The World Bank Resilient Institutions for Sustainable Economy (P171850) Document of The World Bank FOR OFFICIAL USE ONLY Report No: PGD149 INTERNATIONAL DEVELOPMENT ASSOCIATION INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT PROGRAM DOCUMENT FOR A PROPOSED DEVELOPMENT POLICY CREDIT IN THE AMOUNT OF SDR182.3 MILLION (EQUIVALENT TO US$250 MILLION) AND PROPOSED DEVELOPMENT POLICY LOAN IN THE AMOUNT OF US$250 MILLION TO THE ISLAMIC REPUBLIC OF PAKISTAN FOR THE RESILIENT INSTITUTIONS FOR SUSTAINABLE ECONOMY DEVELOPMENT POLICY FINANCING June 16, 2020 EQUITABLE GROWTH, FINANCE AND INSTITUTIONS PRACTICE GROUP INFRASTRUCTURE PRACTICE GROUP SOUTH ASIA REGION This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. . The World Bank Resilient Institutions for Sustainable Economy (P171850) THE ISLAMIC REPUBLIC OF PAKISTAN GOVERNMENT FISCAL YEAR July 1 – June 30 CURRENCY EQUIVALENTS (Exchange Rate Effective as of May 31, 2020) Currency Unit: Pakistani Rupees US$1.00=PKR162.5 ABBREVIATIONS AND ACRONYMS ADB Asian Development Bank AML Anti-money laundering BOP Balance of payments CAD Current account deficit CDMP Circular Debt Management Plan CDNS Central Directorate for National Savings CFT Countering the financing of terrorism CPPA Central Power Purchasing Agency CPS Country Partnership Strategy DFI Development finance institution DFID UK Department for International Development DISCO Distribution company DLI Disbursement-linked indicator DMO Debt Management Office DPCO Debt Policy Coordination Office DPF Development Policy Financing EFF Extended Fund Facility EMI Electronic money institutions EU European Union FATF Financial Action Task Force FBR Federal Board of Revenue FD Finance Division FRDLA Fiscal Responsibility and Debt Limitation Act FY Fiscal year GCC Gulf-Cooperation Council GDP Gross domestic product GST General sales tax IBRD International Bank for Reconstruction and Development ICR Implementation Completion and Results Report IDA International Development Association IMF International Monetary Fund IPF Investment Project Financing MoE Ministry of Energy MoF Ministry of Finance and Revenue m-o-m Month on Month NEPRA National Electric Power Regulatory Authority NFC National Finance Commission NPL Nonperforming loan PACE Program for Affordable and Clean Energy PDO Project Development Objective PEFA Public Expenditure and Financial Accountability PFM Public financial management PforR Program-for-Results PHPL Power Holding Private Limited PKR Pakistan Rupee PSEFT Payments Systems Electronic Funds Transfer RISE Resilient Institutions for Sustainable Economy SBP State Bank of Pakistan SDR Special Drawing Right SECP Securities and Exchange Commission of Pakistan SHIFT Securing Human Investments to Foster Transformation SMEs Small and medium-sized enterprises SOE State-owned enterprise SRO Statutory Regulatory Order TA Technical assistance TAGR Trust Fund for Accelerating Growth and Reforms UAE United Arab Emirates UK United Kingdom US$ United States dollar USA United States of America WB(G) World Bank (Group) y-o-y Year on year . Regional Vice President: Hartwig Schafer Country Director: Patchamuthu Illangovan Regional Director: Zoubida Kherous Allaoua Practice Manager (s): Manuela Francisco Muhammad Waheed, Enrique Blanco Armas, Task Team Leader (s): Shabih Ali Mohib The World Bank Resilient Institutions for Sustainable Economy (P171850) ISLAMIC REPUBLIC OF PAKISTAN RESILIENT INSTITUTIONS FOR SUSTAINABLE ECONOMY TABLE OF CONTENTS SUMMARY OF PROPOSED FINANCING AND PROGRAM .......................................................................3 1. INTRODUCTION AND COUNTRY CONTEXT ...................................................................................5 2. MACROECONOMIC POLICY FRAMEWORK..................................................................................10 3. GOVERNMENT PROGRAM ........................................................................................................25 4. PROPOSED OPERATION ............................................................................................................25 4.1. LINK TO GOVERNMENT PROGRAM AND OPERATION DESCRIPTION .......................................... 25 4.2. PRIOR ACTIONS, RESULTS, AND ANALYTICAL UNDERPINNINGS ................................................. 26 4.3. LINK TO CPS, OTHER BANK OPERATIONS, AND THE WBG STRATEGY ......................................... 44 4.4. CONSULTATIONS AND COLLABORATION WITH DEVELOPMENT PARTNERS ............................... 45 5. OTHER DESIGN AND APPRAISAL ISSUES ....................................................................................46 5.1. POVERTY AND SOCIAL IMPACT .................................................................................................... 46 5.2. ENVIRONMENTAL, FORESTS, AND OTHER NATURAL RESOURCE ASPECTS ................................. 50 5.3. PFM, DISBURSEMENT, AND AUDITING ASPECTS ......................................................................... 51 5.4. MONITORING, EVALUATION, AND ACCOUNTABILITY ................................................................. 52 6. SUMMARY OF RISKS AND MITIGATION .....................................................................................53 ANNEX 1: POLICY AND RESULTS MATRIX ..........................................................................................56 ANNEX 2: FUND RELATIONS ANNEX ..................................................................................................61 ANNEX 3: LETTER OF DEVELOPMENT POLICY.....................................................................................63 ANNEX 4: ENVIRONMENT AND POVERTY/SOCIAL ANALYSIS TABLE ..................................................67 Page 1 The RISE DPF is prepared by a team comprising the following: Muhammad Waheed (Senior Economist, ESAMU), Shabih Ali Mohib (Program Leader, ESADR), Enrique Blanco Armas (Lead Country Economist, EECM2), Adnan Ashraf Ghumman (Economist, ESAMU), Florian Blum (Economist, ESAMU), Gonzalo J. Varela (Senior Economist, ESAMU), Nyda Mukhtar (Economist, ESAMU), Zehra Aslam (Economist, ESAMU), Mohammad Saqib (Senior Energy Specialist, GEE06), Mona Prasad (Lead Economist, ESAMU), Rikard Liden (Lead Energy Specialist, GEE06), Silvia Redaelli (Senior Economist, GPV06), Clelia Rontoyanni (Lead Public Sector Specialist, GGOAP), Akmal Minallah (Senior Public Sector Specialist, GGOAP), Namoos Zaheer (Senior Financial Sector Specialist, GFCSN), Amjad Bashir (Senior Economist, GFCS1), Sarmad Sheikh (Financial Sector Specialist), Rahat Jabeen (Environmental Specialist, GENMS), David I (Senior Financial Sector Specialist, ESAG1), Ria Nuri Dharmawan (Counsel, LEGES), Victor Ordonez (Senior Finance Officer, WFACS), and Abid Hussain Chaudhury (Program Assistant, SACPK). The World Bank Resilient Institutions for Sustainable Economy (P171850) SUMMARY OF PROPOSED FINANCING AND PROGRAM BASIC INFORMATION Project ID Programmatic If programmatic, position in series P171850 Yes 1st in a series of 3 Proposed Development Objective(s) The program’s development objectives are: (i) enhancing the policy and institutional framework to improve fiscal management, and (ii) improving the regulatory framework to foster growth and competitiveness. Organizations Borrower: ISLAMIC REPUBLIC OF PAKISTAN Implementing Agency: MINISTRY OF FINANCE AND REVENUE PROJECT FINANCING DATA (US$, Millions) SUMMARY Total Financing 500.00 DETAILS International Bank for Reconstruction and Development (IBRD) 250.00 International Development Association (IDA) 250.00 IDA Credit 250.00 INSTITUTIONAL DATA Climate Change and Disaster Screening This operation has not been screened for short and long-term climate change and disaster risks Overall Risk Rating High Page 3 The World Bank Resilient Institutions for Sustainable Economy (P171850) . Results Indicator Name Baseline Target Reduction in the deviation between the fiscal deficit in the MTFF No MTFF (FY19) <10 percent and the consolidated (federal government and provinces) budget semi-annual report Publication of a semi-annual report on debt and cost-risk indicators No reports (FY19) (FY23) Land, agriculture income, and property related tax collections (as 4.1 (FY19) >10 (FY23) percent of provincial own source revenue) Stock of PHPL debt transferred to the general government debt 0 (FY19) 804 (FY23) stock (in PKR billion) Competitive bidding for procurement for renewable energy 0 (FY19) >75 (FY23) (percent of total renewable energy projects) Electricity bill collection rate, excluding subsidies (as percent) 90 (FY19) 95 (FY23) Number of annual General Sales Tax Returns filed by registered 60 (FY19) 12 (FY23) taxpayers Aggregate distance to frontier score (Ease of Doing Business 55.31 (2019) >70 (2023) Report) Number of bank accounts biometrically verified (percent) <50 (2018) 100 (2023) Number of digital transactions (annual) 0.7 billion (FY18) >1.8 billion (FY23) Number of licenses issued to Real Estate Developers 0 (FY19) >5 (FY23) Average import duties (in percent) 12.6 (FY19) 10.77 (FY23) . Page 4 The World Bank Resilient Institutions for Sustainable Economy (P171850) IDA AND IBRD PROGRAM DOCUMENT FOR A PROPOSED DEVELOPMENT POLICY FINANCING TO THE ISLAMIC REPUBLIC OF PAKISTAN 1. INTRODUCTION AND COUNTRY CONTEXT 1. The proposed operation – Resilient Institutions for Sustainable Economy (RISE) – supports the efforts of the Islamic Republic of Pakistan to strengthen the fiscal framework, promote growth and transparency, and support foundational energy sector reforms to transition to low carbon energy resources, efforts which are critical to build resilience and support recovery from the effects of the COVID-19 pandemic on the economy. The proposed operation for a Loan and Credit of US$500 million focuses on improving fiscal management and fostering growth and competitiveness. RISE will assist the government in improving the intergovernmental fiscal architecture to enable the country to improve its fiscal position through the establishment of the Macro-Fiscal Policy Unit, the preparation of budgets that are aligned with the Medium Term Fiscal Framework, enhanced debt transparency and management, and a broadened tax base. The operation will support measures to enhance the regulatory framework to promote competitiveness and growth through the harmonization of the general sales tax, increased use of digital financial services, enhanced integrity in the financial sector, and a reduction in the anti-export bias of the national trade tariff policy. The operation also supports foundational reforms for improving the financial viability of the power sector by setting out a strategy to address the sector’s circular debt as well as policies to facilitate the development of low carbon energy resources. The operation will also support measures to improve the regulatory environment to enable the country to become more competitive and thereby boost private investment. Reforms supported by this operation are also important for the country to break out of the boom-and-bust macroeconomic cycles and get on a sustainable growth path to end extreme poverty and boost prosperity of the people of Pakistan. These reforms are critical for stronger and faster recovery as the pandemic subsides. The operation is consistent with the government’s COVID-19 crisis response program, which aims at scaling up spending on health and social protection, including through the fiscal space created by the G20 Debt Service Suspension Initiative. 2. The RISE DPF complements the Securing Human Investments to Foster Transformation (SHIFT) DPF series and an upcoming potential Program for Affordable and Clean Energy (PACE) DPF. SHIFT focuses on reforms to enhance human capital accumulation, increase the contribution of women to economic productivity, and improve federal safety nets to respond to shocks, including those from the stabilization program and the COVID-19 pandemic. PACE will build on two energy-related prior actions included in RISE, and will be focused on the implementation of critical power sector reforms. Collectively, RISE, SHIFT and PACE are expected to strengthen the country’s fiscal position and improve welfare gains. The proposed RISE series is consistent with the government’s economic reform program, the FY15-20 Country Partnership Strategy (CPS) and the World Bank Group’s twin goals of boosting shared prosperity and ending extreme poverty. The operation is aligned with pillar four of the WBG COVID-19 Crisis Response Approach through actions aimed at improving fiscal management and reducing regulatory impediments which constrain private investment. PACE, which will include critical power sector reforms needed to put the country on sustainable fiscal path, will precede RISE 2 and SHIFT 2. The Impact of the COVID-19 Pandemic on Pakistan 3. The COVID-19 pandemic has hit the economy hard. The country was emerging from an economic crisis and making progress in stabilizing its economy and implementing much needed structural reforms when, like the rest of the world, it was suddenly struck by the COVID-19 pandemic. Since March 2020, to curtail the spread of the coronavirus, most of the country has been placed under a partial lockdown, international flights and domestic rail travel have been Page 5 The World Bank Resilient Institutions for Sustainable Economy (P171850) suspended, and educational institutions across the country have been closed. 1 The closure of all non-essential businesses and the disruption to the domestic supply chain have significantly affected the services and manufacturing sectors, which account for nearly 80 percent of total GDP. The drop in domestic and global demand is also expected to affect the industrial sector which is affected by both supply- and demand-side shocks. The country’s main industrial sector – textiles and apparel – is highly exposed to COVID-19 related disruptions because of its labor-intensive nature. As a result, the economy is expected to contract between 2.6 and 3.3 percent in FY20, and between 0.2 and 4.0 percent in FY21, while before pre-COVID19 projections for growth stood at 2.4 percent for FY20 and 3.0 for FY21. 4. The government’s fiscal position has worsened considerably. Before COVID-19, the consolidated fiscal deficit was projected at 7.3 percent of GDP. However, the collapse in economic activity has led to a significant revenue shortfall, and concurrently, there has been immense pressure on the expenditure side. In the power sector, reduced demand (for commercial users by 75 percent and industrial users by 60 percent) and lower than expected recovery of receivables has added US$1.6 billion to the circular debt. There has also been increased spending on social protection, health care, and support to businesses to cope with the fallout of the virus. As a result, the fiscal deficit is expected to expand to 10.2 percent of GDP in FY20. Because of the limited ability to increase revenue collection from a contracting economy, the government has had to rely on external sources to meet the financing gap. 5. The poverty situation is expected to be significantly affected. Pakistan’s poverty headcount fell from 64.3 percent in 2000 to 24.3 percent in FY15/16, as more than 32 million people were lifted out of poverty. The decline was much faster in urban than in rural areas and poverty remains stubbornly high in some parts of the country. Inequalities across and within regions persist and there are inequality traps in which exclusion is transmitted across generations and inequality of opportunities across space and between genders. Emigration, the expansion of social protection programs, and the resilience of the large informal economy all contributed to poverty reduction, despite the recurrent macroeconomic crises. However, these gains are likely to be reversed by the COVID-19 pandemic and its associated containment measures. The economic contraction is expected to contribute to a sizeable increase in poverty, reversing the trend of sustained poverty reduction observed over the past 20 years. Urban workers employed in the informal sector and daily wage workers employed in the formal sector will bear the brunt of the slowdown. In rural areas, the expected decline in off-farm employment opportunities is also likely to increase the vulnerability to shocks of households that rely on agriculture. The unfolding locust emergency also poses a threat to food security in the country. The Government’s Response to the COVID-19 Pandemic 6. In response to the outbreak of COVID-19 in Pakistan, the government announced a fiscal stimulus package of approximately US$7.5 billion. This support is aimed to (a) support the medical health sector in combatting the spread of the virus and providing relief to those affected; (b) implement social welfare measures to support the poor and vulnerable whose livelihoods have been affected by the economic slowdown and partial lockdowns across the country; and (c) provide stimulus to businesses and industries to protect productive assets during the economic downturn. The financing of the response package comprises approximately US$2.5 billion of additional resources, and a re- appropriation from the existing budget, especially from the Public Sector Development Program (PSDP). 