Report and Recommendation of the President to the Board of Directors

Sri Lanka Project Number: 42163 June 2009

Proposed Loans for Subprogram 2 Islamic Republic of Pakistan: Accelerating Economic Transformation Program

CURRENCY EQUIVALENTS (as of 19 May 2009)

Currency Unit – Pakistan rupee/s (PRs)

PRe1.00 = $0.012316 $1.00 = PRs81.2

ABBREVIATIONS

ADB – Asian Development Bank ADF – Asian Development Fund AETP – Accelerating Economic Transformation Program AETP1 – Subprogram 1 of the AETP AETP2 – Subprogram 2 of the AETP AML – Anti-money laundering API – Agricultural Policy Institute BISP – Benazir Income Support Program CFT – countering the financing of terrorism CNIC – computerized national identity card CPPA – Central Power Purchasing Agency DISCO – power distribution company ECC – Economic Coordination Committee FATA – Federally Administered Tribal Areas FATF – Financial Action Task Force on Money Laundering FMU – Financial Monitoring Unit FY – fiscal year GDP – gross domestic product GENCO – public sector generating company IADI – International Association of Deposit Insurers IMF – International Monetary Fund IPP – independent power producer KSE – Karachi Stock Exchange LIBOR – London interbank offered rate MIS – management information system MOF – Ministry of Finance NADRA – National Database and Registration Authority NBFC – nonbank finance company NEPRA – National Electricity Power Regulatory Authority NTDC – National Transmission and Dispatch Company OCR – ordinary capital resources OMC – oil marketing company PASSCO – Pakistan Agricultural Storage and Supplies Corporation PCO – Population Census Organization PEPCO – Pakistan Electric Power Company PPAF – Pakistan Poverty Alleviation Fund PRSP II – second poverty reduction strategy RSPN – Rural Support Program Network SBA – standby arrangement SBP – State Bank of Pakistan SDR – special drawing rights SECP – Securities and Exchange Commission of Pakistan TA – technical assistance TFC – term finance certificate WAPDA – Water and Power Development Authority

NOTES

(i) The fiscal year (FY) of the Government ends on 30 June. FY before a calendar

year denotes the year in which the fiscal year ends, e.g., FY2007 ends on 30 June 2007.

(ii) In this report, “$” refers to US dollars.

Vice-President X. Zhao, Operations 1 Director General J. Miranda, Central and West Asia Department (CWRD) Country Director R. Stroem, Pakistan Resident Mission (PRM), CWRD Sector Director R. Subramaniam, Financial Sector, Public Management, and

Trade Division, CWRD Team leader D. Kertzman, Principal Financial Sector Specialist, CWRD Team members Agriculture A. Kelly, Principal Rural Development Economist, CWRD Energy A. Aleem, Project Implementation Officer (Energy), PRM,

CWRD M. Endelman, Principal Financial Sector Specialist, CWRD F. C. Kawawaki, Principal Energy Specialist, CWRD Fiscal and Macroeconomics S. Parvez, Economist, PRM, CWRD D. Rehm, Senior Economist (Fiscal Management), CFWM Legal C. Png, Counsel, Office of the General Counsel Program Design Support S. Paracha, Programs Officer, PRM, CWRD

L. Raquipiso, Economics Officer, CWRD Social Safety Net M. Van der Auwera, Social Security Specialist, CWRD

In preparing any country program or strategy, financing any project, or by making any designation of or reference to a particular territory or geographic area in this document, the Asian Development Bank does not intend to make any judgments as to the legal or other status of any territory or area.

CONTENTS Page

LOAN AND PROGRAM SUMMARY i

I. THE PROPOSAL 1 II. BACKGROUND 1 III. MACROECONOMIC DEVELOPMENTS AND PROSPECTS 3

A. Overview 3 B. The Government’s Policy Response to the Challenges 5

IV. THE SECTOR 7 A. Issues and Opportunities 7 B. Achievements under Subprogram 1 and Lessons Learned 11 C. External Assistance and Development Partner Coordination 14

V. THE PROPOSED PROGRAM 15 A. Impact and Outcome 15 B. Outputs and Activities 15 C. Special Features 18 D. Financing Plan 19 E. Implementation Arrangements 19

VI. SUBPROGRAM BENEFITS, IMPACTS, ASSUMPTIONS, AND RISKS 21 A. Benefits and Impacts 21 B. Risks and Mitigating Measures 21

VII. ASSURANCES 22 VIII. RECOMMENDATION 23

APPENDIXES 1. Design and Monitoring Framework 24 2. Updated Fiscal Note 27 3. Government’s Development Policy Letter 32 4. Policy Matrix 36 5. IMF Macroeconomic Assessment 42 6. Benazir Income Support Program 43 7. Wheat Marketing Reforms 48 8. Updated Energy Sector Briefing Note 51 9. Power Sector Circular Debt Resolution Plan 53 10. Financial Sector Briefing Note 59 11. Development Partner Matrix 66 12. List of Ineligible Items 67 13. Summary Poverty Reduction and Social Strategy 68

LOAN AND PROGRAM SUMMARY Borrower Islamic Republic of Pakistan

Proposal The proposal comprises (i) a loan of $350 million from ADB’s ordinary capital resources (OCR), and (ii) a loan of $150 million equivalent from ADB's Special Fund resources (ADF) for the second subprogram of the Accelerating Economic Transformation Program (AETP). The AETP is a program cluster that supports short- and medium-term reform actions for restoring macroeconomic stability in Pakistan following the global economic and financial crisis of 2008.

Classification

Targeting classification: Targeted intervention—Household Sector (subsector): Public sector management (energy sector development; economic and public affairs management; social protection) Themes (subthemes): Economic growth (promoting macroeconomic stability); Governance (economic and financial governance); Social development (other vulnerable groups) Location impact: National (high impact)

Environment Assessment

Category C. No adverse environmental impact was identified.

Program Rationale Pakistan continues to face a range of macroeconomic challenges. While the food and fuel price shocks of late 2007 and early 2008 have largely dissipated, the economy is likely to be on a slow growth path for the next 2 years at least, because of the general global slowdown. Real gross domestic product (GDP) growth declined to 5.8% in fiscal year (FY) 2008, after averaging at 7% over the 5 years. It is projected to decline to 2.5% in FY2009. On 30 September 2008, ADB’s Board approved the AETP program cluster framework and two loans totaling $500 million for the first subprogram ($200 million ADF and $300 million OCR) (AETP1). AETP1 supported credible measures to (i) cushion the poorest through social safety nets; (ii) move toward market-based wheat pricing; (iii) resolve the long-term circular debt burden in the power sector; (iv) improve risk management in the financial sector; and (v) launch work on medium-term economic transformation. In parallel to AETP1 preparation, the Government sought advice from the International Monetary Fund (IMF) on policy measures to restore macroeconomic stability. Subsequently, IMF’s standby arrangement (SBA) to Pakistan was approved on 24 November 2008 in the amount of $7.6 billion equivalent and $3.1 billion was disbursed. On 30 March 2009, the IMF concluded its first review of the SBA and disbursed $847 million. On 26 March 2009, the World Bank approved the $500 million Poverty Reduction and Economic Stabilization Operation. On 17 April, the Friends of Democratic Pakistan pledged $5.3 billion in support of reforms and investments.

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The proposed second AETP subprogram (AETP2) will help the Government complete short-term stabilization measures. In parallel, ADB will support Pakistan in taking steps for medium-term economic transformation. Future AETP subprograms will focus on implementation, and they will put into effect public–private dialogue mechanisms to transform the economic structure gradually.

Impact and Outcome The AETP will help Pakistan achieve and sustain higher economic

growth in the medium term. The expected outcome of AETP2 is improved prospects for macroeconomic stability and fiscal sustainability through (i) reducing short-term distortions in the agriculture and energy sectors while improving the social safety net for the poor and vulnerable, and (ii) strengthening financial intermediation.

Special Features AETP2 is an integral part of the Government’s macroeconomic

stabilization program. ADB has participated in IMF missions, at the Government’s invitation and with IMF’s consent, to ensure close coordination on the reform agenda. AETP2 supports the empowerment of women under the Benazir Income Support Program (BISP). The amount of $150 million of AETP2 will go to the BISP, whose primary recipients are female heads of the family so that women of poor families can directly access and manage the social safety net benefits. AETP2 also will help women to obtain national identification cards, a precondition to receiving BISP benefits. The national identification card provides women with a legal identity and will enable them to play a greater role in society.

Coordination with Development Partners

ADB continues to be a lead development partner in Pakistan and works closely with the IMF, the World Bank, and other development partners on macroeconomic stabilization measures and other AETP reforms. Thus, the AETP2 agenda is well grounded in ongoing policy support from ADB and other partners, and regular dialogue with them.

Period and Tranching

(i) AETP2 is the second subprogram under a program cluster of up to four single-tranche subprograms.

(ii) AETP1 (covering reforms from June 2007 to September 2008) addressed the food and energy crisis, supported short-term investment climate measures, and launched studies on medium-term structural transformation. This subprogram was approved by the Board on 30 September 2008.

(iii) AETP2 supports measures taken during October 2008 to June 2009 on short-term social safety net, electricity debt resolution, and risk management in the financial sector. Moreover, the Government—given its present focus on short-term crisis management—needs more time before reform steps can be agreed for structural transformation.

(iv) Future subprograms will focus on structural transformation, based on work underway since mid-2008. The decision to proceed is subject to resource needs, and reform commitment

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and progress. It is likely that two more subprograms may be needed to institutionalize effective public–private partnerships for economic transformation.

Financing Plan The proposed loans for AETP2 are:

(i) A loan of $350 million from ADB’s OCR under the London interbank offered rate (LIBOR)-based lending facility. The loan will have a 15-year term, including a grace period of 3 years; an interest rate to be determined in accordance with ADB’s LIBOR-based lending facility; a commitment charge of 0.15% per annum; and such other terms and conditions as set forth in the draft loan agreement.

(ii) A loan of $150 million equivalent from ADB’s ADF, with an interest rate of 1% per annum during the grace period and 1.5% per annum thereafter; a term of 24 years, including a grace period of 8 years; and such other terms and conditions as set forth in the draft loan agreement.

To retain the reform momentum and predictability of financing, the Government has requested that AETP3 be processed in December 2009 for possible approval in the second quarter of 2010. Subject to reform progress and financing requirements, subsequent subprograms could each be in the range of $400 million–$500 million, putting the AETP program cluster’s aggregate in the range of $1.8 billion–$2 billion. The scope and amounts for each subprogram will be finalized during the review and processing of the respective subprogram.

Counterpart Funds The Government will ensure that the local currency generated from the

proceeds of the OCR loan will be used first to support the adjustment costs of reforms to be initiated and implemented under AETP2, and second to finance expenditures for the Government’s general development purposes. The Government will ensure that the local currency generated from the proceeds of the ADF loan will be used to support poor and vulnerable families that qualify via the new targeting scorecard method under the BISP set forth in output 1 of AETP2.

Executing Agency The Ministry of Finance (MOF) will be the Executing Agency for

AETP2.

Implementation Arrangements

MOF will coordinate with the relevant ministries and agencies on the AETP2 reforms, and it will help ensure that the reform agenda stays on course. In coordination with MOF, the State Bank of Pakistan (SBP) will handle implementation of actions relating to the financial sector. The Government will ensure that other regulatory agencies or ministries are consulted as required. ADB will closely monitor program implementation to ensure that envisaged outputs and outcomes are achieved.

Procurement and Loan proceeds will be used to pay for items procured in ADB member

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Disbursement countries, other than the items specified in the negative list of ineligible items and imports financed by other bilateral and multilateral sources. The proceeds of the program loan will be disbursed in accordance with the provisions of ADB’s simplified disbursement procedures and related requirements for program loans. Loan proceeds disbursed against imports will require a certificate from the Government stipulating that the value of Pakistan’s total imports, minus its imports from nonmember countries, ineligible imports, and imports financed under other official development assistance, is equal to or greater than the amount of the loan expected to be disbursed during a particular year. ADB reserves the right to audit the use of loan proceeds to verify the accuracy of the Government’s certification.

Program Benefits and Beneficiaries

AETP2 will provide the following benefits: (i) Assist the Government to meet the large and immediate fiscal

needs. (ii) Help the Government to transition from the current system of

inefficient and untargeted subsidies toward a targeted safety net program for the poor, with a focus on women. The new federal social safety net program, the BISP, is expanding its coverage from 3.5 million families in FY2009 to 5 million families in FY2010 and aims to target up to 7 million families by FY2011. Benefits are paid to female heads of families.

(iii) Raise public confidence in the banking system by strengthening regulation and supervision of the sector.

(iv) Open the way for structural transformation. (v) Enable ADB to sustain policy dialogue on structural reforms in

sectors where ADB has been actively involved through past and current investments.

Risks and Assumptions

While some of the risks to AETP2 are political and outside its scope, its design will mitigate a range of others, including the following: (i) Interest group resistance and poor intergovernment

coordination. Those adversely affected by reforms in the short-term are likely to resist. The Government has improved inter–ministerial and agency coordination and information-sharing to communicate reform measures more effectively than in the past. Further, the single tranche structure of the AETP subprograms ensures prior actions by the Government before financing is provided, and engagement through a program cluster ensures sustainability of such actions.

(ii) Weak capacity. This is a generic concern which is elevated in the case of complex reforms. Technical assistance is helping to address this concern over the shorter term. Moreover, there is strong ownership for reforms since the agenda under the AETP is also largely home-grown.

(iii) Weak fiduciary controls. With large amounts of safety net needs and assistance, it is vital to design and execute the BISP in a fully transparent and accountable manner. The World Bank

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is providing a dedicated project, backed up by financing support; and ADB has worked closely with the Government and World Bank, particularly to strengthen financial management systems.

(iv) Global financial crisis. AETP measures are predicated on a global recovery. While the program cannot influence global events, it can help cushion Pakistan against exogenous shocks.

At the same time, the risks associated with not supporting macroeconomic stability, fiscal sustainability, and Pakistan’s social safety net programs are very high. In the absence of timely reforms, the Government’s budget would be continually burdened by costly and inefficient subsidies, leaving far less resources for development financing. The financial sector would be vulnerable to systemic risks. High and persistent macroeconomic imbalances would constrain investments and economic growth while aggravating poverty. The underlying assumptions for AETP2 include (i) strong and sustained leadership and commitment to reforms, (ii) development partner coordination, and (iii) open dialogue with the private sector and other key

stakeholders.

I. THE PROPOSAL

1. I submit for your approval the following report and recommendation on two proposed loans to the Islamic Republic of Pakistan for the second subprogram of the Accelerating Economic Transformation Program (AETP).1

II. BACKGROUND

2. Pakistan’s economy suffered serious shocks in 2007–2008 due to skyrocketing international prices for oil and food. The severity of the exogenous shocks, aggravated by uncertainties surrounding the political transition in much of 2008, was felt on several fronts. Overall domestic inflation rose sharply to a year-on-year rate of 21.5% in June 2008 from 7% in June 2007. External accounts deteriorated, with the current account deficit widening to 8.3% of gross domestic product (GDP) from 4.8%. The Pakistan rupee depreciated, and gross foreign exchange reserves declined by more than 40% to $8.6 billion (about 2.7 months of imports) by June 2008. On the fiscal front, there were unprecedented needs for fuel, food, and electricity subsidies, which rose fourfold to PRs408 billion ($6 billion) from their originally budgeted level. Symptomatic of declining investor confidence, the Karachi stock index dropped by more than 35% during April–July 2008, and the international perception of the possibility of sovereign default dramatically increased as evidenced by the yield for 10-year sovereign bonds which rose from less than 10% per annum at the beginning of 2008 to more than 25% per annum in October 2008. The outcome was a decline in real GDP growth to 4.1% in FY2008 from 6.8% for the previous year, with signs of a much steeper decline during the current fiscal year. 3. Against this backdrop, the Government requested ADB and other international development partners to provide exceptional financial assistance. The Government and ADB designed the AETP to mitigate the adverse short-term impact of the spiraling food and fuel prices while helping Pakistan to address some of the more fundamental challenges constraining faster growth. The Government developed a four-point stabilization plan2 which later formed the basis of a standby arrangement (SBA) with the International Monetary Fund (IMF) that was approved in November 2008. During July–September 2008, ADB undertook extensive consultations with the IMF, the World Bank, and other key bilateral partners to formulate the reform measures as well as to determine the budget support. Through an advisory mission launched at the Government’s request, an IMF team worked out various funding scenarios during August–September 2008. It found that Pakistan needed exceptional financing support to shore up its international reserves; restore macroeconomic stability; and ensure essential social, nondiscretionary, and critical development expenditures. The reforms initiated through the AETP in 2008 and the budget support aim to

(i) expand and deepen social safety nets for the poor, (ii) remove wheat pricing and procurement distortions, (iii) bring power tariffs in line with costs and settle long-standing accumulated debt

in the power sector, given the overhang of inter-corporate receivables at $5 billion (2.9% of GDP),

(iv) improve risk management in the financial sector, and (v) diversify Pakistan’s economy to increase the relative size of the industrial

sector while boosting exports and creating jobs. 1 The design and monitoring framework is in Appendix 1. 2 ADB. 2008. Report and Recommendation of the President to the Board of Directors on the Proposed Program

Cluster and Loans for Subprogram 1 to the Islamic Republic of Pakistan Accelerating Economic Transformation Program. Manila (September). See also Box 1).

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4. Following approval by ADB’s Board of Directors for the first subprogram of AETP (AETP1) on 30 September 2008, $500 million was disbursed on the same day to meet urgent requirements and enable the Government to fulfill one of the key conditions in the stabilization plan of reducing borrowing from the State Bank of Pakistan (SBP). The local currency generated from the proceeds of the AETP1 loans financed, among other things, key social safety net programs to cushion the impact of the food and fuel crisis on the poor. More generally, the AETP is an integral part of the financing plan that has emerged as part of the agreement between the Government and the IMF. It was designed as a program cluster comprising up to four subprograms that support short- and medium-term reforms. The proposed AETP2 carries forward the reforms initiated last year in a seamless manner, and it will provide $500 million in budget support to enable Pakistan to meet its urgent social and developmental needs in FY2009. 5. IMF’s 23-month SBA was approved in November 2008 for $7.6 billion equivalent, and $3.1 billion was disbursed immediately to shore up Pakistan’s foreign exchange reserves. The SBA aims to restore macroeconomic stability and confidence while achieving social stability and adequate support for the poor. ADB has been closely involved in the IMF dialogue and monitoring and has participated in the review process. On 30 March 2009, the IMF completed the first review of Pakistan’s economic performance under the SBA. An amount equivalent to SDR568.5 million (about $847 million) was subsequently disbursed, bringing total SBA disbursements to date to an amount equivalent to SDR 2.64 billion (about $3.95 billion). Pending completion of the second review of the SBA, and following the submission of the 2009/10 budget to the Parliament, the IMF will release the next tranche under the SBA.

Table 1: IMF Program Structural Performance Criteria, Status as of April 2009 Targets and Conditions Status 1. Increase State Bank of Pakistan (SBP) discount rate by 200 basis points Implemented 2. Increase electricity tariffs by an average of 18% Implemented 3. Quarterly issuance of treasury bills and publication of the expected volume Underway 4. Submission of amendments to the banking legislation to Parliament to enhance the effectiveness of SBP enforcement powers in the area of banking supervision

Expected by June 2009

5. Submission by the Government of draft legislative amendments to Parliament to harmonize the income tax and general sales tax laws, including for tax administrative purposes, and to reduce exemptions for both taxes

Expected by June 2009

6. Preparation of contingency plan for handling problem private banks Implemented 7. Adoption of an action plan for reforms in the area of tax administration, including harmonization of the general sales tax and income tax administration

Ongoing

8. Finalization of the schedule for further electricity tariff adjustments and elimination of tariff differential subsidies

Finalized schedule for tariff adjustments implemented. Plan to end subsidies by June 2009.

9. Elimination of the SBP’s provision of foreign exchange for furnace oil Implemented 10. Adoption of a strategy and time-bound action plan for adopting specific measures to strengthen the social safety net and improve targeting to the poor

Implemented (March 2009)

11. Preparation of a plan for eliminating the intercorporate circular debt in the power sector

Ongoing

12. Transition to a single treasury account Expected in June 2009 SBP = State Bank of Pakistan. Note: Measures in boldface complement AETP2 reforms. Source: International Monetary Fund.

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6. On 26 March 2009, the World Bank approved the Poverty Reduction and Economic Stabilization Operation in the amount of $500 million through an interest-free International Development Association credit. This operation complements the short-term policy reform agenda initiated under AETP1 and provides budget support to the social safety net and for meeting other needs.

