KARACHI - The State Bank of Pakistan (SBP) has stated that the size of the fiscal deficit cannot be reduced unless the government controls excessive borrowing from the central bank, along with fully implementing fiscal reforms, according to State Banks Third Quarterly Report on the State of Pakistans Economy for FY11 released Monday. Desirable revenue generating measures - broadening of the tax base, improving documentation of the economic system, gradual elimination of un-targeted subsidies and curtailment of quasi-fiscal operations are necessary to contain the fiscal deficit to below 4.5 per cent of GDP in FY12, said the report. These efforts need to be accompanied with better debt management to increase the tenor of domestic debt and lower risks associated with debt re-pricing and rollover, it added. The report predicted these initiatives will also protect the external account position and rebuild confidence of the private sector and the countrys international development partners. More importantly, this will help in reducing inflation and the crowding out of private sector credit, thereby facilitating investment, growth and employment opportunities. The SBP report further said the impact of the widening fiscal deficit is clearly visible in the sharply rising domestic debt. The outstanding government domestic debt reached Rs 5,594 billion (31.8 per cent of estimated GDP) which is more than double the stock at end-June 2007, the report said and added that this sharp growth in debt stock is fueling concerns about macro stability and monetary management. The report showed optimism about the next cotton crop for several reasons: (a) higher cotton prices during FY10 encouraged farmers to increase acreage for the next crop; (b) there is a shift towards more productive (and disease resistive) BT cotton seeds; and (c) water availability is expected to improve over last year. Rising fertilizer prices are the key downside risk at the moment. According to the report, the government has set the wheat procurement target at 6.57 million tones, which is lower than the target for the previous year. However, the government may come under pressure to exceed this target since the market price of wheat is considerably lower than its support price while banks appear to be willing to finance the additional procurement. This could feed the circular debt problem and also crowd out the private sector at the margin. While energy shortages continue to impact a number of industries, some sectors could face new challenges. For example, the disruption in the global supply of auto parts from Japan may impact some manufacturers in Pakistan. In addition, auto manufacturers will face stiff competition from imported cars as the government has increased the age limit for used imported vehicles from 3 to 5 years, it commented. The report stated that the inflation outlook is not very encouraging. International crude oil prices have increased by around 40 per cent since the beginning of FY11, following the unrest in the Middle East and a shift from nuclear to thermal power generation in Japan after the earthquake. Overall, no significant easing in oil prices can be expected at this point. In addition, the increase in palm oil prices is likely to impact domestic prices of vegetable oil and ghee. However, following a good rabi season, wheat and sugar prices have come down, which should contain, and perhaps ease food inflation in the months ahead, it mentioned. The report warned there are real risks of reversal in Pakistans external sector performance. Remittances US$ 1.7 billion higher during Jul-Apr FY11 compared to the corresponding period of FY10 cannot be forecast with much reliability. Imports may come under pressure given the sharp increase in crude oil prices in recent days, while the recovery in global demand appears fragile, and could hit Pakistans textile exports. Furthermore, the price gain in textiles, which helped create a surplus in the current account during FY11, may not be available going forward following a sharp drop in cotton prices even during the off-peak season, it said. Recent political events could have adverse implications for the business environment and the external sector, especially with respect to future IFI flows and bilateral assistance. However, there are two reasons for comfort: first, the relative stability in financial markets is an indication that Pakistan has the ability to handle exogenous shocks; and second, net IFI inflows in the past two years have been low, which means a further curtailment is not likely to change the overall position in the external sector, it revealed. The report observed that in overall terms, although the post-flood hike in CPI inflation has largely dissipated, inflation is stubborn, in excess of 13 per cent. Possible reasons could include: (a) the lagged impact of government borrowings from SBP during Jul-Sep 2010; (b) frequent upward adjustments in utility and POL prices; (c) increase in commodity prices; and (d) the rising trend in the house rent index (HRI). The report said the government is facing difficulties in containing the fiscal deficit. SBP Report stressed that implementation of fiscal reforms still poses political challenges. 'For instance, structural problems that require difficult policy decisions for fiscal consolidation (e.g. expanding the base of GST through the withdrawal of exemptions, tax on agri-income, and restructuring and privatization of PSEs) are pending resolution and awaiting multi-partisan consensus, the report added. As far as financing is concerned, the report observed that the government has had little option but to rely on domestic sources to finance a growing fiscal gap. More specifically, while borrowing from SBP was largely contained at end-September 2010 levels, the abrupt change from April 2011 onwards (the Government borrowed over Rs 350 billion from the central bank during 31st March 3rd May 2011) were largely meant to internalise the growing quasi-fiscal expense (e.g. the circular debt in energy) into the budget. In other words, this borrowing is actually financing the carry-over of quasi-fiscal deficits from previous years, according to the Report. 'In addition, the maturity profile of domestic debt reveals that the government has to rollover the entire stock of Rs 2,854 billion of short term debt at least once a year. Any surge in credit demand from other sectors of the economy could elevate rollover risk, and could also expose the government to interest rate risk, the report added. 'Provisional estimates put forward by the National Income Accounts Committee show GDP growth at 2.4 per cent for FY11, lower than the growth of 3.8 per cent in the previous year. In the context of the prevailing security concerns, the exogenous shock from rising oil prices and the impact of the unprecedented floods, this decline is broadly in line with SBPs expectations, the report added. 'In our view, the growth outlook will be shaped by policy responses to several key domestic challenges: (1) energy shortages, which are restricting growth; (2) the high fiscal deficit whose financing has become difficult partly owing to the backlog arising from the non-recognition of power sector subsidies of earlier years as reflected in the circular debt; (3) build-up of domestic debt, raising concerns for macro stability; and (4) inflationary pressures which are not receding readily, according to the Report. The SBP report said that going forward the policy challenge is to distribute available gas supplies efficiently amongst competing users. 'Keeping this in view, the ECC recently decided to divert gas supply to the fertilizer sector, recognising the importance of stable agricultural input prices and saving foreign exchange on imported fertilizer, the report added. 'In the context of a sustainable energy policy, we believe that feasible alternatives to furnace oil (for power generation) need to be developed urgently. Furthermore, the potential role of imported gas is unquestionable in the medium-term, and policy emphasis must be directed towards developing the necessary infrastructure to use imported gas, the report said, adding more importantly, a better policy option going forward is to rationalise tariffs for different users of this scarce resource and improve the gas pricing structure to incentive further exploration and extraction.