires collaboration by the provincial education departments. In this regard, the Government has obtained an explicit high-level endorsement of the Memorandum of Understanding (MOUs) by the chief secretary in each province and BISP plans to further expand the coverage of CCT to more districts.

38. Results. The number of unconditional cash transfer beneficiaries who received full benefits is at least 5.5 million in June 2016.In addition, 25 districts will pilot CCTs for education, thus opening the door for mainstreaming such mechanisms nationwide.

Under Actions 1.5-18 of DPC-I, the Ministry of Finance has approved the FBR Strategy Paper containing a comprehensive tax reform strategy; and consistent with it, the Federal Board of Revenue has refrained, since July 1, 2013, from issuing statutory regulatory orders granting special tax exemptions. The Federal Board of Revenue, as part of the implementation

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of the FBR Strategy Paper, has: (i) issued at least seventy thousand (70,000) notices to potential tax evaders to register and file tax payments; and (ii) undertaken provisional tax assessments of at least eight thousand (8,000) individuals. The Federal Board of Revenue, as part of the implementation of the FBR Strategy Paper, has: (i) launched an information technology-based Taxpayers Audit Monitoring System; (ii) undertaken ballot-based audits of at least five (5) percent of total tax returns filed for tax year 2012; and (iii) completed at least twenty-five (25) percent of such audits. The Federal Board of Revenue, as part of the implementation of the FBR Strategy Paper, has: (i) published the Parliamentarians Tax Directory; and (ii) issued national tax numbers to all members of the Senate, the National Assembly, and the Provincial Assemblies, and disclosed their respective tax payments.

Under Actions 2.6-2.9 of DPC-II, MoF will have obtained Parliamentary approval of a

budget 2014/15 including (i) a tax expenditure annex; (ii) a set of tax exemptions and SROs eliminated, and additional tax measures for a total revenue impact equivalent to no less than 0.7% of GDP; (iii) a policy statement prohibiting FBR from issuing any special exemptions, other than those approved by the Federal Government, and committing the Federal Government to place all its SROs issued or planned in any given financial year before the National Assembly for ratification or withdrawal; and of (b). amendments of the corresponding tax laws to permanently eliminate the discretion of the Federal Board of Revenue to issue special tax exemptions, making an proposed tax exemption subject to overall parliamentary approval as part of the annual budget low or/and the corresponding tax legislation. FBR will have issued 120,000 notices to identified potential tax evaders to register and file tax payment, and taken administrative and/or legal actions on at least 25 % of the potential taxpayers who received notices by 31 March 2014, but failed to respond to them. (c) FBR will have selected at least 7.5 % of large taxpayers (filed for tax year 2013) through ballot- or risk-based audits, and initiated audits for at least one-quarter of those selected cases. And (d) Federal Government will have provided support to provinces initiative to increase revenue either by expanding the scope of services taxed by the General Sales Tax (GST) or modifying other provincial taxes; so as to increase by no less than 20% the budget 2014/15 allocations to non-salary education and health spending.

39. Creating fiscal space with revenue mobilization. The creation of fiscal space, through mobilizing revenue preferably without raising tax rates and while protecting priority budget for social programs benefitting the poor, is the single most important precondition for achieving sustainable growth with equity (Annex 10). Insufficient fiscal space stems from poor revenue collection at one end and inflexibility of government expenditure at the other. Low revenue mobilization limits the governments options to stabilize the economy against undesirable expenditure controls that ultimately constrain it from making necessary pro-growth public investments. Moreover, additional fiscal resources should not be wasted but prioritized to protect vulnerable segments of the population from the fallout of stabilization and structural reforms that the government intends to undertake to put the economy on a higher growth trajectory. Creation of fiscal space relies mostly on the governments strong fiscal consolidation effort, which would bring down the fiscal deficit from 8 percent of GDP in 2012/13 to about 4 percent by 2015/16. As cutting priority expenditure is undesirable from a growth perspective, achieving this goal hinges critically on fresh revenue mobilization, mainly by widening the tax base: broadly, the tax-to-GDP ratio should increase by about 0.75 percent of GDP a year over the next three years.

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40. There are well-known inherent structural weaknesses in the tax system. These include: (a) inefficient tax administration (no clear vision, high key staff rotation, poor management, weak human resources, lack of adequate information technology support systems, excessive scope for staff discretion and for rent seeking); (b) a narrow tax base (of 39.4 million employed persons, fewer than 10 percent are registered and active taxpayers are further eroded by numerous and generous exemptions and concessions); (c) skewed tax structure (68 percent of tax revenue is from indirect taxes); (d) a complex and nontransparent tax system that favors exemptions (tax expenditure is estimated at around 2 percent of GDP), corruption, and tax evasion (low compensation of tax officials, high informal sector of the economy by international standards); and (e) low revenue collection efforts by the provinces. In response, the revenue mobilization component of the DPC focuses on expanding the tax base and on strengthening registration, tax enforcement, and compliance.

Table 4. Fiscal Impact Under FSIGs and Power DPCs-supported Actions in FY13/14

Estimate in % GDP I. POWER TARIFFS 1.2 Tariff adjustment (FY13/14) 0.8 Tariff adjustment (FY14/15 ) 0.4 II. TAX POLICY 1.5 Eliminate exemptions and SROs (income, GST and Customs) 0.4 Other FY14/15 tax policy measures to broaden tax base 0.3 Customs tariff simplification to 6 slabs -0.1 GST scope expansion by provinces 0.2 Others (FBR & IMF-supported tax policy measures in FY13/14) 0.7 III. TAX ADMINISTRATION 0.2 Customs administration 0.1 Expanding Income Tax