III. MACROECONOMIC DEVELOPMENTS AND PROSPECTS

A. Overview3

7. Real GDP growth dropped to 4.1% in FY2008 after 5 years of averaging near 7%. Significant factors constraining growth have been a sharp decline in the growth of private investment due to political uncertainty, a worsening security situation, and the impacts of high international oil prices and frequent power shortages. The contribution of investment to growth fell to just 0.7 percentage points in FY2008 compared to 2.7 percentage points in the preceding fiscal year. The contribution of net exports to growth turned negative, especially due to the oil price hike and continued slowdown in textile exports, and the manufacturing sector’s contribution is expected to turn negative for the current fiscal year. 8. When combined with the failure to align domestic prices with international prices, the oil price shock and high wheat import price led to a massive buildup of unbudgeted and untargeted subsidies and resulted in a fiscal deficit for FY2008 of 7.6% of GDP—the highest in 9 years. Also, interest payments on Defense Savings Certificates, which were issued in the 1990s with high interest rates, steeply increased interest costs and contributed to the larger deficit. In the absence of additional foreign inflows (e.g., investments and remittances), the deficit had to be financed mainly through domestic borrowing from the SBP. Development spending was compressed relative to that planned in the budget to offset some of the impact from the untargeted subsidies. The tax-to-GDP ratio came in at 10.6%, more than half a percentage point lower than projected in the budget. 9. Subsidies on oil, food, fertilizer, and power contributed to the budget deficit but failed to contain inflation as food prices soared and the price of fuel was adjusted upward in the last 4 months of FY2008. Steep rupee depreciation stoked inflationary pressures as did financing of the expanding deficit through borrowing from the SBP. The consumer price index on a year-on-year basis climbed to 21.5% in June 2008 and to 25.3% in August, which was the highest in 30 years. Core inflation also increased. As food prices rose sharply (by 32% in June 2008 year-on-year), the poorest groups in society were hardest hit. With declining international commodity prices and a slowing domestic economy, the year-on-year consumer price index fell to 20.5% and food inflation to 21.6% in January 2009. Domestic inflation would have fallen by more had the rupee not depreciated by 15.9% against the dollar in the first 7 months of FY2009. 10. Reacting to the rising inflation and the sharp increase in imports, SBP tightened monetary policy three times in FY2008 for a cumulative rise in its discount rate of 250 basis points. That rate climbed by another 300 basis points to 15% (the highest in South Asia) by November 2008 under the IMF program as inflation persisted, the drain on reserves continued, and the Government sought to reduce its SBP borrowings by making treasury bills more attractive to commercial banks. By April 2009, inflation had slowed to less than 17.2%,

3 This section draws from the chapter on Pakistan in ADB. 2009. Asian Development Outlook 2009: Rebalancing

Asia’s Growth. Manila. That information is updated with more recent figures, where available. See also Appendix 2 which includes an updated fiscal note.

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compared with the record 25% level in the last quarter of 2008. This enabled the SBP to reduce the discount rate by 100 basis points. 11. The fiscal deficit is expected to decline to 4.3% of GDP in FY2009, as the Government has removed or reduced subsidies and rationalized development expenditure. It already has fully eliminated the subsidy on petroleum products and is undertaking a phased reduction in the electricity subsidy, with the target to terminate this subsidy by the end of FY2009. A reprioritization of projects is expected to lead to a slashing of the development budget by over PRs100 billion for FY2009. The Government has also frozen supplementary grants to various departments to infuse greater fiscal discipline. Fiscal performance for June 2008–March 2009 suggests that the annual target is achievable. While the slowdown in economic activity in response to the global financial crisis has reduced revenue growth below earlier projections, reflecting in part lower sales tax revenues with the decline in imports, revenue from the petroleum development levy and compressed expenditures will hold the deficit to the targeted 4.3% for FY2009. 12. Growth is expected to slow to 2.0% in FY2009 due to the global slowdown, the Government’s tight demand management policies, and infrastructure deficits. GDP growth could rise to about 3.0% in FY2010. But there are considerable downside risks, including the worsening security situation. Table 2 presents some key macroeconomic indicators, and Table 3 presents the medium-term fiscal framework indicators.

Table 2: Key Macroeconomic Indicators

Indicator 2005 2006 2007 2008 2009a 2010a Real GDP growth (%) 9.0 5.8 6.8 {4.1} {2.0} {3.0} Inflation (%, average for period) 9.3 7.9 7.8 12.0 {21.0} {9.5} M2 growth (% annual growth) 19.3 14.9 19.3 15.3 {9.4} {12.2} External debt (% of GDP) 31.1 28.2 27.1 {26.7} {26.2} {26.0} External debt service ratio (% of

exports of goods and services) 14.9 13.8 12.9 {15.0} {21.5} {22.2}

Total debt (% of GDP) 64.3 58.8 54.1 {58.4} {55.2} {55.1} Overall fiscal balance (% of GDP) (3.3) (4.3) (4.3) {(7.6)} (4.3) {(4.6)} Current account balance (% of GDP) (1.6) (3.9) (4.8) {(8.3)} {(5.3)} {(5.1)} Exchange rate (PRs per $) 59.4 59.9 60.6 62.6 — — Gross official reserves with State

Bank of Pakistan ($ million) 9,791 10,760 13,345 {8,591} {9,850} {12,023}

in months of imports 6.3 5.2 5.9 {2.7 } {3.3} {3.7} ( ) = negative, GDP = gross domestic product, M2 = broad money supply, PRs = Pakistan rupees. a Projections. Sources: Economic Affairs Wing, Finance Division, Government of Pakistan. 2008. IMF Assessment Letter June 2009. Pakistan Economic Survey 2007-08. Islamabad; Federal Bureau of Statistics. 2007. Pakistan Statistical Yearbook 2007. Islamabad; World Bank. 2009. Program Document for a Proposed Poverty Reduction and Economic Support Operation. Washington, DC; International Monetary Fund. 2009. Article IV Consultation and First Review under the Standby Arrangement—Staff Report. Washington, DC.

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Table 3: Consolidated Fiscal Framework (% of GDP) Indicator 2005 2006 2007 2008 2009a 2010a Total revenue (less grants) 13.8 14.2 14.9 14.6 {14.7} {14.5} Tax revenue 10.1 10.6 10.2 10.6 — — Nontax revenue 3.7 3.6 4.7 4.0 — — Total expenditure 17.2 18.5 19.2 22.2 {19.0} {19.1} Current expenditure 13.3 13.6 15.8 18.1 — — Of which: subsidies 1.0 1.3 1.2 3.9 — — Of which: interest payments 3.4 3.4 4.2 4.8 — — Development expenditure and net lending 3.5 4.8 4.8 4.1 — — Overall Fiscal Balance (less grants) (3.3) (4.3) (4.3) (7.6) (4.3) {(4.6)} Financing Fiscal Deficit 3.3 4.3 4.3 7.6 4.3 {4.6} External Financing 1.9 2.0 1.7 1.4 1.7 {2.2} Internal Financing 1.0 1.0 2.0 6.2 2.7 2.2 Bank 0.9 0.9 1.2 5.0 1.5 — Nonbank 0.1 0.1 0.9 1.2 1.2 — Privatization Proceeds 0.4 1.3 0.6 0.0 0.0 0.2 ( ) = negative, GDP = gross domestic product. a Projections. Sources: Economic Affairs Wing, Finance Division, Government of Pakistan. 2007. Pakistan Economic Survey 2006-07. Islamabad; Economic Affairs Wing, Finance Division, Government of Pakistan. 2008. Pakistan Economic Survey 2007-08. Islamabad; State Bank of Pakistan. Annual Report 2006/07. Karachi; World Bank. 2009. Program Document for a Proposed Poverty Reduction and Economic Support Operation. Washington, DC; International Monetary Fund. 2009. Article IV Consultation and First Review under the Standby Arrangement—Staff Report. Washington, DC.

13. The banking system remains relatively well capitalized, but gross nonperforming loans have increased from 7% in 2007 to about 9.1% of all loans and banks’ profitability has declined by about 24% from the previous year (reflecting in part the mounting provisioning requirements in response to the rise in nonperforming loans). Domestic pressures and the global financial crisis have led to greater dollarization and a continued outflow from the system, which contributes to deteriorating liquidity conditions. In response to liquidity pressures, in October 2008 the SBP reduced the reserve requirement by 4 percentage points and eased liquidity requirements. To ease the strains on banks and other deposit institutions, the SBP slowed a mandated rise in paid-in capital for 2013 from a planned PRs23 billion to PRs10 billion (with an annual increase of PRs1 billion per year from 2009 through 2013). The capital adequacy requirement of 10% has not been affected. 14. The crisis had a major impact on financial markets, with the Karachi stock index plunging by 57% in 2008. To halt the steep decline, the Karachi Stock Exchange Board imposed a floor on stock prices in August 2008. This was eliminated in December. To revive the market after the floor was lifted, the National Investment Trust (the government-owned and largest money manager in Pakistan) invested about PRs7 billion into the PRs20 billion State Enterprise Fund, which is investing in the stock market. The market subsequently rallied and has bounced back to precrisis levels. Increased confidence and improved terms of trade have helped stabilize the rupee at around PRs80 to the dollar since October 2008 and enabled the SBP to rebuild its gross international reserves. B. The Government’s Policy Response to the Challenges 15. Immediate Priorities and Challenges. Macroeconomic stabilization is critical, as fiscal policies—particularly regarding subsidies—have left scant resources for countercyclical fiscal measures to address the downturn. Under the IMF program, the Government will address the issues that undermine flexibility and macroeconomic stability. The budget deficit target for FY2009 (4.3% of GDP) is sharply lower than the 7.4% deficit realized for FY2008 but remains

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above the 4% mandated under Pakistan’s Fiscal Responsibility Act (2005). The initial target for FY2010 of 3.4% was well within the authorized range, but it may be raised to accommodate increased external support in the wake of rising requirements for social spending and displaced persons. In this context, policy measures will focus on creating fiscal space by reducing subsidies, increasing revenues, and, at the same time, strengthening the social safety net. There are four key challenges. First, untargeted subsidies are the main threat to fiscal instability: in FY2008, untargeted subsidies for power, oil, wheat, and fertilizer expanded to nearly four times their budgeted amounts (about 3.9% of GDP versus 1.1%). Second, Pakistan’s interest payments are high by historic standards and are expected to remain at 4%–5% of GDP through FY2011. Third, Pakistan’s tax revenues have consistently been among the lowest in the region at about 10% of GDP. Finally, development expenditures rose from about 2.7% of GDP in FY2003 to nearly 5% of GDP by FY2007. Sustaining this trend will require resources that Pakistan does not have, reflecting capital inflows that are no longer available. 16. FY2009 Federal Budget. Despite the continued global financial turmoil and attendant slowdown in economic activity, the Government aims for a much smaller budget deficit. About 2.5 percentage points of the decrease are to come from lower expenditures, with the reduction in subsidies contributing to an overall expected decrease in fiscal spending equivalent to about 1.6% of GDP. The Government eliminated the oil subsidy by December 2008 and has committed to monthly adjustments to pass along the benefits of the oil price decline to consumers. The differential power subsidy has been reduced and will be eliminated by the end of the current fiscal year. In addition, a freeze on non-salary spending was imposed in government departments to curtail current expenditures. 17. Maintaining public sector development spending at the FY2008 nominal level amounts to a reduction from about 4.3% of GDP in FY2008 to just over 3% of GDP for FY2009. The remaining 1.8% of the decrease in the deficit for FY2009 reflects near-term measures to boost revenues, including administrative measures, higher general sales tax, and increased luxury import taxes. While tax revenues posted a considerable increase for the first half of FY2009, this reflected in part the contribution of the petroleum development levy, offsetting lower than expected direct and indirect tax receipts. The stabilization targets announced by the Government in the budget and the planned reduction in the fiscal and current account deficits are important to reinforce sustainable growth. There are risks, however, that continued global economic and financial crisis will impact on economic activity and revenue flows. 18. FY2010 budget targets include allowing the deficit to move to 4.6% of GDP, reflecting increased external support, particularly for safety net provisions for the internally displaced persons. Further spending compression is limited, as lower current spending from the full-year elimination of subsidies may be offset by the need to increase public sector development spending. Revenues are expected to remain broadly unchanged as a share of GDP as improvements in revenue policy and administration largely offset the impact of sustained slow real growth. This is supported by additional administrative measures, including reduced tax exemptions. 19. Medium-Term Context. Pakistan’s strategic priorities are set out in Vision 2030,4 which identifies the need for structural change and transformation to achieve a developed, industrialized, just, and prosperous Pakistan. The second Poverty Reduction Strategy Paper5 includes the development of an internationally competitive industrial base as a key strategic

4 ADB. 2009. Country Partnership Strategy (2009–2013): Pakistan. Manila. 5 Government of Pakistan. 2009. Poverty Reduction Strategy Paper II. Islamabad.

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pillar. Over the short term, structural transformation requires sound fiscal policy with removal of economic distortions while providing an adequate social safety net for the poor and vulnerable, as well as efficient financial intermediation. These objectives are the focus of AETP2, which will help create the necessary preconditions for structural transformation.

IV. THE SECTOR

A. Issues and Opportunities6

20. Targeted Safety Net Intervention. Based on the latest poverty assessment for Pakistan (FY2006), nearly a quarter of the population remains poor and a significant part of the population is clustered around the poverty line. The recent global food, fuel, and financial crises are expected to increase poverty unless appropriate policy measures are taken to protect poor and vulnerable families from these adverse shocks. The BISP was created in October 2008 as the new major social safety net program. It focuses on poor women. The program targeted coverage for up to 3.5 million families during the first year, providing a cash grant of PRs1,000 per month to eligible families whose monthly income is less than PRs6,000. Given the spiraling inflation and the severity of the crisis, the Government wanted to get the BISP launched quickly. For this, the BISP distributed 8,000 forms to each federal parliamentarian (members of the National Assembly and senators) for distribution to eligible families in their constituencies based on 13 criteria. Verification of eligibility and payments to eligible families was contracted by BISP to existing organizations. The National Database and Registration Authority (NADRA) was used to verify the eligibility of applicants. Pakistan Post was contracted to deliver benefit payments through money orders to the homes of verified applicants upon production by the female head of the family of her computerized national identity card (CNIC). As of 30 April 2009, 3 million beneficiaries have been identified under the BISP. Of these, 1.8 million have been declared eligible by NADRA. PRs11 billion in payments have been delivered to eligible families on a retroactive basis (from October 2008, the date of BISP establishment). 21. The separation of the management (BISP), beneficiaries identification (politicians and poverty scorecards), and payment benefits delivery (Pakistan Post) functions under the BISP is intended to guard against misuse and leakages. In line with program goals, the targeting and verification processes need further review to maximize inclusion of the poor and address coverage issues of the CNIC database, as well as to improve the institutional arrangements for managing the program to effectively engage the various tiers of the Government. AETP1 supported expanding federal cash transfer programs and improved targeting. The World Bank is providing support to the Government to improve social safety net programs, including the BISP.7 22. Untargeted Wheat Subsidies and Inefficient Reserve Management. Wheat is the food staple in Pakistan. Given the large population of poor and low-income earners (small-scale producers and consumers), stabilizing the wheat price has been a long-term Government policy objective. It has adopted a number of interventions involving (i) the wheat procurement price, which is the support price paid to producers, (ii) wheat procurement targets for the Pakistan

6 This section presents changes in each focus area of AETP since September 2008. Otherwise, the background

section presented in the AETP RRP remains relevant. 7 Under the Department for International Development Poverty Reduction Trust Fund, the World Bank is providing

the Government with a $2.5 million technical assistance (TA) grant to help strengthen the BISP program. It will focus on the new scorecard targeting method. The World Bank recently approved a $60 million TA loan focused on better coordination of federal programs, preparation of a national social protection strategy, and the design and implementation of programs. In addition, the World Bank is providing program support through its $500 million Poverty Reduction and Economic Support Operation and $200 million Social Safety Development Policy Credit.

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Agricultural Storage and Supplies Corporation (PASSCO) and the provincial food departments, which is of particular importance to the Punjab province, which accounts for 80% of the country’s production, (iii) a wheat issue price, which is the price used for sale to flour millers which is usually less than the cost of procurement and associated handling and storage charges, and with quota allocations and concessionally priced sales of flour to utility stores, and (iv) import and export controls depending on the country’s production and domestic interprovincial restrictions on movement until provincial targets are achieved. 23. In an average season, Pakistan produces 21 million tons of wheat, of which about 8 million to 9 million tons enters the market. The Government annually procures around 50% to 60% of the market amount, ranging from 3.5 million to 4.5 million tons since 2002. Support for Government interventions in procurement (domestically and through imports by the Trading Corporation of Pakistan) and sale of wheat at issue price to flour millers have required Government subsidies plus investments into state-owned storage facilities, procurement centers, and utility retail stores. Also needed has been easy access to credit from SBP and commercial banks to provide operating capital for procurement agencies. These measures involve substantial government subsidies (federal and provincial) to support wheat producers and consumers. These interventions, while providing some price stability, have not been efficient and are not well targeted to reach the intended beneficiaries. The subsidy cost on imported wheat (1.7 million tons) in FY2008 is estimated at PRs40 billion and in FY2009 the subsidy on wheat imports (2.5 million to 3 million tons) will likely be at a similar level. In addition, significant subsidy costs are incurred by the procurement agencies in selling wheat to flour millers at issue prices that do not reflect full cost recovery. 24. Under AETP1, to reduce the inefficient subsidies, the Government committed to market-based wheat pricing and an efficient reserve management system that included adoption of a time-bound action plan by the national Economic Coordination Committee (ECC).8 The ECC plan includes reforms in the producer procurement price and wheat issue price to flour millers that support a move toward more market-based pricing, a reduction in the scale of procurement undertaken by Government agencies for within-year operational reserves and inter-year strategic reserves, and an anticipated expanded private sector role in wheat marketing and storage. The approach adopted was incremental, reflecting the need to maintain price stability for producers and consumers until better targeted and more efficient safety net programs become fully operational. 25. AETP reforms in this area reflect Pakistan’s experiences in the wheat market during 2007 and 2008, when high and volatile wheat and flour prices caused major food security problems for low-income households and social unrest. While 2008 wheat production was average, the effects of the government procurement policy (and in particular the procurement price) caused a number of distortions. The 2008 procurement price was less than the market price (domestic and export parity price), and during the 2008 season the Government needed to raise the procurement price to PRs625 per 40 kilos. To meet market needs, the Government imported wheat that was sold at a loss to domestic flour millers and imposed export bans and interprovincial restrictions to achieve targets. 26. In September 2008, the Government announced the 2009 wheat procurement price of PRs950 per 40 kilos (to be harvested from April 2009). The higher procurement price has had a positive impact on production and was based on cost of production and international and 8 The ECC is a cabinet-level committee of the Government constituted pursuant to Cabinet Notification No.

5/3/2007-Com dated 2 April 2008. It comprises the Prime Minister, various ministers, and such officers as will be invited (including the chairman of the Securities and Exchange Commission of Pakistan and governor of the SBP).

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regional wheat prices as of September 2008.9 In mid-February 2009, the Government held high level meetings to discuss the 2009 wheat crop, which is forecast at 25 million tons. Based on current storage capacity, the announced large procurement target requires establishing and using temporary storage facilities. To support private sector wheat purchase, the Government is facilitating loan access through commercial banks for flour millers (and this has involved lowering the borrower required equity in for loans to 10%) on terms that are more favorable than in previous years. 27. The wheat issue price to flour millers for the 2009 wheat crop will be set in July 2009. While the issue price is technically set by the provinces, the Government has indicated that the wheat issue price will be based on the procurement price and should include all storage and handling costs incurred. Losses incurred from an issue price below the sum of the procurement price and costs (e.g., for interest and storage) are made up from the provincial budget. The new price will impact on flour prices and is expected to result in a 20% to 30% increase. Appendix 7 provides additional information on wheat marketing reforms. 28. Challenges in the Power Sector. Pakistan suffers from a chronic shortfall between electricity supply and demand.10 This will continue to seriously limit productivity and economic growth until the financial deficits, corporate governance, and technical issues in the power sector are resolved in a sustainable manner. 29. The financial deficit is due to (i) tariffs being inadequate to cover operating costs of power distribution companies (DISCOs), let alone depreciation and a fair return on equity; (ii) nonpayment by government, subsovereign, and private sector customers for electricity consumed; and (iii) the excessive accumulation of debt owed by DISCOs to the National Transmission and Dispatch Company (NTDC) in its role as Central Power Purchasing Agency (CPPA), NTDC/CPPA to public sector generating companies (GENCOs) and independent power producers (IPPs), and from these entities ultimately to fuel suppliers and refineries.11 The accumulated debt arrears is often referred to as the power sector circular debt problem. 30. Between 2003 and 2007 in particular, the Government did not allow power tariffs to rise, notwithstanding petitions from DISCOs asking for tariff adjustments to cover significantly increased fuel prices and basic operating and maintenance costs as determined by the National Electricity Power Regulatory Authority (NEPRA).12 This caused (i) the tariff differential owed by the Government to the DISCOs to grow substantially, with the unpaid amount for this year estimated at PRs84 billion ($1 billion); 13 and (ii) the public sector power sector companies (GENCOS, NTDC, and DISCOs) to ultimately borrow PRs216 billion ($2.7 billion) to cover the cash shortfall. Further, the amount owed to DISCOs for electricity sold grew and PRs209 billion 9 In the interim period, international wheat prices have fallen as forecast and on a per ton basis the procurement

price is above the world price. 10 In March 2009, supply totaled 12,074 megawatts (MW), or 82% of peak demand. For June 2009, supply is

expected to be 15,225 MW, or 85% of demand. Such shortfalls have caused widespread shedding and associated interruption of industrial and other economic activity. See also Appendix 8 (Updated Energy Sector Briefing Note)

11 The DISCOs, NTDC, and GENCOs as well as Pakistan Electric Power Company (PEPCO) were formed after the unbundling of the Water and Power Development Authority (WAPDA), and they are owned by the Government. IPPs and for the most part the suppliers of fuel to the IPPs and GENCOs are privately owned.