7. Pakistan has requested debt service suspension under the Debt Service Suspension Initiative (DSSI) and has written to its 22 bilateral creditors and signed the Memorandum of Understanding with the Paris Club to suspend payments coming due between May 1 and December 31, 2020, on debt owed by the country. This will be followed by individual bilateral creditor agreements. The government expects US$1.8 billion in additional fiscal space due to the debt service standstill during the period May 1 to December 31, 2020. The country will use the created fiscal space for additional social, health or economic spending, disclose all debt information, and contract any non-concessional debt 1 These measures have been announced on a temporary basis but are subject to extension as the situation in the country evolves. Page 6 The World Bank Resilient Institutions for Sustainable Economy (P171850) during the suspension period in compliance with limits agreed under the IMF Debt Limit Policy (DLP) or WBG policy on non-concessional borrowing. A monitoring system will be implemented by the government to publish reports on the use of the created fiscal space, in a transparent manner. Under RISE, the government has also committed to enhance debt transparency, including in the power sector, through publication of semi-annual reports on debt and cost-risk indicators. 8. The government also undertook several measures to facilitate access to necessary medical supplies and to cushion the impact of the COVID-19 pandemic on businesses. First, Pakistan eliminated import duties on 61 COVID- 19 essential items, joining the initiative of 76 other countries in the world that have taken a similar approach. 2 Second, export restrictions that were initially introduced on personal protective equipment and sanitary products have been lifted, except for N95 and surgical masks. Third, a relief package was approved to support small and medium-sized enterprises by covering their electricity bills for three months. 3 The government has also frozen the power tariff until September 2020 and approved a package of reforms aimed at reducing the cost of power generation. Additionally, the State Bank of Pakistan (SBP) announced multiple measures to provide liquidity support to firms affected by COVID-19. These include payment holidays on loan repayments (micro-finance and conventional), discounted refinancing schemes for firms providing medical equipment, and relaxation in collateral requirements and banks’ exposure limits for SME lending. To preserve employment, SBP has also introduced the “Refinance Scheme for Payment of Wages and Salaries to Workers”, directing commercial banks to provide refinancing at zero percent. Reports from businesses, however, reveal that commercial banks have been reluctant to provide that facility. To counter the limited uptake of this facility, the SBP has also introduced a risk-sharing facility to complement this scheme. The risk-sharing facility covers 40 percent of the credit risk of any payroll loan availed. Table A summarizes the fiscal stimulus package. Table A: Summary of the Government’s COVID-19 Fiscal Stimulus Package Initiative Announced package (US$ bn) Support to medical and relief efforts 0.5 Support to businesses, agriculture, and exporters. Most of the expenditure under this initiative is 1.2 expected to be undertaken in FY21 due to supply-side constraints during COVID-19 and difficulties in quick mobilization. Social protection program expansion and fund for daily workers. The social protection program was 2.5 budgeted at approximate US$ 1.1 billion for FY20 and around US$1 billion is the additional financing announced for it, mostly under Ehsaas program. Tax expenditures for certain sectors (e.g. construction and food supplies) 0.3 Maintenance of food supply. This is primarily for the procurement of wheat of which only the wheat 2.0 subsidy component is on-budget while the rest is off-budget. Wheat procurement is financed through commercial borrowing backed by a Federal Government guarantee and is expected to be paid off during the year through the sale of wheat Subsidies for electricity and petroleum. This is primarily a deferment of electricity payments for 3 1.0 months beginning in March, the majority of which will be collected by June 2020. The petroleum price reduction is expected to be offset by the decline in global oil prices. Some portion of this package is also expected to have expenditure implications in FY21 TOTAL 7.5 2Source: Global Trade Alert, University of Saint Gallen. 3The support, in the form of a grant, is calculated on the basis of electricity consumption during May, June and July 2019, and to be used by beneficiaries during a six-month period. Both tax-filers and non-filers are eligible, with a maximum of PKR100,000 for commercial consumers, and PKR450,000 for industrial consumers in total. Page 7 The World Bank Resilient Institutions for Sustainable Economy (P171850) 9. The World Bank has developed a Framework for Operational Response to the COVID-19 Pandemic. The framework has four pillars: (a) saving lives, (b) protecting the poor and vulnerable, (c) ensuring Sustainable Business Growth and Job Creation , and (d) Strengthening Policies, Institutions and Investments for Rebuilding better. As part of this framework, the World Bank’s rapid response to the COVID-19 crisis in Pakistan comprises the Pandemic Response Effectiveness in Pakistan project (PREP, US$200 million) and eight ongoing projects that quickly mobilized US$40 million for urgently needed equipment and supplies. The second phase of the COVID-19 rapid response is currently underway, which focuses on interventions to mitigate socio-economic impacts. This includes the recently approved SHIFT DPF (US$500 million), as well as repurposing and restructuring existing operations and aligning the design of proposed operations to prioritize COVID-19-related interventions and support for the medium-term reform agenda—supporting safety nets, public works, microenterprises and small businesses, the digital economy, food security, and learning—so that Pakistan can rebound stronger and quicker as the COVID-19 crisis subsides. Finally, the proposed RISE DPF includes actions that respond to the immediate needs and addresses medium-term reforms. The Asian Development Bank has approved a US$300 million emergency assistance loan to strengthen Pakistan’s public health response to the COVID- 19 pandemic and is also providing US$500 million from its Comprehensive Pandemic Response Option. The IMF disbursed US$1.4 billion under the Rapid Financing Instrument (RFI) to address the economic impact of the COVID-19 shock. Underlying Structural Factors Constraining Pakistan from a Nimbler COVID-19 Response 10. Periodic macroeconomic crises have constrained the country’s growth prospects. The main factors that cause the crises are (a) weak institutions, (b) lack of coordination mechanisms for fiscal policy making between the Federal Government and provinces, which result in unsustainable fiscal targets, (c) the limited operational independence of the central bank, to implement a flexible market-determined exchange rate, (d) frequent reversal of structural reforms, including key measures in the energy sector, (e) complex business regulatory environment that impedes the development of a vibrant private sector, and (f) elite capture, which undermines reforms that reduce elites’ ability to extract rents. Over the last two decades, economic growth in Pakistan has averaged 4.4 percent a year, below the South Asian annual average of 6.3 percent. The slow progress of structural reforms, low private investment (approximately 10 percent of GDP on average in the last decade, which is less than half of the South Asian average) and slow export growth due to an overvalued currency, among other factors, have hindered growth prospects. With a population growth rate of 2.4, the country has seen a limited per capita real growth rate. These weaknesses meant that Pakistan entered the COVID-19 pandemic with weak fundamentals. 11. The existing fiscal institutions and intergovernmental coordination arrangements have constrained the effective management of the government’s finances. Pakistan’s fiscal architecture assigns more than half of consolidated general government revenues to provinces while the Federal Government retains two-thirds of total expenditures. There is no fiscal policy function at the Federal level which is responsible for formulating a coherent medium-term fiscal framework (MTFF) and undertaking fiscal risk analysis for the country. Fiscal policy-making is fragmented and scattered across innumerous bodies. The result is incremental budgeting, lack of coherence between the objectives of the Federal and provincial finance divisions, a build-up of debt, and lax fiscal discipline as evidenced by the country’s persistently high fiscal deficits (at 6.4 percent of GDP on average in the last decade). These challenges limit the country’s ability to respond effectively to the COVID-19 crisis and its ability to recover quickly and remain resilient. 12. The power sector remains a significant fiscal burden to the country, which is now exacerbated by the COVID- 19 pandemic. It incurs annual losses of approximately 2.2 percent of GDP on account of: (a) high costs of power generation, (b) losses accumulated from unfunded public policy mandates and lack of timely revision of tariffs, and (c) Page 8 The World Bank Resilient Institutions for Sustainable Economy (P171850) the poor performance of electricity Distribution Companies (DISCOs). During the 10-year period of FY10-FY19, the power sector accumulated losses of PKR 5.0 trillion (US$45 billion). Almost half of the annual deficit in the sector is covered by federal budgetary subsidies. The remaining deficit accumulates as circular debt to power generators and to fuel importers. In 2012 and 2013 with the support from a previous DPF, the entire stock of circular debt was written off. However, the underlying cause, namely the high cost of power of generation, was not addressed and, as a result, the stock of circular debt has reemerged. The RISE operation sets the foundations for implementation of critical energy sector reform. Specifically, it includes reforms to lay the foundation for a strategy to reduce the circular debt in the energy sector as well as policy reforms to promote cheaper low carbon investments. A potential subsequent DPF operation, PACE, is expected to focus on measures to implement energy reforms with the goal of: (a) reducing power generation costs, (b) rebalancing the future energy mix so it is less reliant on expensive fossil fuels 4 and more reliant on indigenous, clean and green resources, and (c) establishing more efficient and transparent public private partnership arrangements. 13. The current regulatory framework has impeded the growth and competitiveness of the private sector. The country ranked 108/190 in the World Bank’s Ease of Doing Business Index for 2020, up from a low of 147 in 2018. This ranking reflects a cumbersome business regulatory environment with poor contract enforcement, a fragmented tax system with associated significant compliance costs to businesses, and a financial system dominated by commercial banks that lend mostly to the government and large companies. Digital financial services have not developed because of a lack of regulations on electronic money institutions, an incomplete national payment system, and the manual processing of payments to suppliers by the government. The country also dissuaded firms from exploiting export markets by maintaining non-competitive trade tariff structure and an overvalued exchange rate. These factors combined with recurrent macroeconomic crises have depressed private investment and impeded competitiveness. If not addressed, these issues will hamper Pakistan’s COVID-19 recovery and resilience efforts. 14. The nearly two-year-old government has been implementing reforms to increase private investment to boost growth prospects. The government has a two-pronged economic reform program. The first prong is to implement policies to stabilize the economy with support from a 39-month Extended Fund Facility (EFF) arrangement 5 with the IMF. The second is to implement structural reforms to address impediments to private investment. Key reforms to- date include: (a) adoption of a market-determined exchange rate to address the large current account deficit, (b) an increase in the policy rate by 575 basis points to control inflation, 6 (c) approval of the first-ever National Tariff Policy to reduce the anti-export bias and, (d) elimination of the General Sales Tax (GST) exemptions on the five largest sectors of the economy, increased thresholds for personal income taxes, higher energy tariff to close the gap between general costs and tariffs paid by consumers, and a memorandum of understanding with all four provinces to curtail the fiscal deficit in order to reduce the consolidated deficit. However, the COVID-19 pandemic has slowed the pace of these reforms as the government focuses on mitigation measures. 15. The proposed DPF series supports the government’s efforts in addressing the challenges described above, related to macro-fiscal management and economic growth. The first pillar supports reforms that will strengthen macroeconomic stability and fiscal management by (a) establishing institutions and coordination mechanisms between federating units to keep the general government fiscal deficit within sustainable levels, (b) improving debt transparency and management, (c) improving fiscal policy and eliminating distortions, and (d) reducing fiscal risks emanating from the energy sector. Reforms in the second pillar will support growth and competitiveness by: (a) harmonizing the sales tax across the country to reduce the administrative burden on the private sector, (b) enhancing the transparency and 4 In Pakistan, fossil fuels used for power production are coal (22 percent), natural gas (27 percent), and oil (8 percent). Numbers in brackets are estimated shares of overall power production in FY20. 5 IMF Country Report No. 19/212 of July 2019. 6 The State Bank of Pakistan lowered the policy rate by 425 basis points since March 2020, in response to the evolving COVID-19 crisis. Page 9 The World Bank Resilient Institutions for Sustainable Economy (P171850) depth of the financial sector, (c) supporting digital financial inclusion, and () reducing the anti-export bias of the national tariff policy to support integration with global value chains. These reforms will help the country ensure fiscal resilience during the COVID-19 pandemic response and foster a quick recovery after the pandemic abates. 16. The risks to this operation are high. Macroeconomic, political, institutional capacity and stakeholders risks are high. The macroeconomic situation in the near term is likely to remain fragile, with elevated risks now due to the impact of global COVID-19 pandemic on the economy, which could decelerate progress on key reforms. In addition, a delay in the adjustment process, volatility in oil prices, and geopolitical tensions could significantly worsen the economy’s prospects. Macroeconomic risks are mitigated, in part, by the IMF’s EFF arrangement and the Rapid Financing Facility support, increased budgetary financing from the Asian Development Bank, the Asian Infrastructure Investment Bank, and the World Bank. Political risks are high because in the past, reforms that seemingly benefited from broad support, stalled because they challenged an existing equilibrium of power and those benefiting from the status quo. These risks are partly mitigated through the active involvement of the World Bank to help secure buy-in from political leaderships across the spectrum. Institutional capacity risks are high because of weak federal-provincial coordination and technical capacity on taxation and fiscal policy. These risks may be exacerbated in the context of government’s measures to contain the spread of the COVID-19 virus. They are mitigated, in part, by taking an all-of-government approach, engaging with the Federal Government and provinces to address long-standing and long-delayed structural reforms, strengthening of institutions responsible for inter-governmental coordination, and provision of technical assistance for implementation. The World Bank is collaborating with the IMF, the Asian Development Bank (ADB), and other development partners, to provide a coordinated support program to the authorities, both in terms of financing and reform implementation, including on the COVID-19 response. 2. MACROECONOMIC POLICY FRAMEWORK 2.1. RECENT ECONOMIC DEVELOPMENTS 17. Prior to the outbreak of the pandemic, Pakistan made considerable progress in restoring macroeconomic stability, but the outlook has changed more recently. The country was moving towards macroeconomic stabilization with support from the IMF’s EFF. 7 To reduce the fiscal deficit, the government lowered the threshold of income taxes, withdrew tax exemptions for major sectors of the economy, and increased valuation rates for properties for taxation purposes. To narrow the current account deficit, the SBP adopted a market-determined exchange rate, increased the policy rate by 575 basis points between July 2018 and July 2019, and stopped lending to the government for deficit monetization. The government achieved a primary fiscal surplus of 0.4 percent of GDP in Jul-Mar FY20 compared to a primary deficit of 1.2 percent in Jul-Mar FY19. During the same period, the current account deficit narrowed to 1.1 percent of GDP from 3.7 percent. However, since the COVID-19 pandemic broke out in early 2020, economic activity has almost halted and trade flows have collapsed. While tax collections have seen a sharp decline, the government has increased its spending on COVID-19 response and mitigation measures. Preliminary data points to a severe contraction of the economy in the last quarter (April-June) of FY20 8 and potentially a 2.9 percentage point of GDP increase in the fiscal deficit from the budgetary target. The COVID-19 pandemic has further elevated macroeconomic and fiscal risks to the outlook due to the impact of global disruptions on Pakistan’s economy. 