Pakistan has recorded strong recovery because of prudent policy reforms and improved the global outlook for growth. Moreover, economic deregulation, superior governance and enlightened moderation have been the hallmark of the Musharraf government and have been major factors in driving the recent GDP growth rates, said Merrill Lynch in a report in collaboration with KASB Equities.
"Unlike previous administrations, the Musharraf government has been consistent in promoting these three policy initiatives," the report added.
Following a steady recovery in 2003 (5.1 percent) and 2004 (6.4 percent), Pakistan's economy witnessed a sharp rising trend in GDP growth (8.35 percent) in 2005, and we expect this trend to continue ahead. This is the fastest GDP growth the country has recorded in the last two decades. We believe that most part of the strong recovery can be attributed to prudent policy reforms and improved global outlook for growth," the report said.
"In our view, the devastation caused by the earthquake of October 8 is unlikely to hamper the future growth trajectory of Pakistan's economic growth, as bulk of the economic activities, including agriculture and manufacturing, are not centered in such areas.
"Due to steady growth achieved in the last couple of years, we believe productivity growth slowed down as capacity constraints came to the fore, pushing up inflation (9.28 percent YoY). The sudden shift from a current account surplus of US $1.8 billion in 2004 to deficit of US $1.52 billion in 2005 has also added pressure to foreign exchange reserves."
The brokerage unit said it believed that Pakistan's macroeconomic trend had been healthy. However, it was unlikely to escape unscathed from a global downturn led by rising oil prices. "Relatively speaking, Pakistan is quite well positioned to handle the oil woes lingering around its trade account. The high oil prices, if sustained, would likely push Pakistan's trade account deficit to an all-time high in FY06. This would further widen the current account deficit to $4.62 billion in FY06 from US $1.52 billion in FY05. However, we believe current account deficit will be manageable, due to the large influx of FDI at over US $1.5 billion (ex PTCL privatisation) in FY06. Coupled with this, steady remittance flow of US $4 billion along with capacity to raise debt allows Pakistan significant flexibility in managing high oil price pressure."
It said: "In this sense, a current account deficit, regardless of how much, cannot harm the Pakistan economy. The caveat is that it is long-term capital inflows (such as FDI and long term loans) that finance the current account deficit, rather than speculative inflows.
"We reiterate the point that it is not the size of the current account deficit that matters but it is the quality of inflow that is financing it. We believe the quality of inflows is good, as Pakistan is expected to receive US $2.5 billion in the form of FDIs, and long-term loans on confessional rates are already being offered to Pakistan by international lending institutions."
Merrill Lynch said: "On the back of rising current account deficit, we expect Pakistan's external debt to increase (by US $1.40 billion in FY06) and its debt to GDP to decline to 30 percent (from 32.7 percent in FY05). Pakistan's debt management remained impressive during FY05 as total external debt and liabilities were recorded at US $35.83 billion as of June 05 (compared to US $35.26 billion in Jun-04). In our view, the marginal rise in external debt in FY05 can be primarily attributed to revaluation of external debts. In addition, the improved credit outlook has enabled Pakistan to make a successful return into the international debt markets for the first time in five years. Similarly, debt servicing, as percent of GDP, has declined significantly to 2.69 percent (from 5.5 percent in FY04). We believe that the Paris Club debt rescheduling (US $12.5 billion in December-01) has primarily driven the decline in Pakistan's debt servicing. Going forward, we expect debt servicing as percent of GDP decline to 1.8 percent in FY06.
"We expect Pakistan to issue another Eurobond or Sukuk Bond or GDR in the range of US $500-1,000 million in FY06 to maintain its debt profile in international debt markets and to bridge its external account shortfall. On the back of sound external position, coupled with improved credit outlook, Pakistan has made a successful return to the international debt market for the first time in more than five years. In February-2004, Pakistan issued a US $500 million five years Euro bond. This transaction was oversubscribed 4 times and attracted quality investors. The Eurobond was priced competitively at 6.75 percent (UST+375 BPS). We believe the price achieved for Euro bond was much more competitive compared to emerging markets.
"We see higher chances of inflation rate sliding below 8 percent, as upcoming CPI numbers are likely to be benchmarked against very high year earlier comparables (high-base effect). This supports our view that State Bank of Pakistan (SBP) is likely to put its current tightening cycle on ice. We expect less hawkish stance to be adopted by SBP in 2HFY06, as core inflation recorded a MoM decline for straight 2 months--for more than 14 months (since February-2005). We also expect this trend to continue for the next 6 months as Housing Rent Index (HRI) is expected to decline owing to the stabilisation in prices of construction-related industry.
"Post-excellent fiscal management in FY04 (2.4 percent) and FY05 (3.3 percent), we expect budget deficit to likely widen (4.0-4.2 percent) in FY06 owing to higher development expenditures planned. Pakistan was severely affected by the devastation caused by the earthquake on October 8 and in response it arranged a Donors' conference (on November 19) in which over US $6.1 billion was pledged for reconstruction. We believe the US $6.1 billion pledged will bode well for Pakistan's economy in the medium-term and would not only provide a sigh of relief to Pakistan's external account imbalances, but also a stimulus to the manufacturing and services sectors. With the fulfilment of twin objectives of reconstruction and rehabilitation, we also expect the government to continue its ongoing efforts of poverty reduction programs in conjunction with its mega development projects.
"In our view, the foremost challenge on the economic front is to now generate growth under more adverse conditions. Growth was relatively easy in the last 3-4years, as it utilised excess capacity and inexpensive resources.
"Mass transit, better logistics, water resources and adequate power supply will in effect enhance the returns on private investment. Pakistan appears on track in this regard. Given above trend growth, there is a risk, however, that infrastructure projects will compete with the private sector for various resources, causing a crowding out effect.
"We believe Pakistan's main challenge is to spend more (on investment) even as the economy is now operating at above trend level, thus increasing inflation risks which in turn invite vigilance on the part of the central bank to further tighten monetary policy. The question is whether higher interest rates would reduce investment and therefore Pakistan's future growth potential. Our view is that a successful investment-driven growth story would actually result in rising investment, accompanied by rising interest rates."
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