12 NEPRA is the independent regulator of the power sector determining cost recovery tariffs that can be charged by IPPs and GENCOs for capacity and production of electricity, by NTDC for transmission of electricity to DISCOs and other bulk purchasers, and by DISCOs for distributing electricity to customers. The difference between the tariffs determined by NEPRA and those notified by the Government is referred to as the tariff differential.

13 For FY2008, PRs35 billion ($0.45 billion) was paid in cash and the actual tariff differential subsidy equaled PRs87 billion ($0.95 billion). For the first 9 months of FY2009, PRs87 billion has been claimed and PRs59 billion has been paid.

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($2.6 billion). Of this, (i) PRs80 billion ($1 billion) is owed by consumers in the Federally Administered Tribal Areas (FATA), which is unlikely to be recovered and consumers cannot be cut off for national reasons; and (ii) PRs80 billion from the privately owned Karachi Electricity Supply Company of which PRs31 billion will be borne by Government. 31. Inadequate tariffs, nonpayment of the tariff differential subsidy, and nonpayment for electricity consumed are thus the key factors causing overdue receivables owed by DISCOs to NTDC/CPPA to reach PRs407 billion ($5 billion)14 and those owed by NTDC/CPPA to GENCOs and IPPs to grow to PRS250 billion ($3.1 billion). This caused (i) DISCOs and GENCOs to defer critically needed operating and maintenance expenditures to decrease losses, (ii) GENCOs and IPPs to run out of cash needed to purchase fuel for producing electricity at their optimal capacities, and (iii) ultimately to the Government’s taking the first step to resolve the circular debt problem by guaranteeing the issuance by NTDC of PRs92 billion in term financing certificates (TFCs) to convert the short-term trade debt into midterm debt obligations.15 32. Limited Financial Intermediation. Strengthening financial governance has become more urgent as a result of the global financial turmoil, which has led to liquidity constraints in the local banking system. In Pakistan, there is an additional risk of contagion given interconnected and direct lending among banking groups. Because of the Pakistan banking sector’s structure and current regulatory architecture, such risks are currently difficult to supervise. 33. Pakistan has adopted an institutional approach to regulation and supervision under which a firm’s legal status (e.g., as a bank, broker-dealer, insurance company) determines which regulator is tasked with overseeing its activity from a safety, soundness, and business conduct perspective. The SBP is responsible for oversight of the banking sector, while the Securities and Exchange Commission of Pakistan (SECP) is responsible for overseeing nonbank finance companies (NBFCs), some of which are engaged in deposit-taking activities. Ongoing financial sector consolidation has blurred traditional lines of business activity, creating supervisory challenges and increasing systemic risks. Prudential risks are difficult to monitor across different segments of the financial system, which are overseen by different regulators having different regulatory mandates. In the absence of proper consolidated supervision in conformity with Basel Core Principle 24,16 a financial conglomerate, or any of its subsidiaries or affiliates, may become vulnerable to double counting of capital, large intra- and extra-group exposures, contagion problems among entities within the conglomerate, and conflicts of interest between business units within the conglomerate. There is also a risk that to avoid scrutiny losses from banks will be transferred to less regulated and supervised NBFCs, including those taking deposits. 34. One of the emerging lessons arising from the global financial crisis is the difficulty in supervising financial conglomerates where there is more than one financial regulator. While in many countries, including Pakistan, financial sector regulators using the institutional approach to supervision have adopted various coordination mechanisms to try and address supervisory and regulatory gaps, many of these mechanisms have not been sufficient to detect and prevent systemic risks associated with financial conglomerates.

14 This amount was due at the end of March 2009 and represented a 44% increase over the PRs286 billion ($3.6

billion) owed at the end of June 2008. 15 Appendix 8 summarizes the issuance of PRs92 billion of TFCs by NTDC, proceeds from which were used to repay

amounts owed to GENCOs and IPPs, to their fuel suppliers, and ultimately trade credit provided by banks. 16 Basic Core Principal 24 requires banking supervisors to "supervise banking groups on a consolidated basis,

adequately monitoring and, where appropriate, applying prudential norms to all aspects of the business conducted by the group."

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35. Other AETP reforms in this sector support the Government’s efforts to better manage systemic risks. The focus of AETP1 reforms was to develop a new institutionalized structure to support better management of these risks. Under AETP1, cabinet approval was obtained for legislative amendments that would establish a regime for consolidated supervision, under which the SBP would become the lead supervisor of financial groups and conglomerates. Licensing, regulatory, and supervisory authority over deposit-taking institutions would be transferred to the SBP. AETP1 also included legislative amendments to provide for greater accountability and independence of the SBP, clarify its role in the financial safety net and lender of last resort function, and strengthen autonomy of the Financial Monitoring Unit (FMU). AETP1 also included preparation of a new consumer protection law and a deposit protection law, along with improvements in payment and settlement systems. Additional background information on the financial sector is set forth in Appendix 10. B. Achievements under Subprogram 1 and Lessons Learned 36. Achievements. Policy dialogue and reforms under AETP1 helped Pakistan mitigate the fuel and food price shocks in 2008. The budget support has helped Pakistan meet its critical expenditures at a time of fiscal compression and bolster public and investor confidence. Under AETP1, the Government put in place a major new targeted social safety program, the BISP, and began its rollout. The Government initiated steps to resolve electricity debts. Electricity tariffs were raised and the Government began to clarify the intercorporate circular debt chain and determine the debt liabilities in the system. Table 4 summarizes achievements under AETP1 and how the AETP2 actions build upon these reforms.

Table 4: Accelerating Economic Transformation Program –

Achievements under Subprogram 1 and Current Status of Reforms under Subprogram 2

Outputs Subprogram 1 Activities (Until September 2008)

Achievements and Status as of June 2009

Output 1: Immediate distortions removed to initiate structural transformation Output 1.1: Targeted safety nets designed and rolled out for the poor and vulnerable households Social impact of food and fuel inflationary pressures mitigated through targeted social safety net programs

Social safety net cover for up to 5 million poor households provided for through allocation of PRs41 billion in FY2009 budget Clear criteria developed for selecting beneficiaries of cash transfers through the Benazir Income Support Program (BISP)

Reforms are on track. The social safety net cover has been implemented for about 2 million families under the Bait-ul-Mala with an allocation of PRs8 billion in FY2009 and for more than 1.8 million families under the BISP (as of 30 April 2009) with an allocation of PRs34 billion. The National Database and Registration Authority is verifying the eligibility of applicants based on 13 criteria. With the World Bank’s support, the Government is improving targeting through use of poverty scorecards. A pilot project was launched in 16 districts in May 2009 and will be expanded countrywide to all 130 districts between December 2009 and June 2010.

Output 1.2: Market-based wheat pricing and efficient reserve management in place Wheat subsidies reduced and eliminated and wheat procurement made competitive

Time-bound action plan adopted by Economic Coordination Committee (ECC) for market-based pricing and reserve management Support price of wheat for farmers increased from PRs425 to PRs650

Reforms are on track, but sector adjustments and procurement reforms have been slow in light of food security considerations. The ECC-adopted plan is being implemented. In September 2008, the Government set a support price for wheat (PRs950) which was close to the world market

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Outputs Subprogram 1 Activities (Until September 2008)

Achievements and Status as of June 2009

price at that time. In the interim, international prices have declined and Pakistani wheat will be considerably more expensive than in international markets. Notwithstanding a good harvest, the Government will not be able to change the support price once set. This shows the vulnerabilities in setting prices that do not reflect market forecasts and in the absence of hedging instruments. Under AETP2, the Government will enforce a formula-based pricing system.

Output 1.3: Electricity subsidies funded and power sector debt resolution initiated Past liabilities, including electricity subsidies, settled and debt restructuring plan implemented

Parliamentary approval obtained to reduce electricity subsidies through (i) elimination of generalized sales tax subsidies for all domestic consumers and up to 500 units for commercial consumers, (ii) introduction of automatic monthly fuel price adjustments through a surcharge, and (iii) introduction of an additional surcharge to be levied on all consumers to reduce the gap between determined and notified tariffs Work on estimation of power sector debt overhang and circular debt initiated All past electricity subsidy payments (PRs133 billion for FY2008) fully settled, and PRs88 billion allocated in the FY2009 budget to partially cover the difference between determined and notified tariffs for FY 2009

Reforms are on track. The Government has put in place an automatic fuel price adjustment mechanism. It also increased power tariffs by an average 17% in September 2008. With full cost-recovery tariffs planned from September 2009, all subsidies are likely to be eliminated. To resolve the circular debt problem, the Government, working closely with ADB, the World Bank, and the IMF, has adopted a comprehensive debt resolution plan for the power sector (Appendix 9). In addition to cost recovery tariffs, the plan includes placement of debt into a new debt holding company outside the power sector, and the development of a financing plan for servicing and repayment of the debt.

Output 2: Financial intermediation strengthened to support structural transformation Prudential regulation and supervision strengthened

SBP has drafted a new banking act aligning it with international best practices. SBP has raised minimum capital requirements as part of Basel II implementation. SBP has launched work on a 10-year banking sector strategy to broaden and diversify financial markets while developing supportive financial safety nets plus safeguards for consumer protection and effectively fighting against money laundering and financial crimes. Cabinet approval obtained for legislative amendments to enable SBP to better manage systemic risks by (i) adopting a consolidated supervisory framework, allowing SBP to be the lead supervisor of financial groups and conglomerates in compliance with Basel Core Principle 24; and (ii) transferring the licensing, regulatory, and supervisory authority over deposit-taking institutions to SBP

Reforms are substantively on track, but the Government and regulatory bodies want a more holistic and radical approach to achieve consolidated supervision. The global financial crisis is beginning to have an impact on the banking sector. Liquidity has been tight and nonperforming loans are slowly increasing. There is evidence of growing dollarization. With support from the IMF, SBP has in place a plan to promptly address banking sector problems as they emerge. All AETP1 actions are on track, and legislative reforms are moving ahead. A key difference is with respect to the framework for consolidated supervision. While the technical work done on the legal amendments is still relevant, the Government, SBP, and SECP would like to move toward an integrated financial supervisory agency type of model. In preparation for this (and as an interim measure), the SBP and SECP have signed a memorandum of understanding that facilitates coordination and information sharing aimed at improving risk management in the sector, and particularly for supervising financial

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Outputs Subprogram 1 Activities (Until September 2008)

Achievements and Status as of June 2009

conglomerates. Cabinet approval obtained for

amendments to strengthen the anti-money laundering (AML) legal framework incorporating international standards and best practices (Cabinet approved the amendments.) Financial Monitoring Unit (FMU) established and operationalized, with the SBP providing interim budget support and administrative oversight

Reforms are on track, and good progress is being made in strengthening the governance framework for AML. Legislative amendments have been submitted to Parliament to improve FMU autonomy. In addition, the Government has provided a one-line budget allocation to the FMU for FY2009 and onwards, has agreed to promptly release allocated funds, and facilitated the hiring of FMU staff.

Autonomy and governance of the central bank strengthened

SBP has launched work on a new central bank law providing for greater autonomy and accountability of SBP in its monetary and financial policies, effective regulation and supervision of financial institutions under its oversight, and clarity in the role of SBP in financial safety net and lender of last resort functions.

Reforms are on track. The draft law is being reviewed and revised. The IMF’s standby arrangement supports adoption of a revised SBP law by December 2009.

National payment systems strengthened

Payments Systems and Electronic Funds Transfer Act (2007) enacted Real-time gross settlement system launched Centralized online system for retail payment systems established

Reforms on track. The rollout of real time gross settlement has been quite successful, and a retail payment system is in place. SBP has adapted RTGS rules.

Consumer and depositor protection strengthened

Consumer Protection Department established in SBP and work launched on a consumer protection law

Concept paper and draft law on a deposit protection scheme prepared and consultations launched with stakeholders

Reforms on track. Good technical work has been done which could form the basis for strengthening financial system stability.

Output 3: National structural transformation strategies designed and implemented National structural transformation strategy developed and implemented

High-level steering committee established (reporting to the Prime Minister and cabinet) to lead work on Pakistan’s structural transformation; all preparatory steps finalized for the studies on structural transformation

Measures adopted to facilitate investment

Auto Industry Development Program adopted (to accelerate the share of this segment from 2.8% of GDP from FY2006 to 5.6% by FY2012 Risk-based customs inspections introduced and an e-filing and payments system adopted for customs and sales taxes

Strong commitment remains, but more time is needed. Substantive analytical work has been underway. About 40 4-digit product categories under the Standard International Trade Classification Revision 2 (SITC Rev. 2) have been identified as possible areas to accelerate industrialization. The Government and ADB are now in the process of setting up public–private dialogue mechanisms for several of these product categories. In parallel, dialogue and technical work are underway to address the issues in Pakistan’s textiles sector. As more time is needed, and particularly since the Government’s efforts over the last 6–8 months have been on crisis mitigation, AETP2 will focus on the short-term economic policy issues (e.g., safety nets, wheat pricing and procurement reforms, electricity reforms, and financial sector strengthening). Future AETP subprograms will have more exclusive focus on structural transformation.

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a Bait-ul-Mal is a semi-autonomous organization within the Ministry of Social Welfare and Special Education that provides financial assistance to destitute and needy widows, orphans, invalids, infirm and other needy persons.

ADB = Asian Development Bank, AETP = Accelerating Economic Transformation Program, BISP = Benazir Income Support Program, ECC = Economic Coordinating Committee, FMU = Financial Monitoring Unit, IMF = International Monetary Fund, SBP = State Bank of Pakistan, SECP = Securities and Exchange Commission of Pakistan. Source: Asian Development Bank. 37. Lessons. There are three key lessons. First, planning for medium-term reforms when countries are struggling to cope with short-term issues is difficult. The structural transformation agenda needs much greater attention, as it may alter the sectoral and industrial landscape in Pakistan. Although significant analytical work has been undertaken with ADB support and several rounds of consultations have taken place with senior government officials and private sector representatives, the ADB team’s assessment is that it would be better to focus on medium-term reforms in the later part of 2009 and early 2010. 38. Second, consultation with key stakeholders is necessary to build ownership for reforms and realistic expectations as to the time frame for implementation, the implementation risks, and the design of risk mitigation measures. In the context of AETP1, this lesson applies to both wheat policy issues and the financial sector. While ADB’s consultations regarding wheat have been largely with the Government and private sector business entities, dramatically changing global wheat market conditions have underscored the fact that farmers and consumers are also affected parties. In the case of financial sector regulation, the authorities obtained cabinet approval for legislative measures on consolidated supervision. Yet, with the financial architecture being reexamined in many countries in light of the crisis, the Government and regulatory agencies have taken a position that they would like to explore more in-depth reforms instead of making incremental legislative amendments. Earlier and deeper consultations among all parties concerned might have been helpful in shaping ideas and conserving time. 39. Third, expectations on multiple outcomes need to be modest due to capacity constraints in the Government and regulatory agencies that become even more acute at times of crisis. C. External Assistance and Development Partner Coordination

40. A number of other development partners have been involved in broad fiscal, social safety net, agricultural, power, and financial sector reforms in Pakistan. There has also been significant development partner support for a range of cross-cutting issues covered in AETP. The sector agenda in AETP has benefited from ADB’s past work in the relevant sectors, from ongoing dialogue with the IMF and World Bank on macroeconomic stabilization measures, and from dialogue with the World Bank and other development partners on both social safety nets for the poor and vulnerable and resolution of the circular debt in the energy sector. 41. The Friends of Pakistan is a group supporting the Government in its efforts to consolidate democracy in Pakistan and fund social and economic development in the country. The group was launched in New York on 26 September 2008 and consists of 25 countries and multilateral institutions, including Canada, France, Germany, Italy, Japan, the Netherlands, Nordic countries, People’s Republic of China, Republic of Korea, Spain, United Kingdom, United States, and the ADB, European Union, Islamic Development Bank, United Nations, and the World Bank. 42. At a senior level meeting of the Friends of Pakistan group held in Tokyo on 17 April 2009, the Government of Pakistan received $5.28 billion in additional pledges of support over 2 years. The meeting and a Donors Conference were attended by 31 countries and 18

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international institutions. The meeting also endorsed the establishment of follow-up mechanisms for international cooperation and coordination, including the formation of working groups (of interested countries and institutions) in the identified areas of development, security, energy, institution capacity building, trade, and finance. The Friends also agreed to strengthen existing donor coordination mechanisms.

V. THE PROPOSED PROGRAM

A. Impact and Outcome

43. The AETP will help Pakistan pave the way to restoring the precrisis growth path. The short-term outcomes of AETP1 and AETP2 are to create fiscal space. The outputs under these two phases will include better targeting of subsidies and improved risk management in the financial sector. Over the medium-term, the follow-up phases of AETP3 and AETP4 (which will be processed subject to satisfactory progress) will support structural transformation. 44. AETP is structured as a program cluster of four subprograms to be implemented over 2007–2011. AETP1 helped the Government address fiscal implications of the food and energy crisis, as well as short-term investment climate problems. It also initiated reforms that will be carried forward in the medium term. AETP2, in continuation of AETP1, will focus on macroeconomic stability and fiscal sustainability by reducing distortions in the wheat and energy sectors, addressing the circular debt in the energy sector, and strengthening the social safety net. AETP2 will also strengthen financial intermediation. To better reflect the time frame needed for adopting a national structural transformation strategy, policy actions directly supporting structural transformation will not be included not in AETP2 but in subsequent subprograms. Deteriorating security conditions have delayed consultations needed to identify strong leadership and ownership for structural transformation. 45. Appendix 3 presents the Government’s development policy letter. The policy matrix for AETP2 in Appendix 4 lays out the policy actions for AETP2 and indicative outputs and activities for subsequent subprograms under this cluster. The activities for subsequent subprograms will continue to be refined over the next few years, subject to satisfactory implementation progress. The indicators will be updated periodically, depending on implementation progress. ADB has requested the IMF to provide a macroeconomic assessment in connection with AETP2. The IMF has agreed to provide the assessment to ADB on 8 June 2009. Once received, the assessment will be separately circulated. B. Outputs and Activities

1. Remove Immediate Distortions in the Food and Energy Sectors and Protect the Poor and Vulnerable through Targeted Safety Net Programs

46. Targeted Safety Nets Designed and Rolled Out for the Poor and Vulnerable. Under AETP2, the Government aims to extend BISP coverage to at least 5 million families in FY2010. The BISP has become fully operational. The BISP office in Islamabad has been established to manage the program and provincial offices are being set up. Most positions in BISP headquarters have been filled and the directors of the provincial offices have been appointed. 47. Under AETP2, targeting of beneficiaries has also been improved. In May 2009, BISP started piloting in 16 districts the new targeting method using poverty score cards to identify eligible families. Based on lessons learned from the pilot project, the poverty score card will be

16

rolled out to all 130 districts in Pakistan. The World Bank is currently providing assistance to strengthen BISP’s program administration and fiduciary structure, as well as to establish and implement a monitoring and evaluation system plus a grievance redress system. BISP expansion under the new targeting method and improved fiduciary controls will be reflected in subsequent AETP programs. More details on the BISP are included in Appendix 6. 48. Toward Market-Based Wheat Pricing and Introduction of an Efficient Wheat Reserve Management System. Under AETP1, the Government adopted an action plan to move to a more market-based wheat pricing and efficient reserve management system. Under AETP2, the Government has agreed to implement a formula-based system for (i) setting the procurement price for farmers to ensure that such price operates as a floor price and remains below the competitive market price, and (ii) ensuring that the wheat issue price reflects related costs, including those for transport and storage. An efficient safety net program will eliminate the need to subsidize the issue price, which subsidy is in large part captured by flour millers. Under subsequent subprograms, implementation of the ECC action plan will be assessed and key reform initiatives implemented will be reflected. For AETP3, the Government expects that strategic reserves will be maintained at 2 months of annual consumption and that operational reserves will be eliminated. 49. Initiating Power Sector Debt Resolution. Under AETP2, the Government adopted a power sector circular debt resolution plan (Appendix 9)17 and has begun with its implementation. The plan, which was developed in close consultation with ADB, the IMF, and the World Bank should resolve the circular debt problem and more broadly the financial deficit in this sector. It should indirectly support improved corporate governance and reduce technical issues (losses, theft, antiquated equipment, etc.), which have caused the chronic shortfall in Pakistan’s power supply. The plan clarifies the amount of the debt and key activities, including measures to prevent reoccurrence and ensure sustainable debt servicing. It identifies financing sources and agreements and includes milestones, an implementation timetable, and a monitoring framework. 50. The key components of the plan can be group under three headings:

(i) Timely notification of cost recovery tariff (a) The NEPRA Act will be amended by 30 June 2009 to enable the

determination and enforcement of tariff adjustments in a timely manner. (b) Notification of tariffs will not exceed 15 days from determination and the

monthly fuel and power purchase adjustments will be made effective automatically upon determination by NEPRA.

(c) Electricity tariffs will be determined by NEPRA quarterly. (d) A business plan for FY 2009/10 has been prepared to support tariff reform

and maximize outputs and sales in electricity and minimize costs by reducing system losses. Under this plan, electricity tariffs will be increased by 17.5% or as later determined by NEPRA to meet the zero tariff differential subsidy commitment. The adjustment will be front loaded and made effective by 1 July 2009, with the remainder to be effective by September 2009.