7 Current account and fiscal balances worsened during the period of FY17-19 due to a combination of consumption driven growth, an overvalued exchange rate, high volume of imports due to the China Pakistan Economic Corridor investments, and a loose fiscal policy in the runup to the 2018 elections. 8 The Government of Pakistan’s fiscal year runs from July to June. Page 10 The World Bank Resilient Institutions for Sustainable Economy (P171850) 18. The economy had decelerated before the COVID-19 outbreak and measures to contain the pandemic are severely affecting economic activity. Real GDP growth (at factor cost) decelerated from 5.5 percent in FY18 to 1.9 percent in FY19 9. The latest indicators point towards a further slowdown in growth in the first nine months of FY20 (pre- COVID-19) as stabilization measures took effect. The output of large-scale manufacturing (that constitutes approximately 50 percent of industry) contracted by 5.4 percent (YoY) in Jul-Mar FY20, compared to a contraction of 2.9 percent in Jul-Mar FY19. However, leading indicators suggest that the major crops subsector in agriculture is likely to perform marginally better in FY20 than FY19. The situation has worsened as the COVID-19 containment measures including lockdowns across most of the country, restrictions on domestic and international travel, and closure of all non- essential businesses have brought economic activity to a near-halt in the country. Lockdowns and social distancing measures have disrupted domestic distribution channels causing shortages of fertilizer, labor, and transportation. The restrictions on trade (limited to only essential goods) have disrupted supply chains in the manufacturing sector. Shortages in imports of building materials and skilled labor have brought construction activity to a halt. Lower domestic demand has translated to lower consumption of electricity, fuel and gas, further reinforcing the slump in overall economic activity. These measures are adversely impacting the services and industrial sectors, which constitute around four-fifths of the GDP. 19. Headline inflation remained elevated, driven primarily by food and administered price hikes and the depreciation of the exchange rate. Average inflation increased to 11.6 percent during Jul-Apr FY20 (from 7.0 percent in the same period of the previous year) due to a brief surge in food inflation, upward adjustments in administered prices (energy), and the exchange rate depreciation pass-through. Food inflation increased to 14.4 percent during Jul-Apr FY20 compared to 3.8 percent in Jul-Apr FY19. The core inflation metric (non-food non-energy) during this period remained stable at 8.0 percent. From end-March, the COVID-19 containment measures led to a decline in domestic demand that has dampened inflationary expectations. This prompted the SBP to cut the policy rate by 525 basis points to 8.0 percent during March-May 2020. As a result, real interest rates are currently negative. However, according to the SBP, these cuts were necessary to complement other measures recently taken to support the economy, including its commitment to keep the market sufficiently liquid so that schemes to provide concessional financing to companies, among others, could be implemented. 20. The financial sector remained sound, but the COVID-19 pandemic has increased risks. Private sector credit slowed to 4.5 percent between end June-2019 and May 8, 2020, compared to 9.4 percent in the comparable period of FY19, as commercial banks invested in risk-free, high yielding government papers. Overall, the soundness of the banking sector remained strong. According to the latest available data, until end-December 2020, the Capital Adequacy Ratio (CAR) was at 17.0 percent, well above the minimum regulatory requirement of 11.3 percent, while gross and net Non- Performing Loans (NPLs) remained at 8.6 percent and 1.7 percent, respectively. However, the on-going pandemic and the ensuing slowdown in economic activity can lead to an increase in NPLs, thereby eroding the capital buffers of the banking system. 21. The SBP has taken measures to keep credit markets functioning and protect borrowers amidst the pandemic. In this regard, the SBP has instructed banks to defer by on year the payment of principal on loans and advances, (borrowers will, however, continue to pay the interest amount). The deferment of principal will not affect the borrower’s credit history and will also not be reported as restructured/rescheduled in the credit bureau’s data. For more financially distressed borrowers, the SBP has relaxed the regulatory criteria for restructuring/rescheduling of loans. The loans that are re-scheduled/restructured within 180 days from the due date of payment will not be treated as defaults. These measures primarily allow the real sector to preserve cash flows for their ongoing activities, provide 9According to the latest official data released, growth for FY19 has been revised downwards from the initial estimate of 3.3 percent to 1.9 percent. Page 11 The World Bank Resilient Institutions for Sustainable Economy (P171850) incentives for banks to maintain committed credit flows or provide additional credit, and offer immediate relief and additional time to borrowers. 22. The current account deficit (CAD) narrowed considerably during FY20, driven by a decline in imports. The CAD narrowed to 1.1 percent of GDP during Jul-Mar FY20, compared to 3.7 percent in the same period in FY19 (Figure 1). This was mainly driven by a 16.2 percent (y-o-y) reduction in goods imports, primarily, petroleum, transport equipment, mineral products, chemicals and textiles. The decline in imports was, in part, because of the large depreciation of the PKR. Exports grew marginally by 1.1 percent (y-o-y) during Jul-Mar FY20, driven by rice and readymade garments. Since the outbreak of the COVID-19 pandemic, there has been a steep decline in trade related activities, except in imports of medical equipment needed to support the containment of the outbreak. Workers’ remittances also grew by 6.0 percent (y-o-y) during the first nine months of FY20 but are expected to contract in Q4 FY20 as the COVID-19 pandemic and low oil prices impact the Gulf Cooperation Countries (GCC). 23. Financial inflows from multilateral agencies financed the CAD and led to a buildup of reserves. At the beginning of FY20, the SBP’s gross reserves were US$9.3 billion, equivalent to 2.3 months of import coverage. Multilateral disbursements increased in Jul-Mar FY20 supported by the IMF EFF (US$1.4 billion) and the ADB (US$2.1 billion). As foreseen in the IMF EFF program, non-traditional bilateral creditors have retained their exposure and rolled over maturing debt equivalent to US$6.0 billion since the start of FY20. Specifically, these rollovers include bilateral deposits of US$2.0 billion from China 10, balance of payments support loans of US$3.0 billion from the Kingdom of Saudi Arabia (KSA), and US$1.0 billion from the United Arab Emirates (UAE). Foreign direct investment was US$2.1 billion during Jul- Mar FY20, with some contribution from the renewal fee of cellular companies’ licenses. The country received US$3.5 billion in inflows in government securities (mainly in short-term government securities) during Jul-Feb FY20 11 and amortized US$1.0 billion of Sukuks in December 2019. Together with the lower CAD, these developments allowed the SBP to rebuild international reserves. However, since the outbreak of the COVID-19 pandemic, there have been significant outflows from government securities as foreign investors offloaded their positions—around 85 percent of the portfolio inflows received. The government thereafter received US$1.4 billion additional inflows on April 20, 2020 from IMF as part of a Rapid Financing Instrument to help the government address the economic impact of the COVID- 19 crisis. As of May 8, 2020, the SBP’s gross reserves (including the cash reserve requirement and cash holdings) had increased to US$14.3 billion, equivalent to 3.7 months of import coverage. 24. The exchange rate depreciated as the SBP transitioned to a market-determined exchange rate regime in May 2019. The PKR depreciated cumulatively by 25.5 percent against the US$ in FY19 (Figure 2). During Jul-Feb FY20, the decline in the CAD and increased inflows resulted in a nominal exchange rate appreciation of 5.7 percent. This nominal appreciation together with the high inflation differential vis-a-vis trading partners resulted in a 9.5 percent appreciation in the real effective exchange rate between Jul-Feb FY20. However, the recent volatility in global financial markets and related outflow of portfolio investment from Pakistan (both from equity markets and government securities), contributed to a 3.8 percent nominal depreciation in the PKR since end-February 2020. As part of the EFF, the government has committed to amend the SBP Act to institutionalize the inflation targeting framework, enhance the autonomy of the SBP, and improve governance arrangements. This amendment to the SBP Act has been drafted and is expected to be presented to the Parliament for approval by end-May 2020. 12 10 Bilateral deposits from China are classified as loans - http://www.finance.gov.pk/Supplement_2018_19.pdf. 11 Short-term government treasury bills (T-bills) have maturities of 3, 6, and 12 months. 12 The amendment to the SBP Act was an end-March 2020 structural benchmark for IMF-EFF. Page 12 The World Bank Resilient Institutions for Sustainable Economy (P171850) Figure 1. Exports, Imports and the Current Account Balance Figure 1. PKR/US$ Exchange Rate and Gross Official Reserves 80,000 7.0 25,000 180 4.0 20,000 160 40,000 percent of GDP US$ Million 1.0 140 US$ Million 0 15,000 PKR/US$ -2.0 May 120 -40,000 10,000 -5.0 100 -80,000 -8.0 5,000 80 0 60 Jul 2011 Jul 2012 Jul 2013 Jul 2014 Jul 2015 Jul 2016 Jul 2017 Jul 2018 Jul 2019 Jan 2012 Jan 2013 Jan 2014 Jan 2015 Jan 2016 Jan 2017 Jan 2018 Jan 2019 Jan 2020 Export (LHS) Imports (LHS) Gross Official Reserves (LHS) Current Account Balance (RHS) Exchange Rate (PKR/USD) (RHS) Source: WB staff elaboration on State Bank of Pakistan data. Source: WB staff elaboration on International Financial Statistics (IMF) and State Bank of Pakistan data. 25. Before the onset of the COVID-19 pandemic, the fiscal deficit had reduced but the situation has changed more recently. In FY19, the fiscal deficit was 9.1 percent of GDP. In order to reduce the fiscal deficit, the government rolled back tax exemptions granted to export oriented industries, lowered the personal income tax threshold, and increased the land valuation for the purpose of taxation in the FY20 Finance Bill. On the expenditure side, government maintained a check on recurrent expenditures during Jul-Mar FY20. These measures resulted in an increase in tax revenue collections by 13.7 percent (y-o-y) during Jul-Mar FY20. The growth in defense expenditures decelerated to 3.6 percent (y-o-y) during Jul-Mar FY20 compared to 24.2 percent (y-o-y) growth in Jul-Mar FY19. This provided the government with additional fiscal space to ramp up PSDP spending by 24.9 percent (y-o-y) in Jul-Mar FY20 compared to a contraction of 37.9 percent (y-o-y) during Jul-Mar FY19. The revenue measures, together with lower recurrent spending, reduced the fiscal deficit to 4.1 percent of GDP in Jul-Mar FY20 compared to 5.1 percent in Jul-Mar FY19. The government also ran a primary surplus of 0.4 percent of GDP during this period, compared to a primary deficit of 1.2 percent in Jul-Mar FY19. However, the COVID-19 pandemic is likely to affect FY20 fiscal outcomes, through both lower revenues and increased spending to mitigate the impact of the COVID-19 pandemic. 26. Public debt 13 (including guaranteed debt) increased in FY19 driven by the higher fiscal deficit and the depreciation of the PKR. Pakistan’s public debt – comprising general government and state-owned enterprises (SOE) guaranteed debt – stood at 88.8 percent of GDP at end-June 2019—13.6 percentage points higher than end-June 2018. The debt level remained in breach of the Fiscal Responsibility and Debt Limitation Act (FRDLA) 2005 (amended in 2017) which mandates a reduction of total public debt to 60 percent of GDP by end-FY18. 14 The large fiscal deficit, revaluation of the external debt stock due to the depreciation of the PKR,, and borrowing in excess 15 of budgetary requirements led to higher debt levels in FY19. 13Public sector is defined as general government and includes public guarantees, defined as guarantees to State-Owned Enterprises. 14 According to the FRDLA, public debt is defined as “debt of the government (including the Federal Government and the Provincial Governments) serviced out of the consolidated fund, and debts owed to the International Monetary Fund (IMF), less accumulated deposits of the Federal and Provincial Governments with the banking system”. By this definition, debt stood at 76.4 percent of GDP at end-June 2019. The amendment to the FRDLA also stipulates a reduction of total public debt by 0.5 percent each year from FY19-FY23 and by 0.75 percent each Page 13 The World Bank Resilient Institutions for Sustainable Economy (P171850) 2.2. MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY 27. The COVID-19 pandemic has introduced a high degree of uncertainty to the global and domestic macroeconomic outlook. It is not clear when the pandemic will abate or whether there will be a second wave of infections in the latter part of the year. These uncertainties weigh heavily on the global economy and Pakistan’s economic prospects. Therefore, the economic outlook for Pakistan is subject to considerable uncertainty. To account for this, this document presents two scenarios, a baseline and a downside scenario. Box 1 gives further details on the two scenarios in FY20 and FY21 16. 28. Pakistan’s economy is projected to contract in FY20 and FY21. 17 For FY20, the economy is likely to contract between 2.6 and 3.3 percent, 18 due to monetary and fiscal tightening in the first three quarters of the fiscal year and the severe impact of the COVID-19 pandemic in the last 4 months of the fiscal year. This is a significant decline compared to the 2.4 percent growth projected pre-COVID-19. The downside scenario assumes large-scale community transmission of the disease, continuation of the global recession, and devolvement of some contingent liabilities. Under the baseline assumptions, growth in FY21 is projected at -0.2 percent as the fallout of the pandemic is projected to continue in H1FY21. In the downside scenario, real GDP growth could contract by up to 4.0 percent. The wide interval for projections in FY21 is due to the great degree of uncertainty about the continuation of the pandemic next year. 29. Pakistan, like the rest of the world, is being affected by both demand and supply shocks. On the demand side, lower remittances because of the fall in oil prices and the economic fallout on the Pakistani diaspora of the COVID-19 related global slowdown, are expected to reduce private consumption. Government consumption (federal, provincial, and local) will be supported by increased spending to mitigate the effects of COVID-19. Private investment is projected to be adversely affected by weak consumer confidence and uncertainty around the pandemic. Public investment is projected to be subdued in FY20 with some pick up in later years to support economic recovery. Given the global recession, exports are likely to remain subdued. On the supply side, the agriculture sector is expected to register an anemic growth of 0.5 percent in FY20. Industrial production during FY20-FY21 is projected to be lower because of disruptions to supply chains and depressed domestic and foreign demand. Growth in services is projected to stagnate with the decline in remittance inflows, travel disruptions, closure of restaurants, and wholesale markets. An expansion in economic activity is only expected from FY22 onwards, as domestic conditions improve, and global demand picks up (Table 1). Inflation is expected to average 11.5 percent in FY20 and stabilize at 6.5 percent in FY21 and FY22. The significant decline in inflation projections factors the slowdown in domestic demand and a decline in commodity prices. year from FY24-FY33 after which, public debt would be maintained at a level of 50 percent of GDP or less. 15 In anticipation of the fund program which was expected to place a moratorium on borrowing from the SBP, the government borrowed PKR756 billion (2.0 percent of GDP) on June 29th, 2019 to build cash buffers. This extra government borrowing remained in deposits with the banking system. At end-June 2019, government deposits with the banking system stood at PKR 3.2 trillion (8.4 percent of GDP) compared to deposits of PKR 1.9 trillion (5.6 percent of GDP) at end-June 2018 (First Quarterly Report 2019-2020, State of Pakistan’s Economy State Bank of Pakistan). 