KARACHI - The State Bank of Pakistan cut gross domestic product (GDP) growth forecast for the 2008/09 fiscal year to 2.5-3.5 per cent from an earlier target of 3.5-4.5 per cent. The original target was 5.5 per cent. The economy is likely to expand between 2.5 per cent to 3.5 per cent, the State Bank said. The Bank also said inflation would slow sharply in the final quarter of this fiscal year. The Bank lowered its inflation target for this fiscal year to between 19.5 per cent and 20.5 per cent from an earlier forecast of between 20 per cent and 22 per cent. The State Bank of Pakistan released on Saturday its second quarterly report on the 'State of Economy for the year 2008-09. According to the report, the annualised CPI inflation is expected to be around 19.5 per cent to 20.5 per cent while overall fiscal and current account deficits are likely to be in the range of 4.3 per cent to 4.7 per cent and 5.8 per cent to 6.2 per cent respectively during the period under review. Exports are envisaged to stand at $ 18.50 billions to 19.5 worth while imports would be in the range of $31 billion in FY09 against the initial budgetary projection of 37.20 billion dollars. In terms of workers remittances, country is expected to receive $ 7.3 billion worth in 2008-09", report estimated. The report said the recent trends of improvement in key macroeconomic variables are quite encouraging, depicting that the disciplined implementation of the macroeconomic stabilisation programme is bearing fruit. Resultantly, with an improvement in fiscal discipline complementing the tightening of monetary policy, aggregate demand has seen a meaningful contraction. Therefore, on a year-on-year basis CPI inflation is likely to fall sharply during fourth quarter of FY09 despite the fact that to achieve the annual average of inflation seems to be quite high. The report indicated the continued compression in the imports, principally attributed to weakness in domestic demand, lower import unit values as well as depreciation of the rupee, will reduce the current account deficit, allowing Pakistan to build-up foreign exchange reserves. However, it is important to note that export earnings are also going down due to lower prices. The realisation of the expected sustained fall in domestic inflation, and increase in foreign exchange reserves would allow for easing of monetary policy. However, this is not necessarily expected to herald a recovery in manufacturing activity. Not only does monetary easing impact the real sector with a lag, industry will remain constrained by other bottlenecks such as energy shortages, high risk premiums on credit, etc. This means that real GDP growth will remain relatively weak in FY09, despite a reasonably good showing by both agriculture and the services sectors, report added. Report pointed out that any acceleration in growth in the following years too might require a supportive increase in development spending as well as a targeted increase in spending on social safety nets. Unfortunately, this would not be possible without significant shifts in taxation and expenditure. Report said the fiscal consolidation has been a major priority under the macroeconomic stabilisation agenda for FY09 which seems to be having an impact as the fiscal deficit for the first half of FY09 is estimated to have dropped to 1.9 percent of projected annual GDP compared to 3.4 percent in H1-FY08. The fiscal deficit for H1-FY09 thus appears to be in line with the annual target set in the budget FY09 as well as that agreed with IMF under the stand-by arrangement, it added. The fiscal improvement thus far has largely been brought about by elimination of oil subsidies and a cut in development spending. Report found the most important area for the government is to implement reforms in the countrys taxation system. As emphasized in the IMF SBA, an increase in tax-to-GDP ratio is necessary for fiscal sustainability. A focus on expanding the tax base rather than raising the tax rate is required. Most of the services (particularly trade, transport, professional services etc.) and agriculture sectors need to be taxed commensurately with their share in GDP. On the financing side, it will be important to accelerate the development of domestic capital markets. Not only will this reduce the governments need to borrow from the banking system, a vibrant debt market could help ease credit access concerns, increase efficiency of the banks (as they would have to compete for funds), and help foster savings, report added. In short to medium-term, it would be imperative for Pakistan to rely on concessional external assistance to finance development expenditure. The need for greater external assistance for Pakistan is underscored by the fact that the sources of domestic financing are either not available or remain risky due to its vulnerable external account position. Also, given the drying up of capital flows, official assistance seems to be the only option for countries like Pakistan to stimulate its economy to put it back on the sustainable path of growth and development. As per the report details, the worsening outlook for the global economy, and drought in international capital markets mean that Pakistans economic revival strategy must perforce focus on fostering domestic and regional demand. There is a dire need to develop financial sector and to increase intermediation, which is essential to raise rate of savings and sustained growth in the economy. It does not only means require focusing on increasing financial outreach in rural and far flung areas, but also that the development of long-term debt market, investment plans for pension funds, revitalization of mutual fund industry, and corporate bond markets are also necessary for efficient allocation of resources. Another benefit of financial depth would be in the form of more effective monetary policy transmission. The report showed its concern over the short-term growth outlook which is still difficult, with LSM growth in particular being hit by a sharp reduction in demand from both domestic and international factors. Domestic industrial production particularly, has been badly affected by energy shortages, deterioration in the law and order situation, and constricted access to finance (as banks became increasingly risk averse). At the same time, while the direct impact of the international financial crisis on Pakistan has been relatively limited so far, there were significant indirect implications. These include a sharp pull back in some domestic asset markets (real estate and equities), constrained investment flows, and a fall in business confidence. As the global economic environment continues to deteriorate, access to international capital markets looks to become even more difficult, and risks to both, exports and remittances, have increased. The changing economic environment thus has serious medium term implications, particularly for growth prospects, given the countrys diminished ability to finance even moderate fiscal and external account deficits, report said. Report feared that slowdown in export growth and remittances may affect the governments ability to implement counter-cyclical policies to support the domestic economy will be even more impinged on the private sectors ability to borrow from the banking sector. While the net growth in private sector credit has certainly slowed sharply, to a mere 4.6 per cent in July-Feb FY09, from a robust 11.7 per cent in the corresponding period last year, the deceleration owes to factors other than crowding out by government. These include a slowing economic activity, a sharp fall in cost constrained. 1. The countrys ability to fund even short-term external deficits has already been hit by the severe depletion of FX reserves over the last 12 months. 2. Despite meeting the targets under the stand-by arrangement, Pakistan is unlikely to received benefits at the same levels as in yester years. Typically, successful implementation of IMF programme leads to increase investor confidence, thus encouraging international capital flows to the country. Unfortunately, the size and scope of the present international financial crisis suggests that such flows to Pakistan are unlikely to reach even (the relatively low) levels achieved by the country in recent years. To put this in perspective, the Institute of International Finance estimates that private capital flows to emerging markets are likely to fall to just US$ 165 billion in 2009, less than a fifth of the peak of $ 929 billion recorded in 2007. This suggests that even a moderate external deficit could lead to a direct impact on the exchange rate. This would have negative consequences for inflation and growth.