(ii) Sector debt resolution

(a) The Government will establish a debt holding company by 30 June 2009 to assume the debt liabilities of public power companies, which will in turn strengthen the financial position of these companies.

(b) The debt holding company will be wholly owned by the Government and will 17 Power sector debt refers to circular debt and debt overhang.

17

manage and pay the liabilities through the sale of assets, among other things, over the next 5 years.

(iii) Improved technical and financial performance of public power sector companies.

(a) Public power sector companies have outstanding liabilities of PRs142 billion (as of 31 March 2009), which are payable to GENCOs, IPPs and fuel suppliers. Of this, the MOF will settle or assist to settle PRs53.5 billion, power sector companies will recover PRs27.7 billion from customers, and MOF will assist in paying the remaining PRs61 billion in liabilities.

(b) Performance contracts will be entered into between MOWP and each of the power companies effective 1 July 2009 to promote corporate autonomy, financial independence and improved performance.

2. Strengthening Financial Intermediation

51. In recognition of challenges arising under the current regulatory structure for Pakistan’s financial sector (notably with respect to the need to strengthen the supervision of financial conglomerates), the Government is considering adoption of an alternative supervisory model, including integrated regulation. With ADB support, the Government will be examining the costs and benefits of various regulatory approaches, along with lessons learned from other jurisdictions. Changing the regulatory architecture is a long-term undertaking—with human resource implications—and needs to be carefully considered. 52. Over the shorter term, to improve regulatory effectiveness and risk mitigation in the financial sector, the SBP and the SECP have entered into a new memorandum of understanding under AETP2 to promote better coordination, information sharing, and supervision of financial conglomerates. The memorandum provides for setting up task forces comprised of staff from both agencies to help mitigate risks posed by financial conglomerates and to move toward a more harmonized regulatory framework, including a risk-based approach to supervising the nonbank financial sector. In addition, to address systemic risk concerns posed by NBFCs’ deposit-taking activities, SECP has restricted their retail deposit taking. Under subsequent subprograms, the SBP will undertake a self-assessment of compliance with Basel core principles to identify and address ongoing gaps. 53. While AETP1 envisaged adoption of a new banking act that incorporates international best practices, in light of the Government’s strong commitment to strengthen the overall supervisory framework, and to avoid the need for subsequent legislative revisions, it is more prudent to defer legislative changes that impact the supervisory framework at this time. ADB will continue to monitor the status of related legislative initiatives, including the new banking act. Subsequent subprograms will include adoption of a blueprint for a new regulatory architecture, preparation of related draft legislation, and implementation of the new legislation, once adopted. 54. Under AETP2, work continues on the draft deposit protection law and the draft consumer protection law. The draft deposit protection law is expected to incorporate international best practice principles on deposit insurance to help ensure the autonomy and financial soundness of the deposit insurer, close coordination with financial sector regulators, and protection of depositors (including prompt access to their insured funds).18 The draft consumer protection law is expected 18 International best practice principles on deposit insurance have been adopted by the International Association of

Deposit Insurers (IADI). The IADI was established in 2002 as a nonprofit organization under Swiss Law, following deliberations by the Financial Stability Forum. Fifty-two deposit insurance organizations are IADI members. Notable principles provide that (i) a deposit insurer should be provided with adequate powers to finance

18

to address such issues as transparency, confidentiality, availability of statements, account servicing, protection against fraud, unfair contracts and lending practices, methods of debt collection, and arbitrary penalties. Under AETP2, SBP also prepared and adopted new real time gross settlement rules. Subsequent subprograms will reflect progress in this area. 55. To improve FMU governance, under AETP2, the Government submitted to Parliament amendments to the Anti-Money Laundering (AML) Ordinance. The Government has also taken other steps to strengthen the financial and operational autonomy of the FMU (providing a one-line budget allocation to the FMU for FY2009/01 and onwards, agreeing to promptly release allocated funds, and facilitating the hiring of FMU staff). In support of international best practice principles for AML, Pakistan is currently undergoing a mutual evaluation of its AML regime.19 Findings and recommendations are expected to be finalized around July 2009. Subsequent AETP subprograms will take into account relevant priority actions identified through the mutual evaluation to support strengthening the FMU. 56. Under AETP2, ADB continues to support operationalizing the FMU through ongoing technical assistance (TA). The FMU has been relocated into new offices accommodating around 30 staff. Its staffing has increased from 4 staff (during AETP1 preparation in 2008) to 10. The FMU is in the process of hiring 11 additional staff, including 8 professionals. Its workload continues to grow. In FY2008, the SBP and subsequently the FMU received 88 suspicious transaction reports. In FY2009, the FMU has received almost 500 such reports. C. Special Features

57. The AETP is an integral part of macroeconomic stabilization efforts undertaken by the Government with IMF support. AETP1 and AETP2 provide resources and inputs for short-term stabilization measures while paving the way for economic transformation over the medium term. Although the conceptual framework was designed within a short time in mid-2008, ADB has provided the Government with significant advisory support, which formed the basis for the Program. 58. Gender inequality continues to be an area of major concern in Pakistan. Limited access to income-generating opportunities, together with a range of life cycle risks results in increasing

compensation payments, enter into contracts, set internal operating budgets and procedures, and access timely and accurate information to ensure that it can promptly meet its obligations to depositors; (ii) a deposit insurer should be operationally independent, transparent, accountable, and insulated from undue political and industry influence; (iii) a framework should be in place for close coordination and information-sharing among the deposit insurer and other financial system safety net participants; (iv) a deposit insurer should be part of the framework within the financial system safety net that provides for the early detection and timely intervention and resolution of troubled banks; (v) effective failure-resolution processes should facilitate the ability of the deposit insurer to meet its obligations, minimize resolution costs and disruption of markets, maximize recoveries on assets, and reinforce discipline through legal actions in cases of negligence or other wrongdoing; and (vi) a deposit insurance system should give depositors prompt access to their insured funds.

19 As part of its commitment to reforms in AML and combating the financing of terrorism (CFT), Pakistan is currently undertaking a mutual evaluation of its AML/CFT regime. The mutual evaluation (carried out by the World Bank and in conjunction with the Asia/Pacific Group on Money Laundering) is also part of the broader Financial Sector Assessment Program of Pakistan under the World Bank. For the mutual evaluation, Pakistan completed a detailed self-assessment questionnaire prior to the visit of the evaluation team in January and February 2009. This involved a detailed assessment of its compliance with a range of international standards relating to AML and CFT, primarily the Financial Action Task Force (FATF) 40+9 Recommendations. After the on-site visit, a draft report was prepared by the evaluation team for discussion with the Government. With support under the ongoing ADB TA for AML, the Government provided comments on the report. The mutual evaluation report will be finalized following peer review and discussion at the annual meeting of the Asia/Pacific Group on Money Laundering in July 2009.

19

feminization of poverty. The amount of $150 million of AETP2 will go to the BISP, whose primary recipients are female heads of the family so that women of poor families can directly access and manage the social safety net benefits. By the end of AETP3, 7 million female household heads in Pakistan are expected to benefit from BISP. 59. In addition, BISP will work with NADRA to issue CNICs for women. This is a major step forward. ADB's country gender assessment for Pakistan notes that more than 50% of women in rural Pakistan are without CNICs and that this prevents women from exercising their right to vote and run for election and access many government services.20 By receiving CNICs directly, women will have less dependency on their male family members to access services and opportunities. D. Financing Plan

60. Program Loan. As noted above, the costs associated with AETP2 include increases in subsidies to procure wheat from farmers in 2009 (at a price above the import parity price) and expansion of the BISP to cover at least 5 million qualified families. The Government has requested that AETP2 be designed to provide $500 million before the end of June 2009, which is the end of the current fiscal year. For AETP2, two loans are proposed—a loan of $350 million from ADB’s ordinary capital resources (OCR) and one of $150 million equivalent from the ADB's Special Fund resources (ADF). Subject to reform progress and availability of resources, subprograms 3 and 4 are each envisaged to be $400 million–$500 million. Thus, the overall amount for the AETP is estimated in the range of $1.8 billion–$2 billion. 61. The OCR loan will have a 15-year term, including a grace period of 3 years; an interest rate to be determined in accordance with ADB’s London interbank offered rate (LIBOR)-based lending facility; a commitment charge of 0.15% per annum; and such other terms and conditions as set forth in the draft loan agreement. The Government has provided ADB with (i) the reasons for its decision to borrow under ADB’s LIBOR-based lending facility on the basis of these terms and conditions, and (ii) an undertaking that these choices were by its own independent decision and not made in reliance on any communication or advice from ADB. 62. The ADF loan will have a 24-year term, including a grace period of 8 years; an interest rate of 1.0% per annum during the grace period and 1.5% thereafter; and such other terms and conditions as set forth in the draft loan agreement. E. Implementation Arrangements

63. Program Management. The Ministry of Finance (MOF) will be the executing agency for AETP2. The Ministry of Food, Agriculture, and Livestock; Ministry of Water and Power; SBP; and BISP will be the implementing agencies. 64. The secretary of finance will steer AETP2. The financial management arrangements within MOF have been assessed as adequate. 21 MOF’s accumulated experience in implementing a large number of program loans demonstrates its competence and capacity to 20 ADB. 2008. Releasing Women's Potential Contribution to Inclusive Economic Growth. Country Gender

Assessment: Pakistan. Manila. 21 In connection with the processing of AETP2, MOF has been proactively instituting measures to address

outstanding portfolio issues under other ADB programs and projects. Measures include: (i) reconciling imprest accounts; (ii) allocating funds for land acquisition and resettlement; and (iii) improving implementation performance generally.

20

carry out financial management of AETP2 effectively. ADB will monitor program implementation closely to ensure that envisaged outputs and outcomes will be achieved. 65. Implementation Period. The implementation period for AETP2 is from October 2008 through June 2009. The loan of $500 million will become available following satisfaction of AETP2 policy actions and after loan effectiveness. Subsequent subprograms will be processed subject to adequate reforms progress and the Government’s continued commitment to the reform agenda. 66. Procurement and Withdrawal Procedures. Loan proceeds will be used to pay for items procured in ADB member countries, other than the items specified in the negative list of ineligible items (Appendix 12) and imports financed by other bilateral and multilateral sources. The proceeds of the program loan will be disbursed in accordance with the provisions of ADB’s simplified disbursement procedures and related requirements for program loans. Loan proceeds disbursed against imports will require a certificate from the Government stipulating that the value of the total imports of Pakistan, minus its imports from nonmember countries, ineligible imports, and imports financed under other official development assistance, is equal to or greater than the amount of the loan expected to be disbursed during a particular year. ADB reserves the right to audit the use of loan proceeds to verify accuracy of the Government’s certification. 67. Anticorruption Policy. ADB’s Anticorruption Policy (1998, as amended to date) was explained to and discussed with the Government. Consistent with its commitment to good governance, accountability, and transparency, ADB reserves the right to investigate, directly or through its agents, any alleged corrupt, fraudulent, collusive, or coercive practices relating to AETP. To support these efforts, relevant provisions of ADB’s Anticorruption Policy are included in the loan regulations. The World Bank is currently working with the BISP to improve fiduciary controls, including financial management systems. To provide greater accountability and transparency in the flow of funds from the BISP to eligible beneficiaries under the new targeting method, the BISP has agreed to provide ADB with periodic reports and to post these reports on its website. 68. Counterpart Funds. The Government shall ensure that the local currency generated from the proceeds of the OCR loan shall be used first to support the adjustment costs of reforms to be initiated and implemented under AETP2, and second to finance expenditures for the Government’s general development purposes. For the local currency generated from the proceeds of the ADF loan, the Government shall establish and maintain a separate account at the National Bank of Pakistan to ensure that that these funds are used to support poor and vulnerable families that qualify under the new BISP scorecard targeting method. The Government has agreed to provide ADB with periodic reports on the use of these funds (utilization reports) for the period from July 2009 until full utilization, and to have this account and related records audited annually in accordance with standards acceptable to ADB. Certified copies of the audited accounts and financial statements, as well as the auditors’ reports, will be submitted to ADB not later than 6 months after the close of the fiscal year to which they relate. 69. Program Performance Monitoring and Evaluation. The economic reform units in MOF and SBP have established and are implementing a performance evaluation system for the AETP, which includes a database on the status of policy measures and program indicators based on the policy matrix. They are monitoring implementation of the AETP and its impacts and outcomes. They will be proactive in gathering data and proposing revisions as needed to ensure that data compiled provide useful guides to management decision making by policymakers. Policy advisors may be placed within MOF and SBP to assist in monitoring and

21

evaluation. ADB will keep track of program implementation through regular reviews and progress reports throughout implementation. Based on these reviews, modifications and improvements will be considered. The design and monitoring framework in Appendix 1 identifies the targets by which attainment of the outputs will be measured. In addition, each subprogram will include a table summarizing overall AETP achievements (Table 4).

VI. SUBPROGRAM BENEFITS, IMPACTS, ASSUMPTIONS, AND RISKS A. Benefits and Impacts 70. AETP2 will provide significant benefits and have a positive impact on the poor and women. First, it will help the Government move away from inefficient and untargeted subsidies to a targeted safety net program for the poor. The BISP is targeting poor families to protect their nutrition intake. Beginning with about 2 million families, the coverage has been extended to at least 5 million eligible families. During AETP3, the BISP will be further expanded to support at least 7 million families using the new targeting methodology. In addition, AETP2 aims to empower women by targeting women heads of poor families as the direct recipients and issuing the national identity card for them, which they can use not only to access BISP benefits but to also to open a bank account. Appendix 6 provides a summary of the BISP and Appendix 13 presents the summary poverty reduction and social strategy prepared for AETP2. 71. An immediate outcome of AETP2 will be to help Pakistan meet immediate and large fiscal needs. Moreover, it will help the Government address financial deficits in the power sector in a more sustainable manner. This sector’s large circular debt impedes reform much needed to resolve the ongoing energy crisis. In parallel, AETP2 will raise public confidence in the banking system through stronger financial intermediaries that are better able to mobilize and allocate resources and manage risks. AETP2 will also enable ADB to sustain policy dialogue on structural reform in sectors where it has been actively involved through past and current investments. B. Risks and Mitigating Measures

72. While some of the risks of AETP2 are political and outside of its scope, the financing will mitigate a range of others, including the following:

(i) Interest group resistance. This is likely, as those affected by reforms in the short term may resist. The Government is adopting a good communication strategy to articulate the long-term and country-stability interests that are behind the reforms. Further, the program cluster nature of the AETP ensures prior actions by the Government before financing is provided.

(ii) Weak capacity. This is a generic concern, which is elevated in case of complex reforms. Adequate design and implementation support is being mobilized through TA under AETP1 and under related TA projects that are ongoing.

(iii) Weak fiduciary controls. This is a generic concern but is being addressed in connection with the BISP with support from the World Bank. The Government plans to implement reforms in this area to improve transparency and accountability, including to strengthen financial management systems within the BISP.

(iv) Global financial crisis. The measures under AETP2 are predicated on a global recovery. While the program cannot influence global events, it can help cushion Pakistan against some exogenous shocks.

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73. The risk of not supporting Pakistan’s safety net programs and reducing inefficient subsidies is also high. In the absence of timely reforms, the Government’s budget would continue to be burdened by costly and inefficient subsidies, leaving fewer resources for development financing, and the financial sector would be vulnerable to systemic risks. High and persistent fiscal, current account, and investment deficits could lead to unsustainable levels of public debt that would adversely affect the country’s macroeconomic environment, constrain investment and economic growth, and aggravate poverty. 74. The underlying assumptions for AETP2 include

(i) strong and sustained leadership and commitment to reforms, (ii) development partner coordination, and (iii) open dialogue with the private sector and other key stakeholders.

VII. ASSURANCES

75. In addition to the standard assurances, the Government has given the following assurances, which are incorporated in the legal documents.

(i) The policies adopted and actions taken under AETP2, as set forth in the Development Policy Letter and the Policy Matrix, will be in effect for and beyond the duration of AETP2.

(ii) The Government will provide ADB with a report on the utilization of BISP funds for the period October 2008 to April 2009.

(iii) The Government will transfer the local currency generated from the ADF loan to a separate BISP assignment account at the National Bank of Pakistan. Such funds will be used to support poor and vulnerable women and families that qualify for cash benefits under the new BISP scorecard targeting method.

(iv) The Government will provide ADB with a quarterly utilization report for the period beginning July 2009 until full utilization of the local currency generated from the ADF loan on the status of payments under the separate BISP assignment account to qualified beneficiaries using the new BISP scorecard targeting method.

(v) The Government will ensure that the separate BISP assignment account at the National Bank of Pakistan and related records be maintained in accordance with sound accounting principles and audited annually by independent auditors acceptable to ADB in accordance with sound auditing standards. The Government will submit certified copies of the audited accounts and financial statements, and the report of auditors, not later than 6 months after the close of the fiscal year to which they relate.

(vi) The Government will provide ADB with quarterly progress reports for the period July 2009 to June 2010 on the status of implementation of the power sector circular debt resolution plan. The progress report will include updated information on outstanding payments owed by the Government to power distribution companies, power distribution companies to NTDC and CPPA, and NTDC and CPPA to the power generation companies and IPPs.

(vii) The Government will keep ADB informed of policy discussions with other multilateral and bilateral aid agencies that may have implications for the implementation of AETP2 and will provide ADB with an opportunity to comment on any resulting policy proposals. The Government will take into account ADB’s views before finalizing and implementing any such proposal.

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VIII. RECOMMENDATION

76. I am satisfied that the proposed loans would comply with the Articles of Agreement of the Asian Development Bank (ADB) and recommend that the Board approve

(i) the loan of $350,000,000 to the Islamic Republic of Pakistan for the second subprogram of the Accelerating Economic Transformation Program from ADB’s ordinary capital resources, with interest to be determined in accordance with ADB’s London interbank offered rate (LIBOR)-based lending facility; a term of 15 years, including a grace period of 3 years; a commitment charge of 0.15% per annum; and such other terms and conditions as are substantially in accordance with those set forth in the draft Loan Agreement presented to the Board; and

(ii) the loan in various currencies equivalent to Special Drawing Rights 97,126,000 to the Islamic Republic of Pakistan for the second subprogram of the Accelerating Economic Transformation Program from ADB’s Special Funds resources with an interest charge at the rate of 1.0% per annum during the grace period and 1.5% per annum thereafter; a term of 24 years, including a grace period of 8 years; and such other terms and conditions as are substantially in accordance with those set forth in the draft Loan Agreement presented to the Board.

Haruhiko Kuroda President

4 June 2009

24 Appendix 1

DESIGN AND MONITORING FRAMEWORK

Design Summary

Performance Targets/Indicators

Data Sources/ Reporting

Mechanisms

Assumptions and Risks

Impact Sustained high economic growth

Real GDP growth sustained at 8% per year over 2010–2020 Banking sector credit to private sector expanded to 42% of GDP by 2018 Manufacturing sector’s share of GDP increased by 30% by 2020 High value-added output share of exports increased to 40% of GDP by 2020

National income accounts State Bank of Pakistan (SBP)

Assumptions • Strong government

commitment to reforms

• Private sector responds positively to policy reforms

Risks • Resistance from

vested interest groups

• Slowdown in economic activity of trading partners

• Lower-than-expected private capital inflows

• Security • Weak fiduciary

controls

Outcome Improved prospects for macroeconomic stability and fiscal sustainability

Increase in international reserves Reduction in the budget deficit Reduction in subsidies and increase in targeted safety net expenditures for the poor and vulnerable, especially women

National income accounts

Assumptions • Ongoing support and

ownership by implementing agencies

• Development partner support for reforms and close coordination

Risks • Weak absorptive

capacity of implementing agencies

Appendix 1 25

Design Summary

Performance Targets/Indicators

Data Sources/ Reporting

Mechanisms

Assumptions and Risks

Outputs A. Immediate distortions removed 1. Targeted safety

net programs rolled out for the poor and vulnerable families

2. Market-based

wheat pricing 3. Power sector debt

resolution initiated and tariff differential subsidy eliminated

B. Financial intermediation strengthened 4. Prudential

regulation and supervision strengthened

1. Proxy means-tested

targeted safety net program coverage expanded to at least 5 million families, whose primary recipients are women by 2010

2. Increase in the number of identity cards issued to women head of families.

3. Market-based pricing for farmers and flour millers adopted by 2010

4. Increase in electricity

generation from existing plants by approximately 740 megawatts

5. Overall electricity

subsidy brought to zero by 30 September 2009, and maintained at that level, through cross-subsidies for lifeline tariff.

6. Amendment of NEPRA

Act to enable timely adjustment of tariff by 30 June 2009.

7. Debt holding

Company established to assume circular debt burden of public power sector companies by 30 June 2009.

8. Amendments to key laws enacted by 2010

Ministry of Finance (MOF) and Benazir Income Support Program (BISP) BISP; National Database and Registration Authority (NADRA); Ministry of Food, Agriculture, and Livestock Ministry of Water and Power and MOF State Bank of Pakistan; Securities and Exchange Commission of Pakistan; and MOF

Assumptions • Government is

committed to carrying out the policy reforms.

• Private sector dialogue is effective.