16 The baseline scenario assumes that the pandemic will taper off toward end-2020 and the economic recovery will start in early 2021. The downside scenario assumes that the pandemic continues to affect growth in the first half of 2021, with a prolonged impact on global growth, disruptions to global trade and a steeper fall in remittances from the GCC countries. Domestically, this would result in partial/complete lockdowns, increased fiscal pressures and a health crisis. The outlook in FY21 is subject to a higher degree of uncertainty due to the evolving global economic situation. 17 This macroeconomic framework has been prepared by World Bank staff and differs from that of the government. 18 As per official estimates based on 9 months of actual data (published by the Pakistan Bureau of Statistics), the economy is projected to contract by 0.4 percent in FY20. The high uncertainty is reflected in differences in growth projections by different organizations. The IMF projects the economy to shrink by 1.5 percent in FY20, while the ADB projects a 2.6 percent expansion. The macroeconomic framework presented in this document is based on the World Bank staff’s GDP growth projection of -2.6 percent in FY20 for the baseline scenario and -3.3 percent for the downside scenario. Page 14 The World Bank Resilient Institutions for Sustainable Economy (P171850) 30. The financial sector may come under stress. Before the onset of the COVID-19 pandemic, Pakistani banks were well capitalized. However, a likely increase in NPLs and bad loans can erode these capital buffers. As discussed above, the SBP has announced COVID-19 pandemic related support measures for businesses as well as banks. It is expected that the SBP will continue to monitor the financial viability of the banking system by providing liquidity as required. Box 1. Macroeconomic Impact of the COVID-19 Pandemic The economic outlook for FY20 has been revised sharply from a growth of 2.4 percent pre-COVID-19 to a contraction of 2.6 percent. The incidence of the disease in Pakistan was low up until early May 2020, but has started to pick up. As of June 15, 144,478 cases have been confirmed. National or partial lockdowns could continue as the disease progresses domestically. The baseline growth projections reflect a protracted U-shaped recovery because of several factors including (a) the expected increase in domestic infections coupled with lockdowns and ongoing global travel restrictions, (b) slow recovery of remittances, (c) continued uncertainty and its impact on private investments, and (d) the impact of low growth globally. Despite the COVID-19 pandemic, the CAD is expected to decline in FY20 and increase marginally in FY21. The CAD is projected to narrow to 2.1 percent in FY20 due to a sharp contraction in imports and will increase to 3.1 percent of GDP in FY21. Exports— hit hard by disruptions caused by both global and domestic lockdowns, transport related suspensions, and the projected decline in global demand—will contract in both FY20 and FY21. In the post-COVID-19 downside scenario, the CAD could narrow to 1.5 percent of GDP if the pandemic continues until mid-2021, and trade flows decline further. Gross external financing requirements are projected at 10.3 percent of GDP in FY20, and 11.3 percent of GDP in FY21 in the post-COVID-19 baseline scenario. Summary Macroeconomic Indicators: Pakistan FY2020 to FY2021 FY2020 FY2021 Pre-COVID Pre-COVID Post-COVID Scenario Post-COVID Scenario Scenario Scenario Baseline Baseline Downside Baseline Baseline Downside (Percentage change; unless otherwise indicated) Real GDP growth (at market price) 2.4 -2.6 -3.3 3.0 -0.2 -4.0 Contributions: Private consumption 0.1 -3.6 -4.3 2.1 -0.2 -3.1 Government consumption -0.4 1.7 1.8 0.2 0.6 0.6 Investment -0.5 -3.6 -3.7 0.4 0.0 -2.6 Net Exports 3.3 2.9 2.8 0.2 -0.6 1.2 Fiscal accounts (In percent of GDP; unless otherwise indicated) Revenue 15.8 14.2 14.1 17.0 13.9 12.8 Expenditures 23.2 24.3 24.5 23.1 23.2 24.5 Overall balance (excl. grants) -7.3 -10.1 -10.4 -6.1 -9.4 -11.7 General govt. and govt. guaranteed debt (incl. IMF obligations) 85.3 93.8 94.8 82.7 98.4 107.1 External Account (In percent of GDP; unless otherwise indicated) Current account balance (incl. transfers) -2.2 -2.1 -2.0 -2.0 -3.1 -1.5 Exports of goods & services 11.5 10.0 9.9 11.4 9.3 8.8 Imports of goods & services 20.8 18.9 18.5 20.3 18.6 16.4 Financing Requirements (In percent of GDP; unless otherwise indicated) Gross fiscal financing requirements 28.0 32.2 32.7 28.8 34.8 38.9 Gross external financing requirements 10.0 10.3 10.3 10.0 11.3 10.3 Source: World Bank Staff Estimates The government’s gross financing needs are likely to increase substantially. The fiscal deficit is expected to reach 10.1 percent of GDP in FY20 and decline to 9.4 percent of GDP in FY21. Fiscal pressures have increased due to the COVID-19 pandemic as revenues are projected to be impacted negatively by the slower domestic economic activity but expenditures are likely to increase Page 15 The World Bank Resilient Institutions for Sustainable Economy (P171850) due to the pandemic related containment measures, the fiscal stimulus package and other measures aimed at mitigating the economic impact of the crisis. In the post-COVID-19 downside scenario, the fiscal deficit will increase marginally to 10.4 percent in FY20 but projected to increase to 11.7 percent of GDP in FY21 if the low case scenario materializes. Gross fiscal financing needs are projected to increase to 32.2 percent of GDP in FY20 and 34.8 percent of GDP in FY21 in the post-COVID-19 baseline scenario. Table 1. Key Macroeconomic Indicators, Pakistan FY2017 to FY2024 Page 16 The World Bank Resilient Institutions for Sustainable Economy (P171850) 31. The CAD is projected to remain sustainable over the medium term (Table 2), primarily supported by the deceleration in imports. The CAD is projected to narrow to 2.1 percent in FY20 (2.0 percent in the downside scenario) because of a sharp contraction in imports which is in line with reduced economic activity. The adverse impact of the COVID-19 pandemic on export growth is expected to materialize in Q4-FY20 and FY21. The decline in global demand, coupled with global and domestic supply chain disruptions, is expected to keep export growth subdued. Exports are projected to start recovering in FY22 as the impact of the COVID-19 pandemic becomes manageable. The growth in exports is expected to be supported by the flexible exchange rate as well as reforms aimed at reducing the anti-export bias in tariff policy and strengthening of export promotion activities. 19 Imports are projected to recover from FY21 onward, as domestic industrial activity picks up. The impact of the COVID-19 pandemic on overseas workers and the negative economic impact of low oil prices on the GCC economies are expected to reduce remittances in FY20 and FY21 by 7.0 percent and 6.0 percent, respectively. Table 2. Key BOP Indicators, Pakistan FY2017 to FY2024 (In US$ million; unless otherwise indicated) FY2020 FY2021 FY2022 FY2023 FY2024 FY2017 FY2018 FY2019 Pre-COVID Post-COVID Actual Projections i. Current Account -12,270 -19,195 -13,434 -6,141 -5,375 -8,148 -8,596 -9,619 -10,548 A. Trade balance -25,998 -30,903 -27,612 -22,727 -20,140 -21,765 -22,791 -24,252 -25,952 Export 22,003 24,768 24,257 25,597 20,997 19,737 21,908 24,428 27,359 Import -48,001 -55,671 -51,869 -48,324 -41,138 -41,503 -44,699 -48,680 -53,311 B. Services net -4,661 -6,426 -4,970 -2,818 -2,371 -2,534 -2,600 -2,778 -2,947 C. Balance on Primary Income -5,014 -5,437 -5,610 -5,559 -5,464 -5,892 -6,306 -6,683 -7,437 Of which: standstill from DSSI 1/ -95 -227 D. Balance on Secondary Income 23,403 23,571 24,758 24,962 22,600 22,043 23,100 24,093 25,786 of which Remittances 19,351 19,914 21,740 22,580 20,218 19,005 19,917 20,893 22,251 ii. Capital A/c 375 376 229 319 319 298 233 219 207 1. Balance from Current & Capital Accounts (i+ii) -11,895 -18,819 -13,205 -5,822 -5,056 -7,850 -8,363 -9,400 -10,341 2. Financial A/c -9,855 -13,611 -11,759 -10,437 -9,860 -12,073 -12,810 -12,287 -12,185 of which: Direct investment -2,320 -2,772 -1,436 -1,927 -2,010 -1,902 -2,559 -3,238 -4,171 Portfolio investment 250 -2,257 1,274 -2,138 620 -1,896 -2,630 -2,530 -4,660 Net Acquisition of Financial Assets 1,180 273 -67 1,031 1,024 2,582 2,355 1,613 1,886 Net Incurrence of Financial Liabilities 8,965 8,855 11,530 7,403 9,494 10,857 9,976 8,132 5,240 Of which: standstill from DSSI 1/ 320 1,153 3. Errors and omissions 94 -933 -58 690 690 0 0 0 0 Overall balance (-1+2-3) -1,946 -6,141 -1,504 5,305 5,494 4,223 4,446 2,886 1,843 Use of fund credit and loans 102 -86 -376 -746 -745 -1,006 -1,018 -1,063 -1,729 Gross SBP reserves 17,550 11,341 9,301 13,821 14,050 17,267 20,695 22,519 22,633 Net SBP reserves 16,144 9,766 7,285 12,421 12,550 15,767 19,195 21,019 21,133 Financing requirements 18,782 29,684 24,966 27,454 26,367 29,453 30,730 30,856 33,907 Current account deficit 12,270 19,195 13,434 6,141 5,375 8,148 8,596 9,619 10,548 Amortization 6,512 10,489 11,532 21,313 20,992 21,305 22,133 21,236 23,358 Financing sources 18,351 29,697 25,302 27,454 26,367 29,453 30,730 30,856 33,907 Memorandum Items Current A/c Balance ( percent of GDP) -4.0 -6.1 -4.8 -2.2 -2.1 -3.1 -3.0 -3.1 -3.2 Trade Balance (percent of GDP) -8.5 -9.8 -9.9 -8.3 -7.9 -8.4 -8.1 -7.9 -7.8 Export growth percent 0.1 12.6 -2.1 5.6 -13.4 -6.0 11.0 11.5 12.0 Import growth percent 16.7 16.0 -6.8 -8.4 -20.7 0.9 7.7 8.9 9.5 Remittance growth percent -2.8 2.9 9.2 3.4 -7.0 -6.0 4.8 4.9 6.5 Capital & Financial A/c ( percent of GDP) 3.4 4.4 4.3 3.9 4.0 4.7 4.6 4.1 3.7 1/ These estimates are based on preliminarly information as discussions between the authorities and creditors are on-going. Under this initative, interest payments in FY20 and FY21 will be suspended (indicated by negative sign) and the suspension on principal repayments is tantamount to additional financing (indicated by positive sign). Source: World Bank Staff calculations and estimates 32. Financing of the external deficit is projected to remain manageable over the medium term, predicated on the successful rollover of short-term deposits from non-traditional bilateral financiers and additional financing from 19 These reforms will be supported by the “Pakistan Goes Global” IPF, which is under preparation. Page 17 The World Bank Resilient Institutions for Sustainable Economy (P171850) multilateral and private creditors. While the CAD will remain moderate in the medium term, the amortization of external debt will remain high. External financing needs are projected to be, on average, US$30.3 billion a year during FY20-FY24. Multilateral, bilateral and private debt-creating flows are projected to be the main financing sources. On May 1, 2020 the government requested its G20 creditors to activate the Debt Service Suspension Initiative, which allows for all official debt service obligations to G20 creditors to be suspended from May 1, 2020 to December 31, 2020. This will be followed by individual bilateral creditor agreements. This initiative is expected to result in the suspension of nearly US$415 million in FY20 and US$1,380 million in FY21. The Government has committed to its G20 creditors that the additional fiscal space provided by the Initiative will be used to increase social, health and economic recovery spending in response to the COVID-19 crisis. On April 16, 2020 the IMF approved a RFI equivalent to US$1.4 billion to help the authorities address the economic impact of the COVID-19 pandemic. Similarly, the ADB has also committed to providing an additional US$800 million in FY20 to support the government’s efforts to mitigate the impact of the COVID- 19 pandemic. Other lenders are also advancing their disbursement plans to support the government. This outlook also assumes that non-traditional bilateral financing partners (namely China, the KSA and the UAE) will roll over existing short-term loans to Pakistan for the duration of the IMF program (FY20-FY23). In line with this, China has renewed bilateral deposits of US$ 2.0 billion in March, KSA had refinanced balance of payments support loans of US$3.0 billion that matured between Nov-Jan FY20 and UAE rolled over US$1.0 billion BOP support loans in March as well. The BOP financing requirements are presented in Table 3. If the authorities are not able to secure continued rollover of these loans and extend the amortization period, macroeconomic risks will intensify. 33. Pakistan’s reserve coverage is projected to improve to 3.5 months of imports of goods and services by end FY20 but reserve inadequacy continues to be a concern. International reserve accumulation is projected to be an outcome of the improvement in external balances, including the rollover of short-term loans by non-traditional financing partners and borrowings from other creditors. The improvement in reserve adequacy is fragile and Pakistan remains below the IMF Assessing Reserve Adequacy requirement over the medium term, only meeting the reserve requirement from FY24 onwards. Reserve adequacy will also be subject to SBP’s adherence to a market-based exchange rate regime. Page 18 The World Bank Resilient Institutions for Sustainable Economy (P171850) Table 3. BOP Financing Requirements and Sources, Pakistan FY2018 to FY2024 (in millions of US dollars; unless otherwise specified) FY2020 FY2021 FY2022 FY2023 FY2024 FY2018 FY2019 Pre-COVID Post-COVID Actual Projections Financing requirements 29,684 24,966 27,454 26,367 29,453 30,729 30,855 33,906 Current account deficit 19,195 13,434 6,141 5,375 8,148 8,596 9,619 10,548 Of which: standstill from DSSI 1/ (95) (227) Amortization 10,489 11,532 21,313 20,992 21,305 22,133 21,236 23,358 Public Sector 5,789 7,359 17,224 16,903 18,244 18,105 15,141 15,751 To IMF 86 377 746 745 1,006 1,018 1,063 1,729 To other official creditors 4,163 4,444 12,632 12,312 9,332 8,192 5,138 8,322 Of which: standstill from DSSI 1/ (320) (1,153) To private creditors 1,488 1,538 2,846 2,846 7,906 7,895 7,940 4,700 To Eurobonds 52 1,000 1,000 1,000 - 1,000 1,000 1,000 Private Sector 4,700 4,173 4,089 4,089 3,061 4,028 6,095 7,607 Financing sources 29,697 25,302 27,454 26,367 29,453 30,729 30,855 33,906 FDI and portfolio investments 5,272 1,436 5,927 2,510 3,902 5,859 6,538 9,471 o/w: Eurobonds/Sukuk 2,500 - - - 1,000 2,500 2,500 4,500 Capital grants 376 229 319 319 298 233 219 207 Short term debt disbursements 1,725 1,645 6,498 6,498 7,884 10,150 8,650 4,900 Long term debt disbursements 6,782 6,610 12,412 15,254 14,611 10,017 9,121 4,738 from IMF - 2,372 2,846 2,137 1,556 780 - from Multilaterals 3,703 2,917 4,840 6,548 8,374 5,676 4,047 2,386 o/w IDA/IBRD 500 500 1,000 2,200 3,315 2,672 2,186 1,819 o/w ADB 50 50 2,100 3,500 2,350 1,300 1,750 700 from Bilaterals 3,079 3,693 5,200 5,860 4,100 2,785 4,294 2,352 Of which: standstill from DSSI 1/ 415 1,380 Private Sector 7,569 3,784 6,813 6,490 6,881 8,817 9,214 16,334 Other financial flows 2,042 7,516 790 790 100 100 - 100 Drawdown in reserves 5,931 4,082 (5,305) (5,494) (4,223) (4,447) (2,887) (1,844) 1/ These estimates are based on preliminarly information as discussions between the authorities and creditors are on-going. Under this initative, interest and principal payments in FY20 and FY21 will be suspended, leading to a reduction in the financing requirements (indicated by negative sign) and this is also tantamount to additional financing from bilateral creditors (indicated by positive sign). Note: The projection for FY20 assumes World Bank to double the disbursement amount under the RISE DPF (additional financing of US$500 million). Source: World Bank Staff calculations and estimates 34. The fiscal deficit is expected to remain elevated in the medium-term as the government responds to the COVID-19 pandemic. The economic slowdown triggered by the COVID-19 outbreak is expected to significantly affect revenue collections in FY21-FY22. The government has announced a fiscal stimulus package of around US$7.5 billion 20 to mitigate the economic impact on businesses, as well as increase its spending on health and social protection. The fiscal deficit is projected at 10.1 percent of GDP (10.4 percent of GDP in the downside scenario) for FY20 and between 9.4 and 11.7 percent of GDP in FY21. The financing provided through the SHIFT DPF1 21 in the amount of approximately US$500 million is included in the medium-term framework presented in Tables 3 and 4. The medium-term fiscal framework also reflects the government’s fiscal stimulus and key reform measures, described below: • Revenue collection: Tax revenues are projected to fall to 11.1 percent of GDP in FY20, a decrease of 0.7 percentage points of GDP compared to FY19. The economic slowdown and disruptions caused by the COVID- 19 pandemic are expected to result in a fall in tax revenue collection during Apr-Jun 2020. The non-tax revenues are projected to increase to 3.1 percent of GDP in FY20 compared to 1.1 percent of GDP in FY19. The increase in non-tax revenues is coming from higher profits by SBP and receipts from the renewal of 4G license fees from telecommunication companies. Around 85 percent of the total target for non-tax revenues was collected in Jul-Mar FY20. Given the large volume of government debt held by the SBP and revaluation gains 20 The financing of the response package comprises of approximately US$2.5 billion of additional resources, and the re-appropriation from the existing budget, especially from the Public Sector Development Program (PSDP). 