• Development partners support the program and there is close coordination.

• Financial stability

Risks • Political instability • External

vulnerabilities • Policy coordination

risks • Heightened security

risks

26 Appendix 1

Design Summary

Performance Targets/Indicators

Data Sources/ Reporting

Mechanisms

Assumptions and Risks

9. Financial sector

agencies joint task force begins to undertake coordinated oversight of financial conglomerates by 2009

Activities to be completed by 25 May 2009 1.1.1. FY2009/10 budget for BISP increased to provide income support for at least 5 million families under the BISP 1.1.2. BISP offices operationalized: (i) central and provincial offices established, and (ii) improved targeting system for beneficiaries piloted 1.2. ECC endorses implementation of a formula-based system for

setting (i) wheat support price for 2009 and beyond based on (a) cost of production, (b) regional prices, (c) import and export parity prices, and (d) domestic and global market conditions; and (ii) wheat issue price to reflect all related costs

1.3. Power sector circular debt resolution plan prepared and implementation commenced

2.1. (i) New memorandum of understanding between SBP and SECP adopted to improve coordination and information sharing; (ii) joint task force between SBP and SECP established to identify, prevent, and manage risks posed by conglomeration in the financial sector and to continue moving toward a risk-based regulatory approach; and (iii) SECP to restrict NBFCs from taking retail deposits from the public

2.2.1. Amendments to Anti-Money Laundering Ordinance that improve FMU autonomy submitted to Parliament

2.2.2. MOF to approve an annual one-line budget allocation to the FMU beginning with the budget allocation for FY2009/10 and beyond and agree to the prompt release of allocated funds

2.2.3. FMU capacity enhanced through hiring of new professional staff

2.3. Real time gross settlement rules adopted

Inputs • AETP2 loans: $500

million equivalent • AETP TA: $800,000 • TA 4922-PAK

Support to Governance Reforms in Pakistan subproject, Strengthening Financial Sector Governance: $870,000

• TA 4922-PAK Support to Governance Reforms in Pakistan subproject, Anti-Money Laundering Regime: $1.5 million

AETP = Accelerating Economic Transformation Program, BISP= Benazir Income Support Program, ECC = Economic Coordination Committee, FMU = financial monitoring unit, GDP = gross domestic product, MOF = Ministry of Finance, NADRA = National Database and Registration Authority; NBFC = nonbank finance company, SBP = State Bank of Pakistan, SECP = Securities and Exchange of Commission of Pakistan, TA = technical assistance.

Appendix 2 27

UPDATED FISCAL NOTE1

1. Recent Developments and Prospects for FY2010. Most of the sources of fiscal instability for FY2008 have been addressed. Federal subsidies for oil and power have already been substantially reduced, and further increases to put tariffs at cost-recovery levels are set for the very near term. Wheat subsidies, which equaled 0.4% of gross domestic product (GDP) in FY2008, covered high-cost imports late in the season as a result of general mismanagement. The 2009 harvest is a bumper crop, and imports will be unnecessary for FY2010. Interest payments will remain high into 2010, as these reflect amounts due on obligations contracted in the 1990s. Current reforms are focusing on ways to achieve a sustained increase in revenues.

2. Summary of the FY2008 Fiscal Crisis. Surges in commodity prices, coupled with unsustainable subsidy policies and a general stagnation of tax revenues, contributed to a sharp deterioration in the fiscal balance from the overall deficit equal to 4.3% of GDP posted for FY2007 to 7.4% for FY2008. Concurrently, previously ample capital inflows deteriorated, and the lack of commensurate reductions in development spending contributed to a deterioration of Pakistan’s external position as reserves declined to less than 1 month of imports. Since November 2008, the Government has taken steps to address causes of the macroeconomic imbalances and return to a path consistent with the 4% fiscal deficit limit implied by Pakistan’s Fiscal Responsibility Law (2005). This note summarizes key aspects of the fiscal challenge and measures taken since November 2008.

3. Context. The sharp deterioration in FY2008 followed on the heels of substantial improvements in the fiscal balance. From 2001, the Government undertook a range of policies to contain expenditures and improve revenues as part of the Poverty Reduction and Growth Plan approved by the IMF and the World Bank, and by FY2004 the fiscal deficit had declined to 2.4% of GDP. Robust capital inflows provided room for Pakistan to undertake increased development spending while narrowly improving the internal fiscal balance. The fiscal balance deteriorated somewhat in FY2006 and FY2007 to 4.3% of GDP in response to additional public spending following the October 2005 earthquake and a surge in interest payments.

Table 1: Summary of Fiscal Position (% of GDP)

Item 2004/05 2005/06 2006/07 2007/08 2008/09 a Total Revenue 13.8 14.2 14.9 {14.6} {14.7} Tax Revenue 10.1 10.6 10.2 {10.6} {—} Nontax Revenue 3.7 3.6 4.7 {4.0} {—} Total Expenditure 17.2 18.5 19.2 {22.2} {19.0} Current Expenditure 13.3 13.6 15.8 {18.1} {—} Without Interest 3.4 3.4 4.2 {4.8} {—} Development Expenditure 3.9 4.8 4.9 {4.2} {—} Fiscal Deficit 3.3 4.3 4.3 {7.4} {4.3} Sources: Economic Affairs Wing, Finance Division, Government of Pakistan. 2008. Pakistan Economic Survey 2007–08. Islamabad; World Bank. 2008. Program Document for a Proposed Poverty Reduction and Economic Support Operation. Washington, DC; and International Monetary Fund. 2009. Article IV Consultation and First Review Under the Standby Arrangement—Staff Report. Washington, DC. a Projection.

4. Factors Contributing to the FY2008 Deterioration. A surge in the fiscal deficit by more that 3% of GDP in FY2008 reflected in substantial part a failure to trim existing policies in

1 Projections for FY2009 are based on April 2009 data.

28 Appendix 2

response to substantial external shocks, increases in domestic interest payment obligations, and sustained high levels of development spending.

(i) Oil, power, wheat, and fertilizer subsidies. During FY2008, subsidy outlays exceeded budget allocations by 2.8% of GDP, accounting for 37.7% of the 3% of GDP increase in the overall deficit. The unprecedented increase in oil prices drove subsidies far above the budget allocation of PRs15 billion to PRs175 billion (1.7% of GDP), as price increases were not passed along to consumers. The power subsidy roughly doubled from the budget allocation of PRs73 billion to PRs133 billion. The subsidy on wheat supplied at concessional rates through the utility supply stores amounted to about PRs40 billion—and this had no corresponding budget allocation. Fertilizer subsidies for FY2008 amounted to PRs30 billion, more than double the budget allocation.

Figure A2.1: Budgeted versus Actual Subsidies for 2007/08

(PRs billion)

15.0

175.0

72.5

133.3

13.529.5

40.0

0

50

100

150

200

Budgeted Subsidies Actual SubsidiesOil Power Fertilizer Wheat

(ii) Increased interest expenditures. Interest payments on the public debt rose by more than 49% in FY2007 on the back of lumpy payments made on maturing Defense Savings Certificates issued in the late 1990s. Taken as a share of GDP, interest payments rose from 3.1% in FY2006 to 4.8% for FY2008. During FY2008, these interest obligations increased further to PRs490 billion—about 18% higher than budgeted amounts. Payments for FY2009 are expected to be 4.8% of GDP and to remain at about that level for FY2010, placing considerable pressure on the budget. A growing level of debt also contributed to increased interest payments, as total public debt grew by 10% in FY2007 and 16% for FY2008 in response to expanding fiscal and current account deficits.

Sources: Government of Pakistan, Finance Division. 2007. Federal Budget in Brief 2007/08. Islamabad; Government of Pakistan, Finance Division. 2007. Federal Budget in Brief 2008/09. Islamabad.

Appendix 2 29

Figure A2.2: Interest Payments (PRs billion)

619.0

490.0

387.1

260.0219.7226.3235.3

273.9

050

100150200250300350400450500550600650700750

2001/02 2002/03 2003/04 2004/05 2005/06 2006/07 2007/08 2008/09*

(iii) Higher development expenditures. Development expenditures increased

steadily from 2.2% of GDP in FY2003 to 4.2% of GDP in FY2008. In response to the fiscal crisis, development spending was reduced to 3.2% of GDP in FY2009. It is expected to edge up in FY2010, reflecting new commitments by donors during a 19 April 2009 meeting in Tokyo. Overall, Pakistan has taken steps to rationalize development spending over the medium term.

Figure A2.3: Development Expenditure (PSDP) (PRs billion)

419.0

227.7

365.1

433.7 452.0

0

100

200

300

400

500

2004/05 2005/06 2006/07 2007/08 2008/09*

PRs

Bill

ion

Sources: Economic Affairs Wing. Finance Division, Government of Pakistan. 2008. Pakistan Economic Survey 2007-08. Islamabad; International Monetary Fund. 2009. Article IV Consultation and First Review Under the Stand-by Arrangement—Staff Report. Washington, DC.

* Projection. Sources: Economic Affairs Wing. Finance Division, Government of Pakistan. 2008. Pakistan Economic Survey 2007-08. Islamabad; International Monetary Fund. 2009. Article IV Consultation and First Review Under the Stand-by Arrangement—Staff Report. Washington, DC.

30 Appendix 2

Figure A2.4: Tax Revenue—Federal Board of Revenue (PRs billion)

530

770

1,300

588713

847

1,007

176.9 224.6333.7 388411.4

487.9 513.5619

0

200

400

600

800

1,000

1,200

1,400

1,600

2004/05 2005/06 2006/07 2007/08 2008/09*

Total Tax Collection by Federal Board of Revenue Direct Taxes Indirect Taxes

5. Tax Revenue Slippage. Part of the fiscal deficit increase in FY2008 can be attributed to sluggish revenue performance. The Federal Board of Revenue’s collections had increased gradually to about 9.7% of GDP and were expected to reach 10.3% for FY2008. Instead, owing in part to a slowing economy and a decline in corporate profitability, collections came in about 0.7% of GDP lower than budgeted. It is expected that tax revenue collections will be about unchanged as a share of GDP for FY2009, as higher than expected revenue from the petroleum development levy partially offset lower than expected collection of sales tax revenue on imports. The authorities are considering a range of measures for FY2010. 6. Financing the Deficit. Large external capital inflows between FY2005 and FY2007 financed nearly half of the fiscal deficit, limiting the extent to which the Government relied on domestic bank and nonbank institutions. External inflows dropped precipitously in FY2008, financing only about 17% of the deficit, and the Government relied on the banking system to finance 83% of the deficit. Much of that was financed by borrowing from the SBP. SBP claims on the Government for budget support climbed from PRs339 billion at the end of FY2007 to PRs1,274 by November 2008. Alternatively, budget support to the Government increased from 3.2% of broad money at the end of FY2007 to 12.5% of broad money at the end FY2008. The SBP financing for budget support was restricted to the stock target agreed to under the International Monetary Fund Stand-by Agreement. As treasury bill rates rose in concert with a 250-basis point increase in the SBP’s discount rate, these securities became attractive to banks. Most treasury auctions have been oversubscribed, with a wide range of banks participating.

7. Prospects for FY2010. Strains on the fiscal deficit for FY2009 have been reduced. The reduction in international commodity prices (especially for wheat and oil) will generate considerable fiscal space. Additional factors important for the 2010 fiscal outlook include:

(i) Measures will be introduced for FY2010 to strengthen revenue collections, including improvements to both policies and administration.

Sources: Economic Affairs Wing. Finance Division, Government of Pakistan. 2008. Pakistan Economic Survey 2007-08. Islamabad; International Monetary Fund. 2009. Article IV Consultation and First Review Under the Stand-by Arrangement—Staff Report. Washington, DC.

Appendix 2 31

(ii) The Government has undertaken a rationalization and review of development spending.

(iii) The fiscal space generated by recent policy changes has to be viewed in the context of substantially increased risk to Pakistan’s economic performance appearing in recent months. Social safety net requirements can be expected to expand considerably. Not only has unemployment increased, but a substantial number of citizens have been displaced as a result of intensified internal conflict. Security and defense spending will necessarily rise. Real growth could be further reduced, particularly if intensified conflict substantially impacts on agricultural activity.

(iv) The donor meeting in April 2009 resulted in commitments for additional support to shore up development activity and to reflect the increase in social support that will be needed. The original deficit target for FY2010 of 3.4% has been loosened to accommodate up to 1.2% of GDP in additional donor support.

32 Appendix 3

GOVERNMENT’S DEVELOPMENT POLICY LETTER

Appendix 3 33

34 Appendix 3

Appendix 3 35

36 Appendix 4

POLICY MATRIX FOR THE PAKISTAN ACCELERATING ECONOMIC TRANSFORMATION PROGRAM SUBPROGRAM 2

Impact: Sustained high economic growth Outcome: Macroeconomic stability

Outputs Subprogram 1 Activities Subprogram 2 (June 2009) Activities

Subprogram 3 (June 2010) Indicative Activities

Output 1: Immediate distortions removed to initiate structural transformation Output 1.1: Targeted safety nets designed and rolled out for the poor and vulnerable households Social impact of food and fuel inflationary pressures mitigated through targeted safety net programs

Safety net cover for up to 5 million poor families provided for through allocation of PRs41 billion in FY2009 budgeta Clear criteria developed for selecting beneficiaries of cash transfers through the Benazir Income Support Program (BISP)

FY2010 budget for the BISP increased to provide income support for at least 5 million familiesb BISP operationalized with (i) central and provincial offices established, and (ii) improved targeting system for beneficiaries piloted

FY2011 budget allocation for BISP increased to provide income support for at least 7 million families BISP’s fiduciary structure strengthened and improved targeting system implemented

Output 1.2: Market-based wheat pricing and efficient reserve management in place Wheat subsidies reduced and eliminated and wheat procurement made competitive

Time-bound action plan adopted by Economic Coordination Committee (ECC) for market-based pricing and reserve management (ECC action plan)c

Implementation of ECC action plan

Support price of wheat for farmers increased from PRs425d to PRs650

ECC endorsed implementation of a formula-based system for setting (i) wheat support price for 2009 and beyond based on (a) costs of production, (b) regional prices, (c) import and export parity prices, and (d) domestic and global market conditions; and (ii) wheat issue price to reflect all related costs

Appendix 4 37

Outputs Subprogram 1 Activities Subprogram 2 (June 2009) Activities

Subprogram 3 (June 2010) Indicative Activities

Output 1.3: Electricity subsidies funded and power sector debt resolution initiated Past liabilities, including electricity subsidies, settled and debt restructuring plan implemented

Parliamentary approval obtained to reduce electricity subsidies through (i) elimination of generalized sales tax subsidies for all domestic consumers and up to 500 units for commercial consumers, (ii) introduction of automatic monthly fuel price adjustments through a surcharge, and (iii) introduction of an additional surcharge to be levied on all consumers to reduce the gap between determined and notified tariffs Work on estimation of power sector debt overhang and circular debt initiated. All past electricity subsidy payments (PRs133 billion for FY2008) fully settled, and PRs88 billion allocated in FY2009 budget to partially cover the difference between determined and notified tariffs for FY2009.

Power sector circular debt resolution plan (PSDRP) prepared and implementation commenced. The plan includes (i) confirmation of the amount of overdue debt owed by Government and others; (ii) development of a financing plan showing when and how the Government will pay its debt; (iii) tariff adjustments and other measures to prevent reoccurrence of circular debt, (iv) measures that will improve finance, accountability, and corporate governance of public sector entities in the power sector (DISCOs, NTDC, GENCOs); and (v) implementation timetable and monitoring framework.

Implementation of PSDRP with a focus on removal of subsidies and resolution of ongoing circular debt. Differential between the determined and notified tariff eliminated to reflect the actual cost of supply of power to end consumers (except lifeline tariffs) Transfer of nonoperational debt of public sector power entities to a debt holding company outside of the power sector. Tariffs based on a cost-recovery basis determined by NEPRA and notified by Government within 15 days

Output 2: Financial intermediation strengthened to support structural transformation Prudential regulation and supervision strengthened

State Bank of Pakistan (SBP) has drafted a new Banking Act aligning it with international best practices.

New draft banking act that incorporates international best practice standards submitted to Parliament

SBP has raised minimum capital requirements as part of Basel II implementation.

SBP undertakes a self-assessment of compliance with Basel core principles

38 Appendix 4

Outputs Subprogram 1 Activities Subprogram 2 (June 2009) Activities

Subprogram 3 (June 2010) Indicative Activities

SBP has launched work on a 10-year financial sector strategy to broaden and diversify financial markets while developing supportive financial safety nets, as well as safeguards for consumer protection and effectively fighting against money laundering and financial crimes. Cabinet approval obtained for legislative amendments to enable SBP to better manage systemic risks by (i) adopting a consolidated supervisory framework and allowing SBP to be the lead supervisor of financial groups and conglomerates in compliance with Basel core principle 24; and (ii) transferring licensing, regulatory, and supervisory authority over deposit-taking institutions to SBPe

To improve regulatory effectiveness and risk mitigation in the financial sector, (i) a new memorandum of understanding between SBP and SECP adopted to improve coordination and information sharing; (ii) a joint task force between SBP and SECP established to identify, prevent, and manage risks posed by financial conglomerates and to continue efforts by SBP and SECP toward a harmonized risk-based approach to regulation; and (iii) NBFCs restricted from taking retail deposits from the public

SBP updates sector strategy and clarifies status of implementation To foster effective risk management and deal promptly with systemic crisis, Government establishes a financial stability forum comprised of the minister of finance, SBP governor, SECP chairman, and head of the deposit insurance scheme, once established Government to (i) conduct a comprehensive review of the supervisory architecture for the financial sector to address regulatory arbitrage concerns, create a more consistent approach to prudential supervision across sectors, and establish a stronger foundation for consolidated supervision of financial conglomerates; and (ii) drawing on this review and on the input of key stakeholders, adopt a

Appendix 4 39

Outputs Subprogram 1 Activities Subprogram 2 (June 2009) Activities

Subprogram 3 (June 2010) Indicative Activities

blueprint for a more effective financial supervisory architecture in Pakistan

Cabinet approval obtained for amendments to strengthen the anti-money laundering (AML) legal framework, incorporating international standards and best practices (Cabinet has approved amendments.)f Financial Monitoring Unit (FMU) established and operationalized, with SBP providing interim budget support and administrative oversight

Amendments to AML legislation that improve FMU autonomy submitted to Parliament MOF approves a one-line budget allocation to the FMU, beginning with the budget allocation for 2009 and beyond , and agrees to prompt release of allocated funds FMU capacity enhanced through hiring of new professional staff

FMU, with support of the Government (where relevant), addresses deficiencies concerning its operations identified in the mutual evaluation FMU provides annual report to Government on its activities and use of budget allocation

Autonomy and governance of the central bank strengthened

SBP has launched work on a new central bank law that provides for greater autonomy and accountability of SBP in its monetary and financial policies, effective regulation and supervision of financial institutions under its oversight, and clarity in the role of SBP in financial safety net and lender of last resort functions.

New central bank act enacted

National payment systems strengthened

Payments Systems and Electronic Funds Transfer Act (2007) enacted Real-time gross settlement system launched Centralized online system for retail payment systems established

Real time gross settlement rules adopted

Payment systems implementation evaluated and improvements introduced

40 Appendix 4

Outputs Subprogram 1 Activities Subprogram 2 (June 2009) Activities

Subprogram 3 (June 2010) Indicative Activities

Consumer and depositor protection strengthened

Consumer Protection Department established in SBP and work launched on a consumer protection law

Draft consumer protection law submitted to Parliament

Concept paper and draft law on deposit protection scheme prepared and consultations launched with stakeholders

Draft deposit protection law, promoting compliance with international best practice principles, submitted to cabinet

Output 3: National structural transformation strategies designed and implemented Develop and implement national structural transformation strategy

High-level steering committee established (reporting to the Prime Minster and the cabinet) to lead work on Pakistan’s structural transformation All preparatory steps finalized for the studies on structural transformation

Measures adopted to facilitate investment

Auto Industry Development Program adopted (to boost share of this segment from 2.8% of GDP in FY2006 to 5.6% by FY2012) Risk-based customs inspections introduced and an e-filing and payments system adopted for customs and sales taxes

Note: The Government’s efforts in recent months have focused on immediate crisis mitigation. Nonetheless, ADB and Government teams have worked together in doing a significant amount of analytical work on structural transformation. Public-private dialogues have been initiated for the private sector to interface with the Government. Once the energy sector issues are addressed and after the Finance Bill is passed in June 2009, the Government is likely to focus on the medium-term transformation agenda. Pursuant to the aforementioned efforts, AETP3 will be substantially devoted to the structural transformation agenda while implementing medium-term financial sector architecture related reforms.

ADB = Asian Development Bank, AML = anti-money laundering, BISP = Benazir Income Support Program, DISCO = power distribution company, ECC = Economic Coordination Committee, FMU = Financial Monitoring Unit, GDP = gross domestic product, GENCO = public sector generating company, MOF = Ministry of Finance, NBFC = nonbanking finance company, NEPRA = National Electricity Power Regulatory Authority, NTDC = National Transmission and Dispatch Company, PSDRP= Power Sector Circular Debt Resolution Plan; SBP = State Bank of Pakistan, SECP = Securities and Exchange Commission of Pakistan. a Through expanding and strengthening the Bait-ul-Mal Food Support Program (a program that provides financial assistance to the needy, including the destitute,

widows, orphans, and invalids, that is implemented by the Bait-ul-Mal, a semi-autonomous organization within the Ministry of Social Welfare and Special Education) and establishing the new Benazir Income Support Program.