21 The 2-year SHIFT DPF series was prepared in parallel to the RISE DPF series and aims to strengthen systems for human capital accumulation, improve contribution of women to economic productivity and strengthen federal safety nets to respond to shocks in a more efficient manner. Page 19 The World Bank Resilient Institutions for Sustainable Economy (P171850) on its foreign exchange reserves due to the recent exchange rate depreciation, it is expected that the authorities will meet the overall non-tax revenue target for FY20 through higher profits received from the SBP. Under the baseline scenario, the tax-to-GDP ratio in FY21 will remain at approximately FY20 levels. Thereafter, revenue collection is expected to increase over the medium term as growth recovers and the government implements structural reforms related to GST harmonization, rolls back tax expenditures, streamlines tax rates, eliminates special tax treatment on agriculture income, and improves the withholding tax regime. Concurrently, the Pakistan Raises Revenue project will support the Federal Board of Revenue in administering taxes more effectively. • Fiscal response to the COVID-19 pandemic: The government has announced a fiscal stimulus package of approximately US$7.5 billion to: (a) support the medical health sector to combat the spread of virus and provide relief to those impacted; (b) implement social welfare measures to support the poor and vulnerable whose livelihoods have been impacted by the economic slowdown and partial lockdowns across the country; and (c) provide stimulus to businesses and industries to protect productive assets during the economic downturn. However, it is estimated that only around US$2.5 billion is additional spending, as the remainder would be financed through expenditure reallocations including savings on interest payments due to the recent reduction in interests rates, and re-appropriation from the existing budget, primarily from the PSDP on account of underspending by some ministries. For the medical and relief efforts, the government has announced tax relief on food and medical equipment, along with additional funds to the National Disaster Management Authority for medical equipment and staffing. Furthermore, the government’s Ehsaas program has been scaled up to provide monthly financial assistance to around 12 million households, compared to 4.6 million that regularly benefit from social assistance, over a period of 4 months. The government is also providing financing to Utility Stores Corporation and continuing with its wheat procurement exercise to ensure that adequate supplies of food at reduced prices are available during this crisis. In addition, a fund for daily laborers who have lost their earnings due to the economic slowdown has been announced. To stimulate the economy, a fund for SMEs has been established. For exporters and businessmen, tax refunds are being expedited to help businesses maintain liquidity. A relief package for the construction sector was also announced to stimulate the construction sector and maintain employment for the daily workers. • Spending: The government’s fiscal response to COVID-19 is resulting in a significant increase in recurrent spending due to higher social protection spending under the Ehsaas Programme and other support measures. While, recurrent spending is projected to increase to PKR9.1 trillion in FY21, up from PKR8.9 trillion in FY20, it is declining as a share of GDP. Owing to the tight fiscal space and increased requirement for spending on post- COVID-19 related recovery and support programs, capital expenditures are projected to decline in FY21-22. From FY22 onwards, recurrent spending will stabilize while capital spending will be ramped up to support growth. • Strengthening fiscal management: The government remains committed to improving its core fiscal management functions. In addition, policy reforms supported by this operation will help strengthen fiscal management. These include the establishment of a Macro-Fiscal Policy Unit, the integration of the external and domestic management responsibilities in the Debt Policy and Coordination Office (DPCO), and the harmonization of the general sales taxes across the country. These measures are expected to improve fiscal management and fiscal sustainability, with a view to narrowing fiscal imbalances over the medium to long term. Page 20 The World Bank Resilient Institutions for Sustainable Economy (P171850) Table 4: Key Fiscal Indicators, FY2017 to FY2024 (In percent of GDP; unless otherwise indicated) FY2020 FY2021 FY2022 FY2023 FY2024 FY2017 FY2018 FY2019 Pre-COVID Post-COVID Actual Projections Revenue and grants 15.5 15.2 13.0 16.0 14.3 14.0 15.1 16.1 17.2 Total Revenue 15.5 15.1 12.9 15.8 14.2 13.9 15.0 16.0 17.1 Tax revenue 12.4 12.9 11.8 12.8 11.1 11.2 12.3 13.3 14.4 Taxes on goods and services 4.8 4.9 4.5 Direct Taxes 4.2 4.4 3.8 Taxes on international trade 1.6 1.8 1.8 Other taxes 1.9 1.8 1.7 Nontax revenue 3.0 2.2 1.1 3.0 3.1 2.6 2.7 2.7 2.7 Grants 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 Expenditure 21.3 21.6 22.0 23.2 24.3 23.2 23.6 23.9 24.0 Current expenditure 16.3 16.9 18.7 19.4 21.8 20.8 20.5 20.4 20.5 Interest payments 4.2 4.3 5.5 6.5 6.6 6.3 6.2 6.0 6.0 Of which: standstill from DSSI 1/ 0.0 -0.1 Superannuation allowances & pension 1.0 1.0 1.0 1.0 1.0 1.2 1.2 1.3 1.2 Transfers (other than provinces) 2/ 1.1 1.1 1.2 1.2 1.9 1.5 1.4 1.6 1.5 Others 3/ 4.6 4.5 4.9 4.7 5.8 5.3 5.0 5.0 4.9 Provincial 5.4 6.0 6.1 6.0 6.5 6.5 6.7 6.6 6.8 Development expenditure & net lending 5.3 4.7 3.2 3.7 2.6 2.4 3.1 3.4 3.6 Statistical discrepancy -0.2 0.0 0.1 0.1 0.0 0.0 0.0 0.0 0.0 Overall balance (excluding grants) -5.8 -6.5 -9.1 -7.3 -10.1 -9.4 -8.6 -7.9 -7.0 Overall balance (including grants) -5.8 -6.4 -9.0 -7.2 -10.0 -9.3 -8.5 -7.8 -6.9 Financing 5.8 6.5 9.1 7.3 10.1 9.4 8.6 7.9 7.0 External 1.7 2.3 1.1 3.7 4.2 4.3 3.1 2.3 1.2 Of which: standstill from DSSI 1/ 0.1 0.4 Of which : privatization receipts 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Domestic 4.1 4.3 8.0 3.7 5.9 5.1 5.5 5.7 5.7 Memo: Primary balance (excluding grants) -1.6 -2.2 -3.6 -0.8 -3.5 -3.0 -2.4 -1.9 -1.0 Primary balance (including grants) -1.5 -2.1 -3.5 -0.7 -3.4 -2.9 -2.3 -1.8 -0.9 1/ These estimates are based on preliminarly information as discussions between the authorities and creditors are on-going. Under this initative, interest payments in FY20 and FY21 will be suspended (indicated by negative sign) and the suspension on principal repayments is tantamount to additional external financing (indicated by positive sign). 2/ For FY20 onwards, this includes the Ehsaas Programme 3/ This includes other object classifications including operating expenses, civil and military salary, operating expenses of the federal government; subsidies, physical assets and repairs and maintenance Source: World Bank Staff calculations and estimates 35. Pakistan’s public debt-to-GDP ratio is projected to increase over the next two years before gradually declining. Pre-COVID-19, the government was implementing a program of fiscal consolidation, reflected in a narrowing of the fiscal deficit from 5.1 percent of GDP in Jul-Mar FY19 to 4.1 percent in Jul-Mar FY20. However, with the outbreak of COVID-19, a substantial increase in the fiscal deficit is projected over the medium term. Therefore, debt sustainability risks have risen with an increase in debt levels. As a result, under the baseline scenario, public debt is projected to increase from 88.8 percent of GDP in FY19 to 93.8 percent by FY20 and peak at 98.4 percent of GDP in FY21 before gradually declining to 95.1 percent of GDP by FY24 (see Figures 3-4 for a decomposition of debt dynamics and Figures 5-6 for the projected debt path in the baseline and downside scenarios). The debt held by the Power Holding Private Limited (PHPL) is included in the public debt stock. As a result, the fiscal framework and the debt sustainability analysis incorporate the impact of the transfer of debt held by the PHPL to the general government debt stock. 22 However, if the downside scenario were to materialize, public debt could reach 94.8 percent of GDP in FY20 and 107.1 percent of GDP in FY21. Under the baseline scenario, the moderately higher economic growth and declining primary deficits are 22 Aspart of RISE DPF-I, Prior Action 4, the PHPL debt will be transferred to the general government debt stock, as and when it matures. Before that, the PHPL debt was part of the Public and Publicly Guaranteed Debt as it was included in the guarantees issued to State-Owned Enterprises. This transfer changes the composition but not the overall level of Public and Publicly Guaranteed Debt. Previously, PHPL bond issuances were above KIBOR rates while public debt issuance is currently below KIBOR. This is expected to contribute to cost savings. Page 21 The World Bank Resilient Institutions for Sustainable Economy (P171850) expected to support the decline in public debt beyond FY22. Gross financing needs will remain sizeable throughout the projection period because of maturing debt to multilateral and bilateral creditors, Eurobond bullet maturities 23 and repayments of the previous IMF-EFF completed in September 2016 24. Debt management is expected to improve through structural reforms, which include (a) the integration of the external and domestic management responsibilities in the DPCO, 25 (b) the adoption of a medium-term debt management strategy, (c) making issuance of guarantees to SOEs contingent on publication of audited financial statements, and d) the semi-annual publication of debt reports. To ensure the sustainability of these reforms, the government will provide a legal mandate to DPCO, and will further integrate debt management functions through amendments to the FRDLA under RISE-II. The World Bank is providing technical assistance to institutionalize these reforms to ensure their sustainability. Figure 2. Contribution to Change in Public Debt Levels (FY18-FY24) Figure 3. Contribution to Change in Public Debt Levels (FY18-FY24) (Baseline Scenario) (Downside Scenario) 10.0 10.0 5.0 5.0 0.0 0.0 -5.0 -5.0 -10.0 -10.0 FY2018 FY2019 FY2020(p) FY2021(p) FY2022(p) FY2023(p) FY2024(p) FY2018 FY2019 FY2020(p) FY2021(p) FY2022(p) FY2023(p) FY2024(p) Primary deficit Real Interest Rate Real GDP Growth Primary deficit Real Interest Rate Real GDP Growth Exchange Rate Depreciation Residual, including asset changes Exchange Rate Depreciation Residual, including asset changes Source: WB Staff calculations and estimates Figure 4. Public Debt Sustainability Analysis (Baseline Scenario) Figure 5. Public Debt Sustainability Analysis (Downside Scenario) 130 130 125 125 120 120 115 Contingent liabilities 1/ 115 Contingent liabilities 1/ In percent of GDP 110 In percent of GDP 110 105 Interest rate 2/ 105 Interest rate 2/ 100 100 95 95 ER depreciation 3/ ER depreciation 3/ 90 90 85 85 Baseline 4/ Baseline 4/ 80 80 75 75 70 70 65 65 60 60 55 55 1 2 3 4 5 6 7 8 9 Source: World Bank staff estimates Source: World Bank staff estimates Notes: 1/ One time 10 percent of GDP increase in other debt creating flows in FY21 Notes: 1/ One time 10 percent of GDP increase in other debt creating flows in FY21 2/ Real interest rate is at baseline plus one standard deviation 2/ Real interest rate is at baseline plus one standard deviation 3/ One time 30 percent real depreciation in FY21 3/ One time 30 percent real depreciation in FY21 4/ Country team projections 4/ Country team projections Source: WB Staff calculations and estimates 23 Baring FY21, US$1 billion Eurobonds/Sukuk mature each year during the projection horizon. 24 Average payments of US$1,112 million are expected during the projection horizon. 25 Under the RISE DPF, the government has strengthened the debt management office. On April 19, 2020, the newly strengthened office secured PKR200 billion in long-term financing, below the market rates (KIBOR-), through the Power Energy Sukuk–II (PES-II) auction for PHPL. Managed via competitive book bidding at the Pakistan Stock Exchange, these bonds were over-subscribed and priced below the benchmark commercial Karachi Interbank Offer Rate (KIBOR). Page 22 The World Bank Resilient Institutions for Sustainable Economy (P171850) 36. External debt and liabilities 26 sustainability risks have increased and will remain elevated during the projection period. The external debt-to-GDP ratio is projected to increase from 38.2 percent in FY19 to 45.1 percent in FY20, before declining to 44.6 percent by FY24. This is primarily due to higher borrowing from multilateral and bilateral creditors and expected Eurobond issuances to finance the upcoming amortizations. The external debt is most vulnerable to exchange rate shocks, with a one-time 30 percent real depreciation of the PKR increasing the external debt to GDP ratio to 72.8 percent by end-June FY21, which is 24.7 percentage points of GDP higher than the base case (Figure 7 and 8). Figure 6. External Debt sustainability Analysis (Baseline Figure 7. External Debt Sustainability Analysis (Downside Scenario) Scenario) 80 80 75 75 70 70 Current account 1/ Current account 1/ 65 65 In percent of GDP In percent of GDP 60 Combined 2/ 60 Combined 2/ 55 55 ER depreciation 3/ ER depreciation 3/ 50 50 Baseline 4/ 45 Baseline 4/ 45 40 40 35 35 30 30 25 25 20 20 FY2017 FY2018 FY2019 FY2020 FY2021 FY2022 FY2023 FY2024 FY2017 FY2018 FY2019 FY2020 FY2021 FY2022 FY2023 FY2024 Actual Projections Actual Projections Source: World Bank staff estimates Source: World Bank staff estimates Notes: 1/ Non-interest current account is at baseline minus one-half 10-year historical standard deviations Notes: 1/ Non-interest current account is at baseline minus one-half 10-year historical standard deviations 2/ Combination of three shocks: i. Non-interest current account is at baseline minus one-quarter standard deviation, ii. Real GDP growth 2/ Combination of three shocks: i. Non-interest current account is at baseline minus one-quarter standard deviation, ii. Real GDP growth is at baseline minus one-quarter standard deviation, iii. Nominal interest rate is at baseline plus one-quarter standard deviation. is at baseline minus one-quarter standard deviation, iii. Nominal interest rate is at baseline plus one-quarter standard deviation. 3/One time 30 percent real depreciation in FY21 3/One time 30 percent real depreciation in FY21 4/ Country team projections 4/ Country team projections Source: WB Staff calculations and estimates 37. The economic outlook faces considerable downside risks and the restoration of macroeconomic stability hinges upon the implementation of ambitious structural reforms and the duration and impact of the pandemic. The adjustment measures undertaken by the government during FY19 and FY20 have resulted in a narrowing of the CAD and a buildup of external buffers. However, considerable downside risks remain. The uncertainty surrounding the duration and the impact of COVID-19 poses the biggest risk to the outlook. An extended period of weaker global growth, disruptions in industrial supply chains, further turmoil in international oil prices, and difficulty in rolling-over bilateral external debt from non-traditional donors (China, KSA and UAE) are additional external risks. Domestic risks stem from prolonged partial/complete lockdowns, food-insecurity, a health crisis, and potential difficulties in implementing the necessary adjustments and structural reforms. If these downside risks materialize, the country can experience a contraction of up to 4.0 percent of real GDP in FY21. The immediate challenge for the government will be to contain the spread of the COVID-19 pandemic and minimize the economic losses, as well as protect the social and economic wellbeing of the affected and vulnerable population. In the medium to long term, the government should refocus on the implementation of the needed structural reforms, including reforms to improve debt management and enhance transparency, secure a longer repayment profile for short term loans from non-traditional bilateral creditors, implement the Circular Debt Management Plan in the power sector, and implement competitiveness reforms to encourage private investment to increase. 38. The macroeconomic policy framework is considered adequate for this operation based on the stabilization measures adopted before COVID-19 and the adequate response to the COVID-19 pandemic. The COVID-19 outbreak 26Total external debt is inclusive of general government external debt obligations to the IMF, State-Owned Enterprises external debt and private debt. Page 23 The World Bank Resilient Institutions for Sustainable Economy (P171850) will have a significant impact on economic outcomes, but the authorities are taking the necessary steps to mitigate the impact of the crisis while maintaining macroeconomic stability. The mix of prudent policies to manage the crisis, as demonstrated by the fact that two-thirds of the support package was financed by budget reallocations, combined with additional financing made available by Pakistan’s multilateral development partners (including US$1.4 billion from the IMF-RFI, US$800 million from the ADB, and financing from this DPF) will support Pakistan’s efforts to weather the crisis and continue with the implementation of crucial structural reforms. The authorities remain committed to the implementation of the policies in the existing IMF-EFF program as the impact of the COVID-19 shock subsides, which will contribute to the country maintaining an adequate macroeconomic framework. 27 The adoption of a more prudent monetary policy has already resulted in a decrease in external pressures and a gradual recovery in international reserves. The reserve coverage is projected to reach 3.5 months of imports by the end of FY20. Fiscal outcomes are projected to gradually improve from FY21 onwards as the impact of the crisis subsides, supported by ongoing reforms in tax policy and administration as well as a tighter fiscal stance. External balances are expected to improve as exports pick up over the medium-term, led by a supply response to the more competitive exchange rate and structural reforms to support the competitiveness of Pakistan’s exports. The monetary policy framework is being strengthened, including through amendments to the SBP Act, the introduction of administrative measures to increase SBP’s autonomy, and the formation of an independent monetary policy committee. Debt management is being improved, with the consolidation of all functions in an integrated Debt Management Office. The World Bank is providing technical assistance in a number of these areas (tax policy and administration, fiscal and debt management, trade, and competitiveness) to continue the strengthening of institutional capacity for improved economic management. 2.3. IMF RELATIONS 39. The IMF concluded the first review of the 39-month EFF arrangement for Pakistan on December 19, 2019 28 and the second review is ongoing. The EFF arrangement focuses on reducing internal and external macroeconomic vulnerabilities through fiscal consolidation (focusing on revenue generation), adoption of a market-determined exchange rate and monetary tightening. The program envisages expanding social spending mainly by strengthening and broadening of safety nets to support the most vulnerable income groups. The program also focuses on reforms to improve the financial sustainability of the power sector, one of Pakistan’s critical challenges. The first review of the EFF concluded that the economy is stabilizing as reflected by a narrowing of the CAD, an orderly transition to a market- determined exchange rate, and stability in the inflation rate. The review highlighted the need for faster progress on structural reforms in the power sector, the Anti-Money Laundering/Combatting the Financing of Terrorism framework, and fiscal and debt management and to ensure balanced growth. Reforms supported under the RISE series are coordinated with the IMF and are complementary to the EFF’s structural benchmarks. The second review of the EFF is ongoing. The IMF has approved the Government’s request for US$1.4 billion from the RFI to support the COVID-19 pandemic response. 40. The macroeconomic framework underpinning this proposed operation is consistent with the Medium-Term Macroeconomic Framework presented in the IMF Staff Report, “Pakistan—Request for Purchase Under the Rapid Financing Investment”. 29 The IMF Staff Report projects a contraction in real GDP of 1.5 percent in FY20, and an expansion of 2.0 percent in FY21. For the fiscal sector, it projects a fiscal deficit (excluding grants) of 9.3 percent and 6.6 percent of GDP in FY20 and FY21, respectively. With regards to the current account, the RFI Staff Report projects a 27 IMF Country Report No. 20/114 of April 2020. 28 IMF Country Report No. 19/380 of December 2019. 29 IMF Country Report No. 20/114 of April 2020. Page 24 The World Bank Resilient Institutions for Sustainable Economy (P171850) deficit of 1.7 of GDP in FY20 and 2.4 percent in FY21. Finally, the RFI Staff Report projects the gross reserves to reach 2.7 months of next year’s imports of goods and services by end-FY20, and increase to 3.3 months by end-FY21. 3. GOVERNMENT PROGRAM 41. The governing program, outlined in its party manifesto, was adjusted to meet economic realities after they assumed office in August 2018. The ambitious manifesto focused on six areas comprising transforming governance, strengthening the federation, revitalizing economic growth, uplifting agriculture and conserving water, revolutionizing social services, and ensuring national security. However, the FY19 supplementary and FY20 budgets had to be tailored to deal with the macroeconomic crisis that the country was facing. As a result, the government’s efforts shifted to measures that would help stabilize the economy and thereafter revive and sustain growth. These efforts are currently being tested by the evolving COVID-19 crisis. 42. The objective of the government is currently focused on stabilizing the economy while addressing the challenges created by the COVID-19 pandemic. The stabilization efforts have focused on adopting a flexible market- determined exchange rate, raising interest rates, rolling back tax exemptions, improving the regulatory framework governing ease of doing business across the country, and increasing energy tariffs to improve the financial position of the power sector. This adjustment has come at a political cost of adverse public reaction and resistance by the elites. To address the challenges created by the COVID-19 pandemic, the government has approved a fiscal package equivalent to US$7.5 billion for purchasing emergency medical goods and services, increasing social transfers, and supporting daily wage earners. 43. To help protect the most vulnerable from the impact of the stabilization program and the COVID-19 pandemic, the government has enhanced safety nets and is also implementing a new “Ehsaas (Compassion)” program. The government has increased allocations for the Benazir Income Support Program (the national social protection program) by 44 percent to support beneficiaries in coping with their loss of livelihoods due to the COVID-19 pandemic. In addition, the government launched the “Ehsaas” program at the national level to reduce inequality, invest in people, and lift lagging districts. It is organized under four pillars: (a) addressing elite capture and making the government system work for equality, (b) enhancing safety nets, (c) promoting human capital development, and (d) creating jobs and livelihoods. The complementary SHIFT DPF is closely aligned with several interventions in the Ehsaas program. 4. PROPOSED OPERATION 4.1. LINK TO GOVERNMENT PROGRAM AND OPERATION DESCRIPTION 44. The proposed operation is organized under two pillars. The program’s development objectives are: (a) enhancing the policy and institutional framework to improve fiscal management, and (b) improving the regulatory framework to foster growth and competitiveness. The efforts aimed at strengthening fiscal management will contribute towards a strengthened federation and will support the ongoing stabilization efforts. Some of the measures in this area include the establishment of the fiscal policy office, preparation of budgets that are aligned with the MTFF, enhanced debt transparency and management, and a broadened tax base. The proposed operation also sets the foundation for important reforms in the energy sector, namely via setting out a strategy to address the sector’s circular debt as well as policies to facilitate the development of low carbon energy resources. To support growth, the proposed operation will help harmonize the general sales tax framework which will reduce the regulatory burden and create a harmonized tax jurisdiction. The operation also supports increased use of digital financial services, enhanced integrity in the financial sector, and a reduction in the anti-export bias of the national trade tariff policy. Page 25 The World Bank Resilient Institutions for Sustainable Economy (P171850) 45. The design of this series includes country-specific lessons from past operations. The 2018 Implementation Completion and Results Report (ICR) of the Fiscally Sustainable Inclusive Growth programmatic DPC series, the 2018 ICR of the Competitiveness and Growth DPC, and the 2020 Project Performance Assessment Report for these operations included the following lessons: (a) focus on institutions while implementing policies, even if at times this means going at a slower pace, (b) frontload reforms in a multi-year reform process, (c) support implementation through complementary technical assistance and investment projects, (d) engage with provincial governments on reforms which require a whole of government consensus, and (e) build more accountability of the state to citizens through extensive disclosure of information. The lessons from the ICRs have been incorporated in the current operation by: (a) focusing on transforming institutions for better macro-fiscal management, (b) including the provincial governments as part of the design and implementation of prior actions related to GST harmonization, fiscal management, and taxation, (c) complementing the operation with technical assistance, PforR, and IPFs - most notably the Pakistan Raises Revenue IPF tax administration) and the Pakistan Goes Global IPF (trade policy and export competitiveness), and (d) calibrating the substance and pace of the reform program with the IMF’s EFF and government’s implementation capacity, especially as it focuses in the near term on COVID-19 relief and recovery measures. 4.2. PRIOR ACTIONS, RESULTS, AND ANALYTICAL UNDERPINNINGS Pillar I: Enhancing the policy and institutional framework to improve fiscal management 46. This pillar aims to support reforms to enhance the policy and institutional framework to improve fiscal management by: (a) improving fiscal policy and sustainability by establishing effective institutions and strengthening intergovernmental arrangements, (b) enhancing debt transparency and management, (c) broadening the tax base and reducing distortions in tax policy, and (d) improving the financial viability of the power sector through resolution of the circular debt, lower dependence on oil imports, and cheaper energy generation through competitive bidding in the renewable energy sector. These reforms are important to resolve structural weaknesses that have contributed to poor fiscal outcomes in the past, and also to build fiscal buffers so that the country can respond to the on-going COVID- 19 pandemic and support the recovery. Improving fiscal policy and sustainability Prior Action 1: The Finance Division has: (a) assigned Trigger 1 DPF-II: The FD issues revised Rules of Business fiscal coordination responsibilities to the National following the amendment to the Fiscal Responsibility and Finance Commission Monitoring Committee, which Debt Limitation Act (FRDLA) 2005 to: (a) provide legal comprises federal and provincial finance ministers, mandate to the Macro-Fiscal Policy Unit; and (b) provide based on the decision of the Council of Common for automatic safeguards in case of breach of ceilings as Interests; and (b) established the Macro-Fiscal Policy per the FRDLA; and the Provincial Finance Departments Unit to be responsible for developing the medium- have notified regulations for the implementation of the term fiscal and budget framework and fiscal risk Fiscal Responsibility Laws enacted by provincial management assemblies, that are consistent with the federal FRDLA’s amendments Trigger 1 DPF-III: Federal and Provincial budgets for FY23 will be aligned with the MTFF prepared by MFPU and approved by NFC Monitoring Committee 47. The lack of an effective fiscal policy function at the federal level and weak coordination mechanisms between the Federal Government and provinces have contributed to large fiscal deficits. Implementing a credible fiscal policy across the country is challenging as the mandate to drive fiscal consolidation rests with the Federal Government while Page 26 The World Bank Resilient Institutions for Sustainable Economy (P171850) most revenues are allocated to the provinces. The 7th National Finance Commission (NFC) award, implemented in FY10 and in effect since then, 30 reduced the Federal Government’s share in the federal divisible pool of revenues without any corresponding reduction in its expenditure mandates, 31 resulting in a structural deficit at the federal level. As a result, in FY20, for example, the Federal government expenditures were equivalent to 125 percent of its share of the federal divisible pool of revenues. In the same year, provinces received 57.5 percent of the federal divisible pool of revenues, which is equivalent to 80 percent of the total provincial revenues but had no constitutional responsibility to contribute to the national fiscal goals. In addition, the 18th Constitutional amendment, in 2010, enhanced the fiscal autonomy of provinces without establishing any mechanism to coordinate fiscal targets for the consolidated government. This mismatch between expenditure responsibilities and revenue assignments, and lack of effective fiscal institutions and coordination mechanisms, have increased the country’s average consolidated government fiscal deficit by 2.5 percent since 2010, as compared with the preceding decade. 48. As a first step, the Council of Common Interests has assigned the responsibility for fiscal coordination to the NFC Monitoring Committee to commit both the Federal and the provincial governments to common fiscal goals and targets (Prior Action 1). Addressing the responsibility mismatch between the federal government and the provinces requires an institutional framework that coordinates macro-fiscal policymaking and commits both levels of government to common fiscal targets. Such coordination is also critical to ensure that appropriate fiscal mechanisms are in place for the government to respond adequately to crises, such as the COVID-19 pandemic. The NFC Monitoring Committee comprises the federal and provincial finance ministers and is tasked with reviewing and monitoring federal and provincial fiscal policy, including expenditures, revenues, debt and cash management. It provides the necessary platform for all federating units to agree on national fiscal policy goals, and then separate targets for each of the federating units in order to meet these goals. In addition, to provide analytical support for informed fiscal policy decisions by the NFC Monitoring Committee, the Federal Finance Division has established a Macro-Fiscal Policy Unit (MFPU, Prior Action 1). One of its key mandates is to prepare the MTFF and determine the resulting budget ceilings for the consolidated government, which will be endorsed by the NFC Monitoring Committee ahead of budget preparations to ensure that the consolidated fiscal deficit remains sustainable. The MFPU also advises the NFC Monitoring Committee on improving the intergovernmental fiscal transfer system, as well as on measures to reduce fiscal risks. The MFPU shall be responsible for revenue projection and for ensuring that tax laws and procedures are harmonized between the Federal government and provinces. Furthermore, the NFC Monitoring Committee and the MFPU will monitor the implementation of the government’s COVID-19 mitigation fiscal stimulus package. 49. Further reforms will include the adoption of key legislation and regulations at the federal and provincial levels to anchor fiscal sustainability. These reforms include amendments to the FRDLA at the federal level to provide legal mandate to the NFC Monitoring Committee and the MFPU to conduct national fiscal policy, and to provide for automatic safeguards in case of breach of fiscal targets mandated in the law. These safeguards could potentially include hiring or pay and pension increase freezes; limits on the funds provided for new development projects; absence of supplementary grants during the year; and limits on contracting domestic debt. In addition, it is envisioned that the provinces will notify the implementing regulations following the enactment of fiscal responsibility laws that cascade from the federal FRDLA (Trigger 1 DPF-II). These legislations will ensure that both the federal and provincial governments contribute to a consolidated national fiscal position and limit the buildup of public debt by FY23. They will also ensure that the Federal and provincial budgets are aligned with the MTFF prepared by MFPU and approved by 30 The formula for the NFC award transfers to the provinces is based on population (82 percent); poverty or backwardness (10.3 percent); revenue collection or density (5.0 percent) and inverse population density (2.7 percent). 31 The Federal government is responsible for debt service, defense and national security, national energy, rail, roads, and ports infrastructure. Provinces are mostly responsible for health, education, social protection, urban and rural infrastructure, and agriculture extension services, among others. Page 27 The World Bank Resilient Institutions for Sustainable Economy (P171850) the NFC Monitoring Committee (Trigger DPFIII-1). Provisions will be made for regular/quarterly updates to the provincial assemblies on the status of the steps the government is undertaking to adhere to the adjustment measures. 