Appendix 4 41

b This covers the BISP only, as the Government intends to further develop its flagship program as the single targeted cash transfer program and discontinue the Bait-ul-Mal Food Support Program as an unconditional cash transfer.

c The action plan addresses (i) eliminating wheat subsidies through the support price of wheat for farmers; (ii) eliminating operational reserves while maintaining strategic reserves at 2 months of annual average national consumption requirements by June 2010; (iii) removing administrative restrictions on domestic wheat trade; (iv) completing restructuring of Pakistan Agricultural Storage and Supplies Corporation (PASSCO) and the provincial food departments and directorates; (v) implementing a targeted safety net program for poor and vulnerable households; and (vi) divesting government ownership in unused warehouses, storage facilities, and other market infrastructure. The action plan shall be implemented over the period between subprograms 1 and 3.

d For 40 kilograms, which is the standard unit of measurement in Pakistan. e A financial conglomerate includes any group of legal entities whose exclusive or predominant activities are banking and at least one other activity in the financial

sector. f Among other things, the amendments will (i) provide for a single national-level committee to oversee and provide policy guidance for AML efforts, instead of the

two committees that operate at present; (ii) ensure financial and operational autonomy of the FMU; (iii) provide that the FMU shall act as the secretariat for the national level committee; and (iv) set out transparent criteria for the appointment and dismissal of the FMU’s head.

Source: ADB.

42 Appendix 5

IMF MACROECONOMIC ASSESSMENT

Will be circulated separately.

Appendix 6 43

BENAZIR INCOME SUPPORT PROGRAM A. Background 1. On 13 October 2008, the Government launched a new cash transfer program for the poor, the Benazir Income Support Program (BISP), to smooth the impact of the food and fuel crises. The Government allocated PRs34 billion for FY2009, targeting 3.5 million families. This was the third-largest allocation in the budget and constituted 0.3% of GDP. 2. BISP provides cash transfers of PRs1,000 per month to the female head of eligible families whose monthly income is less than PRs6,000 per month. This amount has been estimated as sufficient to finance 20–25 days of flour needs for a 5–6 member family. 3. The different tasks under the BISP are functionally separated to guard against misuse of funds. The BISP is responsible for management of the program. It decides on the policies (including targeting criteria), prepares regulations and manuals, and monitors implementation. In order to quickly launch the program, parliamentarians were asked to identify beneficiary families. The services of the National Database Registration Authority (NADRA) have been hired by BISP to verify eligibility of the selected families based on specified criteria. NADRA sends the list of eligible families to BISP to calculate the payments due and to the Pakistan Post to deliver the payments. Pakistan Post has been contracted by the BISP to deliver the payment through money orders to the adult female in the household every alternate month. B. Program Management 4. As discussed above, key BISP functions, such as targeting, operation, payments, and controls, are carried out by separate actors to allow for checks and balances. This requires a strong central unit to coordinate the program. 5. Strategic and Management Level. The BISP is governed by a management board headed by the BISP chairperson, who is appointed by the President of Pakistan upon advice of the Prime Minister. The BISP board is responsible for design and implementation of the BISP. Currently, the management board is composed of five members of the National Assembly, the deputy chairman of the Planning Commission, and BISP’s managing director. However, the recently approved Benazir Income Support Program Ordinance, 2009 expands the number of board members to not less than nine nor more than 11, half of which should be from the Government and half from nongovernment organizations. 6. Operational Level. The managing director is responsible for day-to-day operations of the BISP and is supported by three departments: (i) the Operations Department liaises with the regional units in each province; (ii) the Administration Department is responsible for administrative matters, media contacts, and information technology; and (iii) the Finance and Accounts Department is responsible for the fiduciary aspects of BISP.

44 Appendix 6

Figure A6.1: Organizational Structure of BISP Headquarters

Chairperson(Federal Minister)

M.D

JS Operations

DirectorPunjab/

ISL

DSAdmin-I

DSF&A

DirectorSindh

DirectorAJK/NA

JS/FAFinance & Accounts

IT Officer

Board

PS= 1PA=12Asst.=8NQ=8S.G=3

Swep=2DR=1

PMO=1ReP=2Dri=11R & I

Asst=3N.Q=1

Asst . Officer (IT)

(2)

A/O/Cashier A/O

A/AA/A

DirectorBaloch

DirectorNWFP/FATA

Asst.Media Liaison Officer

P.SP.AP.AQ

N.QDr.

DSAdmin-II

Media Assistant

DSI/A

JS Administration

Media Liaison Officer

Source: http://www.bisp.gov.pk/benazir/organization-chart.jsp. 7. To date, the managing director and the directors general of operations and administration have been appointed. The position of director general for finance and accounts is vacant. In addition, 83 other staff have been appointed. 8. Accounting and Financing. The institutional arrangements and governance structure of the BISP will be defined under implementing regulations to the new ordinance and are in the process of being drafted. Comprehensive accounting and finance guidelines are being developed. These will incorporate a robust internal control framework and ensure adequate segregation of duties. The finance and accounts guidelines will also provide the minimum staff and capacity required. Additional staff will be needed to effectively address the anticipated nature and scale of operations and satisfactorily manage accounting and financial reporting functions once the entity fully commences operations and subnational formations are functional. An accounting and financial reporting module will form part of the entity’s management information system (MIS). 9. An internal audit unit has also been created. Currently, the unit is reporting to the director general for finance and accounts. To ensure independence and enhance the control environment, the unit will be placed under the administrative control of the managing director. All internal audit reports will be presented to the management board for discussion and appropriate action. An internal audit policy has been drafted and is under internal review. Staff in internal audit will need to be trained to ensure that the internal audit work program can be effectively implemented. 10. Operations. BISP has five regional offices. Each regional office is managed by a director general. The regional offices are small, but they can be expanded if needed. Each

Appendix 6 45

regional office has a number of divisional offices covering zones within the region. There will be 28 divisional offices in total, each headed by a zonal director and assisted by supervisors, 125 in total for all divisional offices. So far, all provincial offices have been set up and most of the director general and director positions have been filled. Other staff still must be appointed as the BISP rolls out its operation. A total of 16 directors have been appointed, including directors general. The divisional offices are still being established. 11. The main function of the divisional offices is to redress grievances. A website has been created where individual applications and benefit payment status can be tracked. As it is unlikely that many targeted individuals have internet access, constituents thus submit their grievances through their parliamentarians. An MIS is under preparation which will provide divisional offices with access to updated applications and payment status of the applicants and beneficiaries. A toll-free number will be launched to submit grievances once the MIS is operational. Moving grievance redress down to the grassroots level is a priority going forward. 12. Flow of Funds. As set forth in the BISP Income Support Program Ordinance, 2009, the BISP prepares an annual budget estimate for the program. The Ministry of Finance reviews and presents a budget before Parliament that includes the annual BISP budget. Periodically, the BISP updates the Ministry of Finance on its budget requirements (in light of qualified beneficiaries). Based on the update, the Ministry of Finance advises the Accountant General Pakistan to release the funds needed into BISP’s assignment account with the National Bank of Pakistan. BISP receives the list of eligible families from NADRA, which is also forwarded to Pakistan Post. BISP calculates the amount owed. The managing director of BISP approves the amount for release to Pakistan Post and issues a check. Pakistan Post then delivers money orders to eligible families and prepares payment information (status of money order for each beneficiary, whether it was delivered or not, cumulative figures). After 30 days, Pakistan Post prepares reconciliation.

Table 6.1: BISP Budget Information (as of 30 April 2009)

Description Amount (PRs million)

Budget allocation for FY 2008/09 34,000Amount disbursed by BISP for

Benefit payments (including Pakistan Post service chargesa) 10,972BISP administrative costs 118National Database and Registration Authority 123Pilot poverty score card survey in 16 districts (PPAF/RSPN/PCO) 173

PPAF = Pakistan Poverty Alleviation Fund; PCO = Population Census Organization; RSPN = Rural Support Program Network. a Pakistan Post will receive PRs25 per money order, the postman will receive PRs5 per money order. Source: Benazir Income Support Program. 13. At the current pace, around half of the allocated PRs34 billion will be disbursed by 30 June 2009. More than 95% of the disbursements are funding benefit payments, meaning less than 5% of the resources are used to cover administrative costs and service delivery (including costs of the pilot project to prepare a new targeting method). 14. Selection of Beneficiaries. In order to quickly launch the BISP, federal parliamentarians (members of National Assembly and senators) were asked to identify beneficiary families. The rationale is that parliamentarians are accountable to their electorates.

46 Appendix 6

All parliamentarians, irrespective of party affiliation, have been provided with an equal opportunity to recommend eligible families. Each politician received 8,000 forms to be distributed based on 13 criteria to the poor and needy in his or her constituency. 1 The completed forms were sent directly to NADRA. This selection process was closed on 28 February 2009. Forms submitted after this date have been discarded.

Table 6.2: Status of Forms Processing (as of 30 April 2009)

Description Total Number Percentage Number of forms distributed to Parliamentarians 3,500,000 100 Number of completed forms submitted by Parliamentarians to NADRA

3,085,919 73.5

NADRA = National Database and Registration Authority. Source: Benazir Income Support Program. 15. In December 2008, the Government decided to improve BISP targeting through the adoption of a poverty scorecard based on a so-called “proxy means testing” approach. The use of the poverty scorecard will be pilot tested in 16 districts. Three organizations have been contracted to conduct the pilot test: Pakistan Poverty Alleviation Fund (PPAF), Rural Support Program Network (RSPN), and Population Census Organization (PCO). The PPAF and RSPN are well established in the rural areas, and the PCO has a broad network of offices throughout the country. The BISP has established clear criteria for evaluating their performance before selecting the organizations for the nationwide rollout of the poverty scorecard survey. The pilot began in May 2009 and is expected to be completed in 2–3 months. 16. This test phase will provide useful insights and the necessary learning for scaling up the program nationwide, including to make improvements in the enrollment, payment, grievance and appeals, and monitoring and evaluation processes. 17. Recipient Verification. NADRA has been contracted to verify targeted beneficiaries under the BISP. NADRA receives the prescribed forms from the parliamentarians and verifies them electronically by applying certain filters. It is not able to check on one of the key criteria, which is money income. Two weeks are allotted to process the forms. The list of eligible beneficiaries is passed on electronically to Pakistan Post for payment. The list of ineligible beneficiaries (those who do not meet all eligibility criteria) is returned to BISP for closure. The list of rejections (due to discrepancies in the forms) is returned to BISP and the applicants for rectification. In addition, NADRA rejects people in cases of fraud or duplication. 1 The criteria for a family's eligibility for benefits under the BISP are as follow: (i) possession of a computerized

national identification card (CNIC) by the female applicant; and (ii) monthly income is less than PRs6,000; (iii) widowed or divorced women, without adult male in the family; or (iv) any physically or mentally retarded person(s) in the family; or (v) any family member suffering from a chronic disease. The following families will not be eligible: (vi) where any member of the family is in the employment of a government or semi-government authority or department or the armed forces; (vii) where any member of the household is drawing a pension from a government or semi-government authority or department or the armed forces; (viii) where any member of the household is receiving any post-retirement benefits from any department or agency; (ix) where any member of the family owns agriculture land of more than 3 acres or a residential house or plot of more than eight square yards (3 marlas); (x) where any member of the family is receiving income support from any other sources; (xi) where any member of the family possesses a machine readable passport; (xii) where any member of the family possesses a national identity card for overseas pakistanis; (xiii) where any member of the family has a bank account (except at NBP, HBL, UBL, MCB, ABL, BOP, Bolan Bank, Khyber Bank, First Women's Bank, Zarai Tarakyati Bank, Khushali Bank, and all microfinance banks).

Appendix 6 47

Table 6.3: Number of Beneficiaries Verified by NADRA (as of 30 April 2009)

Province Total Received Total Eligible Total Ineligible Total Rejected Punjab 1,546,637 819,583 285,935 441,119 Sindh 708,150 469,642 44,699 193,809 NWFP 509,547 343,628 59,672 106,247 Balochistan 214,834 112,800 20,635 81,399 FATA 106,751 55,627 15,736 35,388 Total 3,085,919 1,801,280 426,677 857,962

FATA = Federal Administered Tribal Areas; NWFP = NorthWest Frontier Province. Source: Benazir Income Support Program. 18. One of the eligibility criteria is that a female member of the family apply as the named applicant. She needs to have a computerized national identification card (CNIC). The NADRA network in rural areas, especially in the FATA region, is incomplete but is being expanded as the BISP extends coverage. As of October 2008, 67.3 million CNICs had been issued out of an eligible adult population of 85.5 million. Since the introduction of BISP, NADRA has issued a total of 2 million new CNIC cards to women. The issuance has potentially a strong emancipatory impact, as the possession of a CNIC is required for most business activities, such as opening a bank account, obtaining a telephone connection, and for any government application. 19. Disbursement. Pakistan Post has a network of 12,343 post offices that can help reach BISP beneficiaries. Payments are delivered at home without collection cost for the recipient. Pakistan Post has agreed to provide BISP with computerized payment information and a reconciliation of financial transactions within the subsequent month after completion of the disbursement cycle. In case of abuse (when a postal delivery person asks for a fee), sanctions will be imposed. Pakistan Post has its own institutionalized mechanism based on its internal monitoring cell for reconciliation, random checking, and reporting. So far, 11 postal delivery persons have been sanctioned for mishandling the payment delivery. The Postal Department has also taken administrative action against officials as well as officers.

48 Appendix 7

WHEAT MARKETING REFORMS A. Background 1. Under the Accelerating Economic Transformation Program, the Government committed to a market-based wheat pricing and efficient reserve management system. This involves wheat marketing reforms regarding the producer procurement price and wheat issue price to flour millers, as well as a reduction in the scale of procurement undertaken by government agencies for the within-year operational reserves and for inter-year strategic reserves. Given an anticipated expansion in the private sector’s role in marketing, the Government also committed to undertake the sale of surplus storage facilities. 2. The approach approved by the Government’s Economic Coordination Committee (30 September 2008) was incremental, reflecting the need to maintain price stability for producers and consumers until new government safety net programs become fully operational that are better targeted and more efficient. A key new program is the Benazir Income Support Program (BISP), which will provide income support to 7 million poor and low-income families by 2010. 3. The existing wheat marketing support measures have involved government subsidies (federal and provincial) to support wheat producers and consumers that include significant subsidy transfers to flour millers. The interventions, while providing some price stability, have not been efficient or well targeted in terms of reaching their intended beneficiaries. While the wheat subsidy was only 0.3% of GDP in FY2008, it is still significant in terms of government expenditure (accounting for approximately PRs40 billion). B. Wheat Economy

4. Wheat Marketing System. Wheat is the staple food in Pakistan, and, given the large population of poor and low-income earners (small-scale producers and consumers), wheat price stabilization has been a long-term government policy objective. The Government has adopted a number of interventions involving

(i) a wheat procurement price (set by the Government for purchase from producers);

(ii) wheat procurement targets for the Pakistan Agricultural Storage and Supplies Corporation, or PASSCO, and the provincial food departments (with Punjab accounting for approximately 80% of the country’s production);

(iii) a wheat issue price for sale of procured wheat to flour millers (usually at less than the costs of procurement plus storage, handling, and transport, it is quota based); and

(iv) controls on wheat movement, with import and export controls (tariffs and prohibitions) depending on the country’s production level, and domestically interprovincial restrictions on movement until provincial targets are achieved.

5. In an average season, the country’s production is around 21 million tons, of which about 60% is retained while the remaining 40% (i.e., 8 million to 9 million tons) enters the market. In terms of demand, procurement is undertaken by government agencies, flour millers, and traders (some of which is for illegal export). For 2009, production is forecast at 25 million tons. The Government’s policy agenda calls for increasing wheat production, with a target of 30 million tons by 2015. To achieve this through productivity improvements would require a large program providing farmers improved access to quality inputs, finance, water, and technical services.

Appendix 7 49

6. In a market-based wheat producing economy, the wheat price will range between the import and export parity price, depending on the level of production and whether the country is exporting or importing in that year, and with adjustments for associated transport and handling charges. The export parity price is lower, with the difference being the cargo or freight cost (international to port for imports) and the transport and handling costs from farm to port (for exports). 7. In Pakistan over the period 2005–2007, the domestic price was akin to the export parity price, as over this period crop production was good and export was undertaken at some level (see Table 1). The exception was the period of high fluctuating prices during 2007–2008. Given government interventions into the wheat market in Pakistan, the link between international price changes and movement in domestic prices is at times distorted.

Table A7.1: Wheat Production and Trade ('000 tons)

Consumption Year Production Imports Exports

Domestic Procurement Releases

2000–2001 19,024 80 8,582 5,537 2001–2002 18,226 267 4,081 3,376 2002–2003 19,183 148 649 4,045 5,130 2003–2004 19,500 108 1,140 3,514 4,104 2004–2005 21,612 427 43 3,939 4,500 2005–2006 21,277 816 4,514 2,088 2006–2007 23,295 136 4,422 6,003 2007–2008 20,959 1,820 3,918 6,320

Note: Export numbers are official exports, and do not include informal sales and exports to Afghanistan. Source: Official Government of Pakistan Statistics (MINFAL, Federal Bureau of Statistics). 8. The existing government procedure for setting the procurement price involves the Agricultural Policy Institute (API) under the Ministry of Food, Agriculture, and Livestock undertaking a wheat market analysis. This involves assessing the following factors: domestic supply, demand, stocks, and price; cost of production, comparative economics of competing crops, fertilizer costs, nominal and real prices, and world market supply and demand; and the domestic parity price and import and export parity prices. 9. While the API analyses a range of factors, its report does not make a specific price recommendation. API does not use a structured methodology with weightings for the key factors determining price, such as forecast international prices and the cost of production. Under the current system, it appears that the dominant determining factor is cost of production. The analysis is submitted to the Ministry of Food, Agriculture, and Livestock, which prepares a recommendation on the wheat procurement price that is then submitted to the ECC. The ECC makes the final decision on the procurement price. The procurement price movements over 2007–2009 and associated impacts on supply and procurement indicate the risks associated with the current procedure when international wheat prices are fluctuating. To reduce the risk of the wheat procurement price’s being distortionary and to set the price at a level that is above the market price, a more structured price setting methodology is needed. Such a methodology should require a more thorough assessment of international forecast wheat prices. 10. The level of wheat stocks and reserves tend to be country-pecific and is influenced by domestic policy and assessment of potential risks. Pakistan does keep large national stocks in relation to its policy of assisting to stabilize prices, which results in high costs to the Government.

50 Appendix 7

During 2001–2007, levels were approximately 19% of production (Table 2). In comparison, national stocks in India over the same period were about 23%, which is high relative to other countries in South Asia. For India, it reflects the country’s large demand given its population and the impact that increased Indian wheat import requirements would have on the world price. That is not a factor for Pakistan. For 2009, the Indian procurement price is equivalent to PRs750 per 40 kilograms (kg). (Price comparison between the two countries may not reflect the wheat quality difference between them.) By contrast, Bangladesh operates with substantially lower stock levels. 11. Impact of Wheat Prices in 2007 and 2008. During 2007 and 2008, wheat prices increased rapidly. In Pakistan, this price volatility impacted on households’ capacity to access and purchase wheat. This, in turn, led to social unrest. The announced 2008 procurement price was less than the market price (export parity price), and during the 2008 season the Government had to raise the procurement price to PRs625 per 40 kg. Initially, exports had been undertaken in 2008. Later in the year, to meet consumer needs, Pakistan had to import wheat (1.8 million tons) at a much higher price, which was then sold at a lower price to domestic flour millers. It is estimated this subsidy cost PRs40 billion. Trying to meet this domestic demand, the Government banned exports and producing provinces imposed interprovincial restrictions to control supply and movement and to achieve required targets.

Table A7.2: Wheat Procurement and Issue Price

Year

Procurement Price

(PRs/40 kg)

Issue Price Sep–Oct Nov–Dec Jan–Feb Mar–Apr

2000–2001 300 330 335 340 345 2002–2003 300 330 335 340 345 2003–2004 350 330 335 340 345 2004–2005 400 380 380 392 398 2005–2006 415 425 2006–2007 625 430 2007–2008 625 625 2008–2009 950 TBD

kg = kilogram; TBD = to be determined. Source: Official Government of Pakistan Statistics (MINFAL). 12. Wheat Prices in 2009. In September 2008, the Government announced the procurement price (support price) for the 2009 crop of PRs950 per 40 kg. The crop is harvested from March in Sindh Province and from April in Punjab Province and the other provinces. This procurement price is significantly higher than the 2008 price (PRs625 per 40 kg), and it has had a positive impact on production. Current 2009 wheat forecasts are for 25 million tons. The Government indicated that the procurement price was based on cost of production and reflected regional and international wheat prices at that time of approximately $360 per ton (US hard red wheat grade 2). It did not reflect forecast international wheat price movements. 13. Since setting the procurement price, international wheat prices have fallen (to approximately $250 per ton, at present), and the procurement price is currently approximately $70–$100 per ton above the world price and above the export parity price but below the import parity price. This price differential, with a procurement price above the international wheat price, has increased pressure on the Government to undertake higher levels of procurement, and it has imposed financial and logistics burdens on the procurement agencies. In February 2009, the Government announced a wheat import ban.

Appendix 8 51

UPDATED ENERGY SECTOR BRIEFING NOTE 1. The acute power shortage in Pakistan is a threat to the social and economic fabric of the nation. Since FY2007, Pakistan has been suffering from an energy crisis caused by a severe supply deficit (reaching up to 5,000 MW peak shortfall in FY 2009). In some places, especially in rural areas, there are 10–12 hours of load shedding. Thirty four percent (34%) of the population has no access to electricity from the national grid. Disruptions in electricity and gas supply are further slowing down economic growth and global competitiveness. Growth in 2008 was constrained to 5.8%.1 With the shortage of supply it is difficult to increase access to reliable and affordable electricity needed. A. Technical 2. According to the Government's Medium-Term Development Framework (2005–2015), if the economy were to grow at 8% per annum, around 2,000 MW of generating capacity would need to be added each year. New capacity has not been added in line with demand. There is 19,420 MW of installed power generation capacity in Pakistan. However, accounting for the seasonal nature of hydroelectric plants, gas shortage and closure of some plants, the available capacity is around 14,000 MW. Uncapped demand is estimated at 21,000 MW. Larger commercial customers are relying on captive generation, which has raised their cost of business, while smaller commercial customers are facing a decline in their productivity due to the unreliability of electricity supply. In FY2009/10, 2,114 MW of new installed capacity is expected from independent power producers (IPPs) and 1,247 MW from rental power contracted for 3–5 years. Even with this addition, some shortage is expected and load-shedding would be necessary. 3. The energy system also suffers from high transformation losses. System-wide transmission losses remain high at 23.4% of dispatched power, despite some improvements in recent years. Investment in the sector has been inadequate, and ageing plant and equipment are hampered by inadequate maintenance in the past. The Government has developed clear roadmaps and investment plans for the power transmission and distribution sectors, which are now being implemented with financing assistance from development institutions. Each distribution company (DISCO) has been given an incentive to reduce their technical losses through their tariff. B. Governance 4. Although good progress has been made in strengthening the financial and corporate independence of the power sector companies after unbundling in 1998, problems continue to exist. Examples of this include: the National Transmission and Dispatch Company (NTDC) acting as a borrowing vehicle, which is beyond its transmission company mandate; the cross servicing of, and pledging of receivables and other assets to secure debt owed by other entities; and central control of cash flows. 5. The lack of independence impacts the ability of these public power sector companies to effectively perform their mandate (distribute, transmit or generate electricity), maximize the long-term return on assets and attract new investment into the sector through the provision of creditworthy power purchase and other agreements. Under the current arrangement, there is no incentive to improve performance. 1 Asian Development Bank. 2009. Asian Development Outlook 2009 (Pakistan, pp. 210-216).

52 Appendix 8

C. Financial Issues 6. From 2003–2007, customer tariffs were not raised despite the threefold increase in cost. Despite the 20% increase in 2008/09, the extraordinary spike in oil prices accelerated the payment arrears to the power generating companies, and plants were not able to operate at optimal capacity due to lack of funds to pay for fuel. These conditions made the environment difficult for increased private investment in power generation through IPPS or rentals. The situation has improved since the decrease in oil prices and recent steps taken by Government, which include the adoption of the Power Sector Circular Debt Resolution Plan. 7. The National Electricity Power Regulatory Board (NEPRA) determines generation, transmission, distribution and retail/wholesale tariffs. The price is determined at full cost recovery and agreed profitability. Based on the determination, the Government notifies the official tariff. For the retail/wholesale tariff, any difference between the determined and notified tariff should be paid by the Government through the tariff differential subsidy. Tariff differential subsidies were to be paid to the DISCOs to make up for the shortfall in the customer tariff and cost recovery tariff. It is estimated that PRs 308 billion of subsidy is owed by the Government. With this and non-payment by public and private customers (PRs226 billion), the DISCOs accumulated PRs407 billion ($5.08 billion) of payables for their electricity purchase from the NTDC, being the Central Power Purchasing Agency (CPPA), as of 31 March 2009. 8. With Government guarantee, in March/April 2009, NTDC/CPPA had to borrow PRs92 billion from banks to pay the fuel costs of IPPs and government-owned generating companies (GENCOs). Total liabilities of NTDC/CPPA owed to these firms, amount to PRs250 billion ($3.12 billion) as of 31 March 2009. 9. Further, a total amount of PRs216 billion of bank debt has been accumulated by WAPDA, DISCOs and NTDC to remedy the cash shortfall. To service this debt, tariffs need to be significantly increased or the Government needs to take over the debt. IPPs and GENCOs also need to be paid PRs142 billion in cash immediately for them to be able to provide power at optimal capacity. D. Analysis 10. For a reliable, sustainable power sector, there is a need for (i) cost recovery tariff, (ii) resolution of the accumulated debt, (iii) financial and corporate independence of public power sector companies, (iv) establishment of CPPA as an independent entity, and (v) cash injection into the IPPs and GENCOs to cover fuel, operating, and maintenance costs that are immediately payable. On the technical side, (i) an updated integrated energy plan, (ii) reduction of losses and increase collection in line with the distribution road map, and (iii) continued augmentation and improvement of transmission lines based on the transmission road map, would need to be implemented. The adoption and implementation of the Power Sector Circular Debt Resolution Plan by the Government should address many of these issues.

Appendix 9 53

POWER SECTOR CIRCULAR DEBT RESOLUTION PLAN

54 Appendix 9

Appendix 9 55

56 Appendix 9

Appendix 9 57

58 Appendix 9

Appendix 10 59

FINANCIAL SECTOR BRIEFING NOTE A. Introduction 1. Structural transformation depends upon an effective and efficient financial sector to mobilize savings, help identify good business opportunities, and monitor business performance. The Government is committed to reforming this sector to enable it to become a more inclusive part of the Pakistan economy. 2. Asian Development Bank (ADB) has been supporting the Government to develop the financial sector for the last 14 years. ADB’s initial focus was on capital market development,1 which was later expanded to support development of the nonbank financial sector and to improve access of the poor to the financial sector.2 In 2008, the Government requested ADB to provide assistance for banking sector reforms.3 Strengthening financial governance has become more urgent as a result of the global financial turmoil, which has led to liquidity constraints in the banking system and increased prudential risks. B. Bank-Dominated Financial Sector 3. While efforts have been made to expand the role of the nonbank financial sector in Pakistan, privately owned banks continue to dominate; overall, banking sector assets comprise approximately 72% of total financial sector assets. As reflected in Table A10.3, banks have been increasing their market share in recent years. However, the rapid credit growth during the last few years has increased the credit risk for this sector. Nonperforming loans increased to about 9.1% of loans outstanding in 2008 compared to 7.2% in 2007. Banks’ profitability declined by about 27.1% from the previous year, reflecting in part growing provisioning requirements in response to the rise in nonperforming loans. 4. The sector has also become more diversified. To promote greater economies of scale, there have been 22 bank mergers and 7 bank acquisitions since 2000, most of which involved mergers between commercial and investment banks. Groups of affiliated financial sector entities (financial conglomerates) are becoming the norm, as banks broaden their product offerings and seek cross-selling opportunities. A number of banks also own shares in insurance companies and have interests in asset management companies and mutual funds. Some banks engage in

1 ADB. 1995. Report and Recommendation of the President to the Board of Directors on a Proposed Loan and

Technical Assistance Grant to the Islamic Republic of Pakistan for the Financial Sector Intermediation Loan. Manila. (Loan 1371-PAK, approved on 17 August for $100 million); ADB. 1997. Report and Recommendation of the President to the Board of Directors on Proposed Loans to the Islamic Republic of Pakistan for the Capital Market Development Program. Manila. (Loan 1576-PAK, approved on 6 November for $250 million); ADB. 1997. Technical Assistance to the Islamic Republic of Pakistan for Capacity Building of the Securities Markets. Manila. (Loan 1577-PAK, approved on 6 November for $5 million); ADB. 2002. Report and Recommendation of the President to the Board of Directors on Proposed Loans and Guarantees to the Islamic Republic of Pakistan for the Nonbank Financial Markets and Governance Program. Manila. (Loans 1955-, 1956- and 1957-PAK, approved in August for $260 million, $3 million, and $3 million, respectively); ADB. 2006. Report and Recommendations of the President to the Board of Directors on a Proposed Loan and Technical Assistance Grant to the Islamic Republic of Pakistan for the Second Generation of Capital Markets Reform Program (Loan 2340-PAK, approved on 10 July 2007 for $260 million).

2 ADB. 2006. Report and Recommendation of the President to the Board of Directors on Proposed Loans and Technical Assistance Grant to the Islamic Republic of Pakistan for Improving Access to Financial Services (Phase I) Program. Manila. (Loans 2291- and 2292-PAK, and TA 4894-PAK, approved on 14 August for $300 million, $20 million, and $2 million, respectively).

3 ADB. 2007. Technical Assistance to Pakistan for Support to Governance Reforms in Pakistan. Manila.

60 Appendix 10

other nonbank activities, including leasing, advisory, brokerage services, modaraba 4 management, and foreign exchange. C. Nonbank Finance Companies (NBFCs) 5. NBFCs include mutual funds, private equity and venture capital funds, modarabas, pension funds, real estate investment trusts, and companies engaged in the businesses of leasing, investment banking, house financing, and investment advisory services. In terms of asset size, mutual funds constitute 68% of the NBFC subsector. The number of mutual funds increased from 67 in 2007 to 87 (as of 30 June 2008). While NBFCs have been growing, due to the expansion of mutual funds, their share of total financial sector assets continues to decline. The insurance sector has had limited growth. The housing finance sector remains stagnant and venture capital development is at an early stage. Universal banking also places pressure on NBFCs. D. Capital Market 6. The capital market in Pakistan includes three stock exchanges, located in Karachi, Lahore, and Islamabad. The exchanges trade ordinary shares; mutual fund certificates; modaraba certificates; government and corporate bonds, including sukuk 5 and term finance certificates (TFCs). In the capital market, new issues of shares are very limited and private corporate listed issues of TFCs and sukuk are of limited importance. Growing financing requirements of private and public infrastructure investments, particularly in the transportation and energy sectors, are likely to remain unmet unless new long-term financing sources are developed outside the banking system. The Government’s Medium-Term Development Framework (2005–2010) conservatively estimates that some $150 billion (PRs120 trillion) will be required for such investments over this period. E. Financial Sector Supervision 7. Pakistan has adopted an institutional approach to financial sector regulation and supervision under which a firm’s legal status determines which regulator is tasked with overseeing its activity from a safety, soundness, and business conduct perspective. Under this approach, the State Bank of Pakistan (SBP) supervises and regulates banks, development finance institutions, microfinance banks, and exchange companies. The Securities and Exchange Commission of Pakistan (SECP) regulates the nonbank financial sector. Regulatory approaches differ—the SBP focuses on prudential regulation and mitigation of systemic risks, and the SECP concentrates on investor protection through conduct of business and disclosure requirements. 8. Under the Banking Companies Ordinance (1962), banks are deposit-taking institutions and can perform all of the functions performed by NBFCs, either directly or through a subsidiary. When performed through a subsidiary, SECP has jurisdiction over the subsidiary. Due to the nascent state of the capital market, a number of NBFCs are engaged in deposit taking, which is traditionally regulated by banking regulators to address prudential risks concerns. These NBFCs mobilize short-term funds from the general public and extend working capital and overdraft facilities to businesses. Since they are prohibited from undertaking commercial banking

4 Modaraba is a contract in which one party provides capital to another party for the purpose of carrying on a

business with the stipulation that the profit will be shared by participating parties in clearly defined proportions agreed beforehand. Any loss incurred is borne by the capital owner.

5 A sukuk is a security resembling a bond but that complies with Islamic law.

Appendix 10 61

activities, they get around this restriction by issuing withdrawal slips that work like checkbooks. A recent scandal involving one of the largest investment banks in Pakistan led the SECP to issue a directive to this bank to cease taking deposits. 9. NBFCs were previously supervised by the SBP, notwithstanding the absence of enabling legislation providing SBP with sufficient supervisory powers. Since all NBFCs were incorporated as companies under the Companies Ordinance (1984), only the SECP appeared to have the power to take action against these firms. Thus, when off-site surveillance and on-site inspections of NBFCs by SBP highlighted irregularities, SBP had to request SECP to take action against them. In December 2002, the Companies Ordinance was amended to clarify SECP’s jurisdiction over NBFCs. That jurisdiction was thus transferred from SBP. The amendments allowed NBFCs to offer a range of financial products in order to encourage single-product NBFCs serving a specific market niche to merge. There was limited consolidation of NBFC activities, however, even as banks started making rapid inroads into this area. At the time of their transfer from SBP to SECP, there were 16 investment banks, compared with 8 at present. F. Government Reform Agenda 10. In the mid- to late-1990s, the Government undertook major financial sector reforms. Based on the institutional approach to regulation, reforms focused on institutional versus sector-wide issues. 11. Banking sector. Prior to the Government’s reform program, state-owned banks comprised 80% of the banking sector and were characterized by poor performance and high nonperforming loans (often in excess of 70%). Financing for small and medium enterprises and microfinance was nonexistent. Under the reform agenda, banking sector performance was facilitated by privatization; restructuring of major banks; consolidation; strengthening of the regulatory and supervisory framework and related capacity; and improvements in transparency, corporate governance, and the credit culture. Reforms included adopting international best practice standards for risk management and money laundering (see discussion below). 12. As a result of the successful reform agenda, the private sector now accounts for approximately 81% of the banking sector. Access to financial services has increased. Banking sector assets rose by 50% over the last 3 years and the industry’s assets now exceed PRs5 trillion. There has been a major improvement in the sector’s profitability and financial strength. Return on banking assets after taxes rose from 0.1% in 2002 to 1.2% in 2008. Return on equity increased from 3.2% in 2002 to 11.3% in 2008. The SBP introduced Basel II and banks have higher capital adequacy levels that are well above the minimum level for the sector as a whole. Despite economic shock and stress in the stock market, the banking system has shown increased profitability in the first quarter of 2009. 13. SBP is implementing payment and settlement system reforms. In July 2008, the SBP launched the Pakistan Real Time Interbank Settlement Mechanism (PRISM), which is the real time gross settlement system for wholesale payment transactions. The system is designed to handle all large-value payments. Preliminary work has also started on modernizing the retail payment and settlement system to encourage electronic and mobile telephone-based transactions. SBP is working with a wide range of stakeholders to promote the use of efficient electronic payment instruments that includes a high level of standardization, schemes that allow straight-through processing and development of infrastructure for new retail payment instruments, and alternative channels for making payments.

62 Appendix 10

14. To guide its reform agenda over the longer term, the SBP adopted and launched a 10-year strategy to broaden and deepen the banking sector. The objectives of the strategy are to make the banking sector (i) more responsive to the needs of the economy and thus help achieve a more rapid and sustainable economic growth; (ii) financially stronger, more resilient, and stable; (iii) better regulated and supervised; and (iv) more efficient and stable. 15. Nonbank Financial Sector. Pakistan has made progress with capital market reforms since 1998, when a year-long economic crisis had resulted in a stock market crash. A new regulator, the SECP was established to help develop the capital markets.6 16. With support from ADB, SECP has undertaken a number of regulatory, supervisory, and market-reform initiatives, including risk management measures and introduction of new products. Equity capitalization has improved, and Pakistan’s stock market has been one of the best performing markets since the start of 2008. Nevertheless, and although the stock market capitalization has shown spectacular increases in recent years,7 the market does not play a major intermediary role. There have been few new listings and stock values declined sharply in 2008. The private debt securities market remains rudimentary in scope. The government debt market has grown in recent years to meet the Government’s growing financing needs, but the framework for issuing, pricing, and trading government securities remains underdeveloped. The growth of NBFCs continues to lag that of banks. 17. Preventing Money Laundering. The Government is strongly committed to safeguard the financial sector from being used to launder the proceeds from criminal activities. In furtherance thereof, Pakistan has become a member of the Asia Pacific Group on Money Laundering, a regional body associated with the Financial Action Task Force on Money Laundering (FATF). FATF sets international standards for global efforts in anti-money laundering and countering the financing of terrorism. The FATF 40+9 recommendations set forth international standards. In September 2007, Pakistan adopted an Anti-Money Laundering (AML) Ordinance that establishes its framework for AML activities and establishes the Financial Monitoring Unit (FMU) in the SBP to receive and process reports on suspicious activities. 18. Ongoing Issues in Financial Sector Development. Notwithstanding reform initiatives, financial sector indicators in Pakistan continue to lag behind those of other countries. Key issues in the financial sector8 include the following:

(i) Investor and depositor protection. The legislation establishing the SBP and the SECP, respectively, do not provide for the level of independence and accountability arrangements needed to enable these institutions to effectively

6 The capital market includes three stock exchanges, a national clearing and settlement system, a central depository,

and 449 NBFCs (as of 2007). NBFCs include leasing companies, investment banks, discount houses, housing finance companies, and mutual funds. The state-owned Central Directorate of National Savings is the largest institutional investor in Pakistan, followed by the State Life Insurance Company and Employees' Old Age Benefits Institution.

7 The global financial crisis, macroeconomic conditions, political uncertainty, and implementation of a pricing floor at the Karachi Stock Exchange (KSE) in 2008 have badly hurt the stock market. Subsequent government interventions have helped stabilize the market. Based on deteriorating macroeconomic conditions and security concerns, and a related decline in the share trading prices on the KSE, KSE management imposed a floor on exchange traded prices in August 2008. While the floor halted a further drop in share trading prices, once it was lifted the benchmark KSE 100 index continued to decline. During 2008, Pakistani stock lost 55% of its value. In January 2009, to stabilize the market, the government-owned National Investment Trust (NIT), the country's largest asset management company, helped establish the NIT State Enterprise Fund to invest PRs20 billion into the stock market.

8 Included here are issues reflected in the AETP that ADB is helping the Government to address.

Appendix 10 63

fulfill their assigned functions, address the blurring of product lines and the emergence of financial conglomerates, or provide an effective enforcement framework to deter and address violations. The recent global financial market turmoil and the privately owned structure of the banking system also highlight the urgent need for a financial safety net to deal with contagion and systemic risks. This includes depositor protection, liquidity, and lender of last resort facilities in the SBP; an exit framework to deal effectively with bank failures in a way that strengthens the banking system; and improved coordination mechanisms within the Government in cases of systemic problems.

(ii) Regulatory arbitrage. NBFCs that take deposits are subject to lower prudential regulations imposed by the SECP, thus raising concerns about regulatory arbitrage. Lending limits by banks that are part of a financial conglomerate may be circumvented by directing loans to NBFCs that take deposits. There is also public confusion about the role of the SBP in supervising NBFCs, since many investment banks use the word “bank” in their names.

(iii) Payment system. Although Pakistan has made progress in developing electronic payments, the existing retail payment system is largely based on checks and cash. SBP has requested ADB support in this area to accelerate efforts to take advantage of new technologies and prevent a proliferation of incompatible systems by developing and implementing an overall strategy in this area.

(iv) FMU autonomy. The AML Ordinance provides for a cumbersome FMU supervisory structure consisting of a national executive committee and a general committee. The national executive committee includes relevant ministers, the SBP Governor, the SECP chairman, and the director general of the FMU. The general committee includes principal civil servants from the ministries represented at the national executive committee, the SBP governor, SECP chairman, and the director general of the FMU. While the general committee is intended to provide assistance to the national level committee in implementing the law, it is unclear how this structure is supposed to work in practice. The two-prong structure appears bureaucratic and may be cumbersome to implement. The law also envisages that the director general of the FMU will be supervised and controlled by the general committee, which is inconsistent with international standards. The FMU also needs to be financially and operationally autonomous.

64 Appendix 10

Table A10.1: Asset Composition of the Financial Sector

Item 2001 2005 2007 2008 Assets (PRs billion) 3,042.7 5,201.5 7,115.2 7,646.6 Growth rate (%) 15.1 19.4 7.5 % of total assets MFIs 0.1 0.2 0.2 0.2 NBFIs 6.6 7.6 8.0 8.0 Insurance 3.7 3.9 4.6 5.5 CDNS 25.8 18.0 114.6 14.2 Banks 63.8 70.4 72.7 72.1 % of GDP MFIs 0.0 0.1 0.1 0.1 NBFIs 4.7 5.6 5.9 5.9 Insurance 2.6 2.9 3.4 4.0 CDNS 18.1 13.3 10.8 10.3 Banks 44.8 51.8 53.9 52.6 Overall 70.2 73.7 74.1 73.0 CDNS = central directorate of national savings, GDP = gross domestic product, MFIs = microfinance institutions; NBFIs = nonbank financial institutions. Source: State Bank of Pakistan. 2008. Financial Stability Review 2007–2008. Islamabad.

Table A10.2: Financial Sector Depth and Structure in Emerging Markets and Pakistan (end 2006)

Financial subsector (% of GDP) All Emerging

Market Countries China, Peoples

Rep. of India Pakistan

Bank deposits 85 169 73 47 Government debt securities 34 30 34 32 Private debt securities 18 16 5 1 Equity markets 79 92 91 32 Total financial assets 216 307 202 111 Total financial sector assets ($ trillion)

23.6 8.1 1.8 0.151

Total financial assets (% of GDP) 11.1 2.6 0.9 0.143 GDP = gross domestic product. Source: McKinsey Global Institute. 2008. Mapping Global Capital Markets: Fourth Annual Report. San Francisco: State Bank of Pakistan.