50. Expected Results: Establishing effective institutions for intergovernmental fiscal coordination and anchoring the consolidated general government budgets within a credible MTFF will help the country maintain fiscal sustainability. By FY23, it is expected that the MTFF will set the fiscal deficit for the consolidated government budget and that the deviation between the MTFF deficit target and consolidated government budget deficit will be less than 10 percent 32. Enhancing debt management and debt transparency Prior Action 2: The Finance Division has: (a) transferred Trigger 2 DPF-II: The FD: (a) notifies the transfer of domestic and external debt management and issuance responsibility for the choice and pricing of retail debt of guarantees to the Debt Policy Coordination Office; instruments from the Budget Wing (through CDNS) to (b) mandated the publication of a medium-term debt the DMO; and (b) issues detailed rules for the DMO management strategy; (c) mandated the semi-annual Trigger 2 DPF-III: The FD publishes an annual report on publication of a debt bulletin; and (d) required the public debt that compares debt management strategy issuance of sovereign guarantees for all SOEs to be implementation with targets contingent upon publication of previous year’s audited financial statements and submission of a detailed plan to achieve financial stability 51. The lack of an integrated debt management function undermines sound debt management. The public debt to GDP ratio is projected at 94 percent in FY20. Despite the high level of debt, there is no entity responsible or accountable for managing the cost, risk or level, in a holistic manner. Debt management is fragmented across entities: the Budget Wing in the Ministry of Finance, the Central Directorate for National Savings (CDNS), the Economic Affairs Division (EAD), the External Finance (EF) Wing and the Debt Policy Coordination Office (DPCO). There is no single entity accountable for achieving debt management objectives. The DPCO — established through FRDLA in 2005 as part of the Competitiveness and Growth development policy operation – plays an important coordination and advisory function but does not have strategy implementation authority. 33 52. The fragmentation of debt management functions has led to a disconnect between debt management strategy design and implementation. The medium-term debt management strategy (MTDS) is prepared by the DPCO. However, given that the DPCO is vested with a coordination and advisory function only, the strategy has little relevance in practice. This is evidenced by, for example, a short yield curve, lack of a deep domestic debt market, and different interest rates by different debt instruments. This is because different entities manage their portfolios in silos and there is no single entity that can manage the entire public debt stock strategically and reduce cost. 53. SOEs are a significant source of fiscal costs and risks. Financial support to SOEs is a major driver of the fiscal deficit and a source of substantial fiscal risks. In FY20, budgetary support to loss-making SOEs amounted to almost 2.0 percent of GDP and corresponded to approximately 25 percent of the fiscal deficit. The stock of sovereign guarantees to SOEs has risen rapidly in recent years, reaching 4.2 percent of GDP. These guarantees cover 78.6 percent of SOEs’ debt, which reached over 5.3 percent of GDP in FY19, representing significant implicit contingent liabilities. In addition 32 A deviation of less than 10 percent between the MTFF and the consolidated budget deficit is be consistent with good practices on credibility of medium term budget estimates. 33 DPCO focuses on advising on debt reduction path; providing policy advice; monitoring the costs of borrowing; and preparing the Debt Policy Statement. Page 28 The World Bank Resilient Institutions for Sustainable Economy (P171850) to these risks, there is little accountability. Even though SOEs are mandated to publish their annual audited statements, very few do so regularly. Little transparency regarding their financial accounts and the lack of a plan to achieve financial sustainability have, however, not deterred budgetary support from the state budget. 54. As a result, the country faces high interest rates and rollover risks. By end-December 2019, 23.5 percent of consolidated government domestic debt was in short term securities with costly financing terms. 34 Debt service on domestic borrowing reached US$11 billion or 4.7 percent of GDP. Furthermore, in recent years, Pakistan began to tap more aggressively into external commercial loans to build foreign exchange reserves. Commercial debt stock increased from US$1.5 billion (0.5 percent of GDP) at end-June 2016 to US$9.6 billion (3.5 percent of GDP) at end-December 2019. 35 55. There is limited consolidation of debt data that citizens, investors, and creditors can access and that policymakers can base their decisions on. While information on public debt is available in several documents, 36 debt reporting has the following shortcomings: (a) the content of published reports contains overlapping information, (b) some information is only available at an aggregated level, and (c) information on fiscal risks and contingent liabilities is neither comprehensive nor disclosed. Since Pakistan is accessing commercial funding, both domestically and externally, a semi-annual debt bulletin would be important to strengthen accountability and transparency. 56. To address these challenges the Government has implemented several measures to transform debt management and enhance transparency. To address institutional fragmentation, the government has transformed the DPCO into a fully integrated debt management office, responsible for devising and implementing all aspects of domestic and external debt management and issuance of guarantees (Prior Action 2). The DPCO has integrated decision-making responsibility and enforcement authority for domestic wholesale and retail market issuance (from Budget Wing), external borrowings from the market, and bilateral and multilateral institutions (from the External Finance Wing), and project loan terms for bilateral and multilateral project loans (from the External Affairs Division), and the mandate to issue guarantees. To provide an overarching objective, the Federal Finance Division has published a medium-term debt management strategy, and to strengthen transparency, the it has issued a decree mandating the semi-annual publication of a debt bulletin (Prior Action 2) which includes comprehensive and consolidated debt data in a user-friendly format. In addition to debt stock and flow indicators which are already published, this report will also include the breakdown of government debt between the federal and the subnational levels, guaranteed debt, collateralized debt, and domestic debt securities by tenors and by creditors (Prior Action 2). The DPCO is also providing technical support to the External Affairs Division on the G20 Debt Service Suspension Initiative and ensuring that the government raises financing from all sources with the least cost and risk as it deals with the COVID-19 pandemic. 57. In addition, to mitigate fiscal risks originated by SOEs, the Cabinet has notified that sovereign guarantees for all SOEs will be contingent upon publication of the previous year’s audited financial accounts and a detailed plan to achieve financial stability (Prior Action 2). This will allow for an informed assessment of the demands for guarantees, 34 Before the recent and one-time reprofiling of domestic debt with the SBP in June 2019, the government’s domestic debt had an Average Time to Refixing (ATR) of 1.6 years while external debt had an ATR of 6.6 years. Similarly, the Average Time to maturity (ATM) of domestic debt was 1.6 years vis-à-vis 7.6 years for external debt (Federal Risk Report June 2018— http://www.finance.gov.pk/dpco/RiskReportOnDebtManagement_End_June_2018.pdf). The government’s domestic portfolio has also been heavily reliant on borrowing from the State Bank of Pakistan (SBP) up until FY19, after which the government has committed to end SBP borrowing, as per the conditions of the IMF program. At end June FY19, PKR 7.8 trillion of central bank debt was reprofiled, primarily into medium and long-term bonds. 35 The new borrowing in commercial loans between FY17-FY20 was primarily meant for balance of payment support with a bullet repayment, a maturity of 2-3 years and a floating interest rate linked to LIBOR. 36 These reports are published by different entities such as, the Ministry of Economic Affairs, the Debt Policy Coordination Office (DPCO), SBP, and the Ministry of Finance. There are several reports available such as Statistical Bulletins by SBP; Risk Reports, Debt Policy Statements, Medium Term Debt Strategies, and Fiscal Policy Statements by DPCO, as well as some provincial debt bulletins. Page 29 The World Bank Resilient Institutions for Sustainable Economy (P171850) based on objective information, including an enterprise’s profit and loss account and balance sheet, and the detailed action plan will help ensure SOEs can achieve financial stability over time. 58. To ensure the sustainability of these reforms the government will provide a legal mandate to the DPCO, and further integrate debt management functions through amendments to the FRDLA. The government will issue (a) the revised ‘Rules of Business’ under the amended FRDLA to transfer the responsibility for the choice of retail debt instruments from CDNS to the DPCO, and (b) the Rules for the Debt Management Office covering its operations. Moreover, the FD will publish an annual report on public debt that compares debt management strategy implementation with targeted outcomes (Trigger 2 DPF-III). 59. Expected Results: These reforms are expected to enhance debt reporting through the publication of a semi- annual report on debt and relevant cost-risk indicators, and an annual report on debt management strategy implementation, in line with sound practice. Integrated management of public debt is also expected to reduce the cost of borrowing over time and risks to public debt. Broadening the tax base and reducing distortions in tax policy Prior Action 3: The Federal Board of Revenue has: (a) Trigger 3 DPF-II: Provincial governments issue a increased the immovable property valuation to eighty- notification adopting the FBR valuation tables applicable five (85) percent of the market value for withholding to Urban Immovable Property Taxes to keep the income tax and capital gains tax; (b) reduced the assessment ratios at 85 percent of market value personal income tax thresholds; and (c) removed the Trigger 3 DPF-III: Provincial governments: (a) increase special treatment on general sales tax for five (5) the agriculture income tax rates and thresholds to those sectors existing in non-agricultural sectors; and (b) extend land- based taxation to uncultivated land 60. Pakistan’s tax revenues as a share of GDP are low when compared to other emerging market economies. 37 With a tax-to-GDP ratio of 11.6 percent (FY19) and tax expenditures equivalent to 2.5 percent of GDP, Pakistan is collecting too little and providing too many tax exemptions. In terms of shares of total revenue collection, GST accounts for 33 percent, direct taxes for 32 percent, import duties for 16 percent, non-tax revenues for 9 percent, and the remaining 10 percent comes from other taxes. With regards to tax expenditures, approximately 61 percent are related to the GST. The tax gap 38 for GST and income tax are estimated at 87 percent and 73 percent, respectively. 39 However, under the GST regime, industries (textiles, sports, surgical, carpets, and leather) receive tax concessions under the Statutory Regulatory Order (SRO) 1125. This SRO provides a lower GST rate of 9 percent and 6 percent, compared to the standard rate of 17 percent, along with zero-rating GST on purchases of inputs related to exports. These special treatments create distortions and increase administrative costs. 61. The country is also foregoing revenues from capital gains and land transactions because of outdated property valuation tables. Outdated land valuations result in revenue losses and diversion of investable funds to the relatively unproductive non-built up real estate sector. Capital gains and taxes on immovable property have been calculated using notional values in the “district collectorate valuation tables”, which are compiled by provincial revenue 37While in 2019, tax-revenue-GDP in Pakistan stood at 11.6 percent, it was below par when compared to its regional counterparts - 18.9 percent in China, 17.1 percent in Egypt (2017), 17.8 percent in India (2017), 25.9 percent in South Africa (2018), and 17.6 percent in Thailand (2017). − ( ) 38 = . 39 Tax gap analysis and recommendations – GST and Income Tax. World Bank TA Report, 2019. Page 30 The World Bank Resilient Institutions for Sustainable Economy (P171850) authorities and do not reflect market prices. Recent analysis 40 shows that the values recorded in these tables are a small fraction of actual market values or sale prices. For instance, notional values for a sample of properties in Karachi were, on average, only 6 percent of their market value. As a result, the total tax liability for this sample is only 0.14 percent of the total value of capital gains on the sale of immovable property. To address this issue, the Federal Board of Revenue (FBR) issued property valuation tables in the Finance Bill FY17 for the assessment of capital gains tax (a federal mandate). However, even these valuation tables captured less than a quarter of the actual market value of properties. 62. The income tax base is also narrow, with less than 1 million active taxpayers and income tax accounting for only one-third of total tax collections. Pakistan collects about 3.7 percent of GDP from income taxes (personal income tax and corporate income tax). Comparator countries generally collect about 4.7-8.15 percent of GDP from this source (East Asia and Pacific, 2017 average). In the FY18 budget, the government increased the income tax exemption threshold from PKR 0.4 million to PKR1.2 million and reduced the tax rates (with average tax rate on PKR 10 million monthly salary falling from 23 percent to 11 percent) as a populist measures ahead of the general election. This measure resulted in a 0.7 percent of GDP loss in tax receipts from personal income tax in FY19. 63. Corrective fiscal measures have been recently implemented to broaden the tax base and reduce tax distortions. In this regard, the Finance Bill for FY20: (a) increased the immovable property valuation to 85 percent of the market value for withholding income tax and capital gains tax; (b) removed the special sales tax exemptions to the textile, sports, surgical goods, leather, and carpet sectors; and (c) rationalized the income tax slabs and reduced the minimum exemption threshold for income tax to PKR 0.6 million for salaried and PKR 0.4 million for non-salaried individuals (Prior Action 3). These measures are expected to increase revenues by 0.4 percent of GDP in FY20 and are incorporated in the fiscal framework presented in Table 4. These measures have helped the country safeguard domestic revenues, as much as possible, in wake of the COVID-19 pandemic. 64. Further policy measures to broaden the tax base will be supported by the next two operations of this series. These include the adoption of market based immovable property valuation tables by the provinces (Trigger 3 DPF-III) and the increase in taxation on agriculture income (Trigger 3 DPF-II). Constitutionally, the income tax base is divided into agricultural and non-agricultural income, with provinces owning the former. The agriculture sector is taxed very lightly. Whereas the sector contributes approximately US$50 billion to GDP (19 percent of GDP) it pays only about US$141 million in taxes, of which only about 10 percent (US$14 million) is land-based tax and agricultural income tax. This makes for an agriculture tax to agriculture GDP ratio of 0.25 percent as compared to an economy wide tax to GDP ratio of about 12 percent. The proposed reform will increase taxation in the agriculture sector, bringing it closer to the tax regime applicable to other sectors. It will also seek to prevent landowners with non-agricultural ventures from shifting profits to the agricultural sector (Trigger 3 DPFIII). 65. Expected Results: These reforms are expected to contribute to an increase in tax collection related to land, agriculture income and real estate. Overall these taxes, which are collected by provinces, are estimated to go up by at least 10 percent of the total own resource revenues by FY23. These reforms will also contribute to broadening the tax base by resolving inconsistencies in tax policy, rationalizing tax expenditures, and increasing transparency and accountability. These measures will be critical for the country to meet the increased financing needs emanating from the COVID-19 pandemic. 