Appendix 10 65

Table A10.3: Financial Sector Overview

Outcome 1990 1995 2000 2005 2007 2008

(end December) Increased financial sector intermediation Broad money (M2) as a % of GDP 37.1 40.8 36.0 44.8 45.4 44.8 (June) Financial sector assets as a % of GDP 80.8 73.3 79.9 73.7 74.1 73.0 (June) Banking sector assets as a % of GDP 64.9 59.9 47.2 51.8 53.9 52.6 (June) Banking sector assets as a % of financial sector assets

70.4 72.7 72.1 (June)

Insurance sector assets as a % of GDP — — 2.2 3.9 4.6 5.5 (June) NBFI assets as a % of GDP (excluding insurance)

5.6 5.9 5.9 (June)

Outstanding government bonds as a % of GDP

— — — 4.9 4.5 5.8 (June)

Stock market capitalization as a % of GDP 7.2 16.8 9.3 42.0 49.0 26.9 Outputs Improved financial sector soundness and stability

Regulatory capital of banks as a % of risk-weighted assets

— — 9.7 11.3 13.2 12.2

Return on assets (after tax) — — (0.2) 1.9 1.5 1.2 Nonperforming bank loans as a % of gross loans

— — 23.5 8.3 7.2 9.1

Total number of commercial banks 24 — 44 39 40 40 Total number of NBFIs 36 117 123 Efficiency Interest rate spread (lending – deposit rate) — — 8.7 7.3 7.1 7.8 Money outside banks as a % of deposits — — 39 30 30 27 Annual stock market turnover as a % of GDP

0.6 5.3 44.6 128.8 70.1

Longest availability bond maturity, years 0 5 5 8 30 30 Financial market indicators Yield of 6million treasury bill — 12.7 11.0 8.2 9.3 14.0 Yield of government bond 8.0 13.0 — 6.4 9.6 13.7 Stock market index (KSE-100) 9,556.61 14,075.85 5,865.01 ( ) = negative, — = not available. KSE = Karachi Stock Exchange, NBFI = nonbank financial institution. Sources: Asian Development Bank; International Monetary Fund; Securities and Exchange Commission of Pakistan; State Bank of Pakistan; World Bank.

66 Appendix 11

DEVELOPMENT PARTNER MATRIX

ADB Portfolio

ADB Strategy or Activity Other Development Partners’ Programs

Social safety nets

Accelerating Economic Transformation Program (AETP) reform measures, attached technical assistance (TA)

World Bank: Poverty Reduction and Economic Support Operation, $500 million (approved on 26 March 2009) World Bank Technical Assistance Credit, $50 million over 3 years (to be approved in the second quarter of FY2009) World Bank: $200 million Social Safety Development Policy Credit (to be approved in the second quarter of FY2009) Department for International Development of the United Kingdom: TA, $2.5 million. German development cooperation through KfW: Planned Social Safety Net Project

Wheat Continuation of AETP reforms, building on earlier agriculture sector program loans

USAID: Competitiveness Support Fund

Energy AETP reforms Range of transmission and distribution projects (see AETP’s September 2008 report and recommendation of the President)

World Bank: Poverty Reduction and Economic Support Operation USAID

Finance AETP Second Generation Capital Market Program Attached TA projects

Limited focus in World Bank’s Poverty Reduction and Economic Support Operation Department for International Development Access to Finance TA to State Bank of Pakistan

ADB = Asian Development Bank, AETP = Accelerating Economic Transformation Program, TA = technical assistance, USAID = United States Agency for International Development. Note: This table should be read in conjunction with ADB. 2008. Proposed Program Cluster and Loans for Subprogram 1, Islamic Republic of Pakistan: Accelerating Economic Transformation Program. Manila (September). Source: ADB staff inputs and inputs from other development partners in Islamabad.

Appendix 12 67

LIST OF INELIGIBLE ITEMS

No withdrawals shall be made in respect of the following: (i) expenditures for goods included in the following groups or subgroups of the United

Nations Standard International Trade Classification, Revision 3 (SITC, Rev. 3), or any successor groups or subgroups under future revisions in the SITC, as designated by ADB to the Borrower:

Table 1: Ineligible Items

Chapter Heading Description of Items 112 Alcoholic beverages 121 Tobacco, unmanufactured; tobacco refuse 122 Tobacco, manufactured (whether or not containing

tobacco substitute 525 Radioactive and associated materials 667 Pearls, precious and semiprecious stones, unworked

or worked 718 718.7 Nuclear reactors, and parts thereof, fuel elements

(cartridges), nonirradiated for nuclear reactors 728 728.43 Tobacco processing machinery 897 897.3 Jewelry of gold, silver, or platinum-group metals

(except watches and watch cases) and goldsmiths’ or silversmiths’ wares (including set gems)

971 Gold, nonmonetary (excluding gold ore and concentrates)

Source: United Nations.

(ii) expenditures in the currency of the Borrower or of goods supplied from the territory of the Borrower;

(iii) expenditures for goods supplied under a contract that any national or international

financing institution or agency will have financed or has agreed to finance, including any contract financed under any loan from ADB;

(iv) expenditures for goods intended for a military or paramilitary purpose or for luxury

consumption; (v) expenditures for narcotics; (vi) expenditures for environmentally hazardous goods, the manufacture, use, or import of

which is prohibited under the laws of the Borrower or international agreements to which the Borrower is a party; and

(vii) expenditures on account of any payment prohibited by the Borrower in compliance with

a decision of the United Nations Security Council taken under Chapter VII of the Charter of the United Nations.

68 Appendix 13

SUMMARY POVERTY REDUCTION AND SOCIAL STRATEGY

Country/Program Title: Pakistan/Accelerating Economic Transformation Program

Lending/Financing Modality: Policy-Based Department/

Division:

Central and West Asia Department/ Financial Sector, Public Management, and Trade Division

I. POVERTY ANALYSIS AND STRATEGY A. Linkages to the National Poverty Reduction Strategy and Country Partnership Strategy The pro-poor component of the Program focuses on the transition from untargeted subsidies toward targeted interventions to the poor and the vulnerable. The scope is in line with Pakistan’s second poverty reduction strategy (PRSP II) and ADB’s Country Partnership Strategy. The Government’s PRSP II covers a 3-year period from FY2009 to FY2011. Its overall vision is to regain macroeconomic stability and attain gross domestic product (GDP) growth of 7% by FY2013; create adequate employment opportunities; improve income distribution; and enhance global competitiveness through economic liberalization, deregulation, and transparent privatization. PRSP II is built upon nine pillars: (i) macroeconomic stability and real sector growth, (ii) protecting the poor and the vulnerable, (iii) increasing productivity and value addition in agriculture, (iv) an integrated energy development program, (v) making industry internationally competitive, (vi) human development for the 21st century, (vii) removing bottlenecks through public-private partnerships, (viii) capital and finance for development, and (ix) governance for a just and fair system. To support the second pillar, protecting the poor and the vulnerable, the Government has taken steps to improve the social safety system and is implementing a major new cash transfer system for the poorest, the Benazir Income Support Program (BISP). The Program supports the expansion and improvement of targeted social safety net interventions to the poor and vulnerable under BISP. ADB is a leading partner in addressing governance and institutional bottlenecks, as well as binding constraints to transformation and growth. During the country partnership strategy period, ADB will focus on structural transformation, including reforms in energy and financial markets. Policy distortions and institutional impediments continue to constrain the structural transformation of the economy. These limit growth and investment. In the agriculture sector, for example, public interventions distort the wheat market and create disincentives for farmers to raise production. This has been detrimental to food security and has resulted in a need to import wheat at a time of high prices, adversely affecting the balance of payments position. In the power sector, inefficient and unfunded subsidies and the accumulated problem of circular debt seriously undermine investment, leading to major power shortages that have become a constraint on industrial production. In the financial sector, weak governance impedes the development of long-term financial instruments. This restricts growth in domestic savings. Consequently, savings have been insufficient to finance domestic investment and the savings–investment gap has increased. The Program supports interventions that enable the reduction or abolishment of federal subsidies for wheat and energy, given the development of targeted safety nets. B. Poverty Analysis Targeting Classification: Targeted intervention, TI-H 1. Key Issues Between FY2003 and FY2008, Pakistan experienced a period of macroeconomic stability and strong economic growth, which accelerated from 4.4% in FY2003 to an average 8.1% during FY2004 and FY2005, reached an all-time high of 9% in FY2006, then maintained high growth at 6.5% and 7% in FY2007 and FY2008, respectively. Efforts were made during this period to redirect a larger share of total public spending to social services and to poor and vulnerable groups. Poverty-related expenditures grew from 3% of GDP in FY2003 to 5.7% of GDP in FY2008. In addition, the inflow of foreign remittances rose substantially. Between 2002 and 2008, an inflow of more than $31 billion, or 18.7% of GDP, was attributable to remittances. All these factors combined (robust growth, macroeconomic stability, rising poverty expenditures, and high remittances from overseas Pakistanis) contributed to a decline in poverty’s incidence in Pakistan. Poverty estimates based on the FY2006 Pakistan Socioeconomic Living Standard Measurement Survey indicated a decline of people living below the poverty line1 from 34.5% in FY2001 to 22.3% in FY2006. The lack of new poverty data after FY2006 does not permit an assessment of the present poverty situation, but it is to be expected that poverty started increasing again in FY2009 with the high domestic inflation caused by high food and energy prices. Household expenditure surveys indicate the average share of food in total expenditures is inversely

1 The poverty line is based on a threshold of 2,350 calories per adult equivalent per day, using the calorific approach

for estimation.

Appendix 13 69

related to income levels. A sharp rise in food prices can have a devastating effect on the poor. In Pakistan, food prices went up by more than 20% in the first quarter of 2008. ADB’s analysis2 shows that a 10% increase in food prices can throw an additional 7 million into poverty in Pakistan, a 20% increase 14.7 million, and a 30% increase an additional 22 million. While energy prices also went up by about 30% in the first quarter of 2008, the rise in poverty incidence is estimated to be much smaller at about 1.5 percentage points. ADB’s analysis also shows that if every poor person were to be compensated to offset the loss in real expenditure, the Government could incur a cost of between PRs18.5 billion (0.3% of GDP) and PRs83 billion (1.3% of GDP). 2. Design Features This Program will directly benefit the poor. The impact will be through two principal mechanisms: (i) safety net support for poor households; and (ii) targeting electricity subsidies. The Program will support the transition from untargeted to targeted support to the poor and vulnerable through expansion of the social safety net program, making it more efficient to protect the poor and vulnerable from the adverse impact of recent global developments. Specifically, 5 million poor families (up to 6 persons per family on average) will benefit from the BISP under AETP2. As part of the cluster, the BISP will cover 7 million poor families by June 2010. Hence, potentially the Program will help direct benefits to up to 42 million poor people in Pakistan. Further, the Program will help generate a significant amount of fiscal space by targeting electricity and wheat subsidies. A. Poverty Impact Analysis for Policy-Based Lending 1. Discuss the impact channels of the policy reform(s) to the country and major groups affected.

The Program will provide significant benefits in general, and directed benefits for the poor in particular. • First, it will help the Government to meet large and immediate fiscal needs. • Second, the Program will assist the Government to transition from inefficient and untargeted subsidies to targeted

safety net programs for the poor. In FY2009, budget provisions were made to target 5 million households under federal government cash transfer programs (of which, resources were provided for up to 3.5 million families under BISP). In FY2010, the budget allocation will be increased to support up to 5 million families under BISP as a policy condition under AETP2. Subsequently, for the next phase, the Government will target up to 7 million families.

• Third, the Program will raise public confidence through stronger financial intermediaries that are better able to mobilize and allocate resources and risks.

• Fourth, the Program will open the way for structural transformation. • Overall, the Program will enable ADB to sustain policy dialogue on structural reform in sectors where ADB has

been actively involved through past and current investments. 2. Discuss the impact of the policy reform(s) on vulnerable groups and ways to address it/them (refer to social

analysis).

The Government is expanding the coverage of its social safety net programs from a targeted 5 million households in FY2009 to 5 million families under BISP in FY2010. The Government has agreed to use the local currency generated from the proceeds of the ADF loan to support poor and vulnerable families under the new BISP. One of BISP’s qualification criteria is that the household income should be below PRs6,000. The monthly benefit is equal to PRs1,000 per month, a substantial increase of the monthly income. This would allow a household to finance 20–25 days of flour needs for a 5–6 member family. The payout will not alleviate poverty, but it will protect the nutrition intake to a large extent during the series of shocks from sharp increases in food and fuel prices last year and the ongoing global financial crisis. The Government is committed to move toward market-based wheat pricing and an efficient reserve management system. The transition will be gradual, reflecting the need to maintain price stability for producers and consumers until better targeted and more efficient safety net programs become fully operational. An efficiently functioning safety net program will eliminate the need for continuing the existing untargeted wheat subsidy. The current untargeted subsidy is largely going to flour millers. Discontinuation of the wheat subsidy would cause millers to pay the market price. This would involve significant structural change in the flour milling industry and a likely expansion in private sector storage capacity. The Government’s strategic reserves could provide supply security to minimize risk of collusion in price determination at the local level. Specific policies are needed to deal with the root causes and consequences of high energy prices. For FY2009, the Government budgeted a PRs65 billion subsidy for tariff differential and decided to completely eliminate this subsidy by next fiscal year. It is estimated that an additional 5% increase in power tariff is required to eliminate the subsidy. This increase is expected to scarcely affect the poverty incidence (see key issues).

2 ADB. May 2008. Food Prices and Inflation in Developing Asia: Is Poverty Reduction Coming to an End? Special

Report. Manila; and AA. Chaudhry and T.T. Chaudhry. 2008. The Effects of Rising Food and Fuel Costs on Poverty in Pakistan. Lahore School of Economics.

70 Appendix 13

3. Discuss how the policy reform(s) contribute(s) to poverty reduction, pro-poor growth, and the Millennium Development Goals.

The challenge to alleviate poverty remains huge. Pakistan, being a signatory to the Millennium Development Goals, is committed to achieving the target for poverty by halving the poverty incidence between 1990 and 2015. The estimated 1990 level of poverty in Pakistan was 26%. Thus, this needs to move to 13% by 2015 if the target is to be met. With the latest poverty estimates (FY2006) at 22.3%, there is clearly still a long way to go. The poverty problem, therefore, is not about to be immediately eliminated and will require sustained efforts. Key to ensuring long-term success of the Government’s poverty reduction strategy and programs will be continued and consistent pursuit of pro-poor growth policies, along with accompanying investments and a focus on the effectiveness of investment spending, plus forging long-term and constructive partnerships with the private sector, civil society, and development institutions. The combined impact of the jump in food and fuel prices and the global financial crisis could pose a substantial setback in the fight against poverty and further jeopardize the already slow progress toward achieving the Millennium Development Goals. Prompt and well-targeted policy responses can substantially reduce the depth, length, and long-term impact of these sudden economic shocks. The expansion of targeted safety net interventions could provide short-run assistance against income shocks and protect the nutrition intake. Good safety nets require workable systems for enrolling beneficiaries, making payments, and monitoring. The most effective interventions will be those that target people who are the most vulnerable to income declines and most exposed to the crisis. The Government decided to refine its targeting method using poverty score cards. Under the BISP program, the score card method was piloted in 10 districts in FY2009, and it will be rolled out in the coming fiscal year to all districts. The other safety net programs would eventually use the same targeting method. With the introduction of BISP, the Government opted for direct cash transfers which have low administrative costs and do not distort prices. The fiscal implications of public interventions may seem daunting, particularly given the public spending stresses already experienced by Pakistan. But the fiscal costs of well-targeted interventions for the poorest need not be unduly high, especially compared to the present and future costs of not having them in place. For a large share of developing countries, spending on overall safety nets has been on the order of 1–2% of GDP in recent years. Critically, the future costs associated with not taking action are likely to be many times higher than the savings from inaction.

II. SOCIAL ANALYSIS AND STRATEGY A. Findings of Social Analysis The poor and the vulnerable are the primary beneficiaries of the targeted interventions through social safety net programs. Based on the FY2006 poverty assessment, 22.3% of the population, or roughly 35 million people, are living under the poverty line. Estimates of the incidence of vulnerability range between 47% and 67%. The vulnerable include both the chronically poor and the transitorily poor (those around or just below the poverty line). The vulnerable in Pakistan typically include the landless and the homeless; widows, and especially those with dependents and no support; women and children from poor households; low-caste and marginalized ethnic groups and minorities; those without access to health and education and dependent on charitable donations for subsistence; and the politically disenfranchised. About one third of the entire population is vulnerable due to low levels of resources, while for 24% to 34% of the population vulnerability to poverty stems from high volatility of consumption. Vulnerability is concentrated in rural areas and is mainly caused by low levels of consumption. Wheat is the main staple in Pakistan. Given the large population of poor and low-income earners (small-scale producers and consumers), wheat price stabilization has been a long-term government policy objective. Half of Pakistan’s population is considered to be "food insecure.” Food security is measured in terms of physical access to food (or its availability), economic access to food, and biological utilization of food (food absorption). Many studies note that in Pakistan physical availability of food (including wheat flour) may not be the main issue, but rather that consumers are constrained by poverty, as their low incomes impede their ability to use food adequately to obtain balanced and proper nutrition. The Program will assist the Government in ensuring food availability and access to wheat flour, and especially for the poor and vulnerable groups. The key agenda for action includes to (i) develop social safety net programs targeting the poor and vulnerable with cash transfers, and (ii) move toward market-based wheat pricing. B. Consultation and Participation

1. Provide a summary of the consultation and participation process during the project preparation. Extensive consultations were conducted with the Government, including the Ministry of Finance; Ministry of Industries; Ministry of Commerce; Ministry of Food, Agriculture, and Livestock; Ministry of Labor, Manpower, and Overseas Pakistanis; State Bank of Pakistan; Planning Commission; Board of Investment; Privatization Commission; Engineering Development Board, and the Prime Minister’s Secretariat responsible for the Benazir Income Support Program; with the private sector (including ABN/AMRO, KPMG, McKinsey); and with other development partners (including the United Kingdom’s Department for International Development, the International Monetary Fund, and the World Bank). 2. What level of consultation and participation (C&P) is envisaged during the project implementation and monitoring?

Information sharing Consultation Collaborative decision making Empowerment

Appendix 13 71

3. Was a C&P plan prepared? Yes No If a C&P plan was prepared, describe key features and resources provided to implement the plan (including budget, consultant input, etc.). If no, explain why. A list of key agencies and individuals to be consulted was drawn up prior to loan processing missions. Strong coordination and decision-making abilities are vital for the Program. The Secretary of Finance is steering the Program. C. Gender and Development 1. Key Issues. Gender inequality continues to be an area of concern in Pakistan. Limited access to income-generating opportunities, together with a range of life cycle risks related to malnutrition, school non-attendance, marriage and dowry, pregnancy and child birth, and widowhood has left women considerably more vulnerable to poverty than men. This results in increasing feminization of poverty. 2. Key Actions. Measures included in the design to promote gender equality and women’s empowerment—access to and use of relevant services, resources, assets, or opportunities and participation in decision-making process:

Gender plan Other actions/measures No action/measure

BISP, the Government’s flagship safety net program, has a unique feature in which the payment will be made only to the female head of a family, thereby aiming to address the feminization of poverty. Computerized national identity cards (CNICs) are being issued by the National Database and Registration Authority (NADRA) to those women who have none, providing them with a legal identity that represents a first step to empowering women. BISP will provide ADB with an update on the progress In issuing these cards in quarterly utilization reports. The ultimate aim of the Government is to devise programs that also support graduation from the safety net through income generation and sustainable livelihoods.

III. SOCIAL SAFEGUARD ISSUES AND OTHER SOCIAL RISKS Issue Significant/Limited/

No Impact Strategy to Address

Issue Plan or Other Measures

Included in Design Involuntary Resettlement

No impact

Full Plan Short Plan Resettlement Framework No Action

Indigenous Peoples

No impact

Plan Other Action Indigenous Peoples

Framework No Action

Labor Employment opportunities Labor retrenchment Core labor standards

No impact.

Plan Other Action No Action

Affordability

No impact

Action No Action

Other Risks and/or Vulnerabilities

HIV/AIDS Human trafficking Others(conflict, political

instability, etc), please specify: Disaster relief

In the recent past, Pakistan has been affected by natural and manmade disasters, an earthquake in Balochistan, recent troubles in the Swat Valley and in the Federal Administered Tribal Areas (FATA)

The mandate of BISP has been expanded to include vulnerable groups affected by natural or manmade disasters. During FY2009 BISP registered 18,000 female internally displaced persons in the FATA, who are receiving the same cash benefits.

Plan Other Action No Action

IV. MONITORING AND EVALUATION Are social indicators included in the design and monitoring framework to facilitate monitoring of social development activities and/or social impacts during project implementation? Yes No The following indicators have been included to measure the expansion and gradual improvement of social safety net programs: number of recipient households, allocation for social safety nets in government budget, number of districts with targeting by use of poverty score cards.