40 Reform of the Taxation of Capital Gains under the Income Tax Ordinance 2001 – 2015, the World Bank. Page 31 The World Bank Resilient Institutions for Sustainable Economy (P171850) Addressing the stock of circular debt in the power sector Prior Action 4: The Cabinet has approved the Circular Trigger 4 DPF-II: The Cabinet ratifies tariff guidelines Debt Management Plan, which includes policy including a surcharge mechanism in accordance with the measures to minimize the flow, gradually eliminate the Amended NEPRA Act (2020); the MOE signs stock of circular debt, and improve DISCO efficiency; performance contracts with the Board and management and the Finance Division has issued a notification to of all; and the Cabinet ratifies a subsidy reform to transfer the PHPL debt to the public debt stock improve targeting of power sector subsidies Trigger 4 DPF-III: The Government implements the revised power sector subsidy targeting mechanism 66. Addressing the circular debt in the power sector is critical to ensure the sector’s financial viability and reduce the burden on the people of the country. As of December 31, 2019, the total stock of circular debt in the power sector was PKR 1,721 billion (equivalent to 3.6 percent of GDP). This stock can be disaggregated into two parts: (a) the Central Power Purchasing Agency Guaranteed Limited (CPPA-G) 41 outstanding payables to power generators (PKR 917 billion, 1.9 percent of GDP); and (b) the Power Holding Private Limited (PHPL) 42 outstanding debt owed to private commercial banks (PKR 804 billion; 1.7 percent of GDP), see Table 5. Table 5. Breakdown of Flow and Stock, PKR billion Estimated Annual Circular Debt Flow FY19 Accumulated Stock as of December 31, 2019 1. Unbudgeted subsidies and 153 A. CPPA-G outstanding payables 917 delayed notifications to power generators 2. DISCOs inefficiencies and 220 B. PHPL stock owed to local 804 regulatory gaps commercial banks 3. Uncovered financial costs 92 TOTAL 465 TOTAL 1,721 67. There are three direct contributing factors to the generation of circular debt flow. These include: (a) the difference between tariffs and cost of supply due to government policies and not covered by budgeted subsidies,which result in DISCOS not being able to cover costs, a liability which is transferred to PHPL which then borrows from commercial banks to make up for the loss, (b) DISCOs’ high technical and commercial losses, and (c) additional costs that include penalty payments to Independent Power Producers (IPPs) in case the government does not pay them on time and debt-servicing by PHPL. The heavy dependence on imported fossil fuels increases the generation costs, and more so if there are delays in tariff notifications. For example, tariffs were not increased between June 2015 and March 2018 and, during this period, generation costs increased by 25 percent. As a result, during that period, PHPL liabilities increased by PKR 180 billion and DISCOs’ financing requirements went up by Rs 2.25/kWh. 68. Servicing of the PHPL debt adds to the stock of circular debt. All PHPL debt is held by private commercial banks and is more expensive (up to 350 basis points higher) than government debt of comparable maturity. 43 A financial cost 41 CPPA-G was established as a wholly owned public sector company incorporated under the Company’s Ordinance as a single buyer of power from producers on behalf of electricity distribution companies. 42 PHPL was established as a special purpose vehicle to clear the books of DISCOs and keep the liability off budget. 43 The typical pricing for various tranches of this debt is 3-month KIBOR plus 2 percent, with an average maturity of 5 years. As of September 19, 2019, this is about 15.84 percent (3-m KIBOR on September 19, 2019 was 13.84). On the other hand, in an auction on September 19, 2019, 5- year Pakistan Investment Bond was sold at the weighted average yield of 12.367, indicating a difference of 350 bps. Page 32 The World Bank Resilient Institutions for Sustainable Economy (P171850) surcharge (FCS) of PKR 0.43/kWh, to be collected from consumers, was introduced in October 2014 to help service PHPL debt. However, the surcharge has not been enough to even cover the interest payments. For example, in FY20 the debt service is projected to be PKR 120 billion while the surcharge collection is estimated to be approximately PKR 40 billion, so that a shortfall of PKR 80 billion will be added to the stock of circular debt. 69. Inefficiencies in DISCOs are also a major cause of circular debt and high electricity prices. These inefficiencies include high system losses (including theft), misbilling, and under collections. In FY19, the average system losses in DISCOs in Pakistan were 17.7 percent, while the National Electric Power Regulatory Authority (NEPRA) only allowed 15.5 percent in losses to be passed on to the consumers. The differential contributed PKR37 billion to the circular debt. Another PKR116 billion was added to the circular debt as DISCOs collected only 91 percent of the billed amount. 70. To resolve the circular debt problem in the power sector, it is critical to address the underlying factors that are creating the buildup of debt. To achieve this, the government has approved the CDMP that includes foundational measures to resolve the gap between costs and revenues, gradually pay back the outstanding liabilities of DISCOs to CPPA-G and improve the efficiency of DISCOs (Prior Action 4). A key reform to clear the stock of PHPL debt is to transfer it to the public debt stock (Prior Action 4) while the FCS surcharge will be used to cover the late payment penalties to IPPs. This reform, together with the strengthening of debt management (Prior Action 2), will enhance debt transparency, reduce debt service costs, and contribute to arresting the buildup of the stock. The government is also starting reforms to reduce losses in the DISCOs to avoid further circular debt accumulation. In this regard the government will: (a) launch consumer awareness campaigns and anti-theft and recovery campaigns (with support from the district administration), (b) disconnect those that do not pay, (c) start legal proceedings against high-end defaulters, and (d) install prepaid meters for public consumers with overdue bills. This will be followed by steps from DISCOs, which include: (a) submitting their programs to control theft, (b) signing performance contracts with the MoE, (c) establishing a benefit-sharing mechanism with employees of DISCOs and district administrations for successful anti-theft and recovery campaigns, (d) conducting operational audits of DISCOs and, (e) publishing of performance against key indicators and target milestones (Prior Action 4). 71. The COVID-19 pandemic has temporarily disrupted the government’s program to reduce the flow of circular debt. The CDMP had the goal of reducing the circular debt flow to US$ 0.8 billion in FY20. However, the COVID-19 pandemic is expected to add US$ 1.6 billion in flows because of the delayed tariff increase, the reduced demand (by 75 and by 60 percent respectively for commercial and industrial users), and lower than expected recovery of receivables. In addition, there will always be a minimal flow because of a billing-payment mismatch across fiscal years. To ensure that the flow does not turn into arrears, the government will include in its annual budget an allocation to clear this so that no arrears accumulate. After the COVID-19 abates, the annual flow accumulation should decline to $0.5 billion by FY22/23, thanks to the planned tariff adjustments in the CDMP plus the additional measures to improve DISCO efficiency and bill collections. 72. Tariff adjustments alone will not ensure the viability of the sector, and therefore reforms to reduce the cost of generation are needed. In this regard, the Federal Cabinet decided in April 2020 to reduce the cost of generation by independent power producers to complement tariff adjustments, reduction in distribution losses, increase transparency and improve collection. The first rounds of talks between the government and power producers took place between April 15-20, 2020. A Special Committee has been assigned to continue discussions. These measures will be supported by the potential subsequent PACE operation. 73. To ensure the sustainability of this reform, RISE II and PACE will include measures to target the power sector subsidies and implement the ratified tariff guidelines, including a surcharge mechanism in accordance with the Amended NEPRA Act, 2020 (Trigger 4 DPFII). In FY20, the government will spend approximately PKR 226 billion in power subsidies. These subsidies cover approximately 75 percent of consumers and are not targeted effectively. Only Page 33 The World Bank Resilient Institutions for Sustainable Economy (P171850) 26 percent of the power subsidies benefit the bottom two quintiles of the population. RISE II and PACE operations will support the targeting of these subsidies to the poor. Other measures include the amendment to the NEPRA Act 2020 to require automatic quarterly tariff adjustment in addition to the monthly fuel cost adjustments currently being done. Together, these measures are expected to address, to a large extent, the flow of the circular debt. 74. Expected Results: The policy reforms in the power sector are expected to start the process of reducing the flow of the circular debt from FY22 and eliminate the stock by FY29. They will also help with better management of tariffs and subsidies, the monitoring of sector performance, and avoidance of discretionary policy decisions that have a negative financial impact on the sector cashflows. These actions will also contribute to improve the targeting of power sector subsidies and enhance budgetary transparency and accountability. Reducing the dependency of imported fuels and lowering electricity generation cost Prior Action 5: The Council of Common Interests has Trigger 5 DPF-II: The Alternative Energy Development approved the Renewable Energy Policy, which includes Board (or equivalent provincial organization) adopts the adoption of competitive bidding as the main competitive bidding principles for the issuance of procurement method Request for Proposals 75. Power generation costs in Pakistan are high and contribute to the accumulation of circular debt. The average cost of power generation is US¢ 8.5/kWh in FY20, which is significantly higher than in neighboring countries. 44 The main reason for the high average cost of power is the use of cost-plus power purchase contracts. The country has entered into many power purchase agreements without going through a competitive bidding process where potential suppliers would compete on price and provide innovative solutions to fulfil needs. Instead, it entered into direct contracting with private sector suppliers and others which did not meet the test of open competition. This has resulted in higher than benchmark rates of return for many power producers. Also, most power purchase agreements are linked to the US Dollar, which has increased power costs significantly in PKR terms due to the recent depreciation. 76. In addition, the large dependence of imported fuel makes Pakistan vulnerable to international oil prices and exchange rate fluctuations. In FY19, a total of PKR740 billion was spent on fuel costs for power generation (fuel oil, natural gas, liquefied natural gas, diesel, and coal), which accounted for more than 50 percent of the generation cost. Of the FY19 fuel cost, PKR544 billion (US$3.7 billion) was imported and paid in foreign currency. Costs of renewable energy (RE) from solar and wind have rapidly decreased during the last few years and reached US$0.03/kWh in neighboring countries, much lower than the current generation costs at US¢ 8.5/kWh. However, until recently, solar and wind only accounted for 4 percent of the installed capacity and less than 2 percent of the generation mix. Cheaper domestic hydropower, mainly on the Indus River, is also underutilized compared to its potential. 77. A broad range of actions to reduce the power generation costs will take place over the next decade. In the short-term, it is essential to lower the cost of generation to enable the full recovery of the increased sector costs due to PKR depreciation. The government aims to reduce the return on assets for governmental power producers and to reduce the rate of return and extend tenors for private power producers. With the current liquidity in the global markets, it is possible to remove the frontloading of power costs over the short lending period. Over the next ten years, the government shall reverse the energy mix from the current 70-30 ratio between fossil fuel and domestic low carbon energy (hydro, solar, and wind). The new Least-Cost Generation Plan, based on economic optimization of the energy mix, has been launched and shows that the optimal energy mix by 2030 is 65 percent hydropower, solar, and 44 An assessment of power generation costs in Bangladesh and selected states of India showed costs between US¢ 5.3-6.8 cents/kWh. Page 34 The World Bank Resilient Institutions for Sustainable Economy (P171850) wind 45. This can be achieved by implementing the ambitious goals for renewable energy generation in the new Renewable Energy Policy (Prior Action 5). 78. Looking ahead, the government plans to implement this reform by engaging with the provinces. In this regard, the government has committed that the Alternative Energy Development Board (or equivalent provincial organization) will adopt competitive bidding principles for the issuance of Request for Proposals (Trigger 5 DPF-II). 79. Expected Result: These reforms are expected to increase low carbon power generation and result in all solar and wind energy to be procured through competitive bidding. This is expected to lower the cost of generation, contribute to reduce circular debt, and enhance the transparency of public procurement in this area. Pillar 2: Improving the regulatory framework to foster growth and competitiveness 80. This pillar supports reforms to improve the regulatory framework to foster growth and competitiveness. The key challenges affecting Pakistan’s competitiveness and investment climate are the high costs of complying with the general sales tax regime, the opaque and overregulated business environment, the lack of transparency in the banking sector with limited opportunities for SMEs to access finance, the hegemony of commercial banks on electronic money operations, and significant anti-export bias of the national tariff policy. Reforms supported under this pillar will (a) harmonize the GST nationwide, (b) ensure that all bank accounts are biometrically verified and non-banks can deploy electronic money platforms, (c) promote better regulated real-estate developments, and promote competitiveness. Overall, these measures will lower barriers to the formalization of firms and help them recover stronger after the COVID-19 pandemic. Harmonization of the GST across the country Prior Action 6: The National Finance Commission Trigger 6 DPF-II: The Finance Division and provincial Monitoring Committee has approved a general sales finance departments issue implementing regulations tax harmonization framework with common taxation following the approval of common GST laws passed by principles, harmonized definitions of goods and the Federal and provincial Assemblies to generate a services, common place of supply rules, and a single harmonized GST for goods and services across the rate country Trigger 5 DPF-III: The Finance Division and provincial ministries of finance issue regulations that reduce the GST filing frequency for all firms from monthly to quarterly 81. The GST regime has fragmented Pakistan into five competing tax jurisdictions resulting in double taxation, high compliance costs for businesses, and a significant tax-gap. The country ranks 173 out of 190 in the Ease of Doing Business 2019 paying taxes indicator. Businesses operating across the country need to submit 60 tax returns annually and sales tax refunds take an average time of 18 months. The power to tax goods is vested in the Federal Government, but each province has the power to tax services supplied within its jurisdiction and levy its own tax rates on these services. This fragmented nature of the base has led to inter-provincial and Federal-Provincial jurisdictional conflicts resulting in double taxation, exporting of taxes to other provinces, tax evasion, and consequently high costs of compliance for businesses, especially small and medium enterprises with a small capital base. In addition to the high compliance cost, the efficiency of the GST is low, with an estimated tax gap of 87 percent. 45 World Bank Staff analysis have shown that it is technically feasible to reach 20 percent share of installed solar and wind capacity by 2025. Page 35 The World Bank Resilient Institutions for Sustainable Economy (P171850) 82. To reduce compliance costs and close the tax-gap, the Federal government and provinces have agreed to harmonize the GST. Towards this goal, the Council of Common Interests (CCI) has empowered the NFC Monitoring Committee to agree on a harmonized GST framework with common definitions and taxation principles, place of supply rules, a common rate, and a single tax return (Prior Action 6). In addition, to improve intergovernmental coordination of tax policy in the country, a permanent National Tax Council (NTC) comprising the Federal and provincial finance ministers has been notified. The NTC will be supported by federal and provincial tax administrators and finance officials. As a result, the country will function as a single coordinated tax jurisdiction for taxpayers. The approval of the GST harmonization framework by the NFC Monitoring Committee ensures that it is legally binding for all provinces. Implementation will be achieved through legislation issued in FY21 by provinces as well as the Federal government (Trigger 6 DPF-II). These will be separate but linked laws, as agreed in the GST harmonization framework, and in conformity with the constitution. Federation and provinces will continue to administer their own service tax base, but this will be based on the common rules that govern the coordination and administration of the GST. 83. GST harmonization will be especially beneficial to informal and small firms that are receiving financial support from the government during the COVID-19 pandemic. The government’s package to provide financial support to firms to cope with the COVID-19 pandemic requires them to register with the government. Firms have been so far reluctant to register because of the immense GST compliance burden. However, thanks to the GST harmonization, which will significantly reduce compliance costs by making the tax system simpler, more firms are expected to register which will facilitate the government’s efforts to support them at this time of crisis. 84. Further reforms will aim to reduce compliance costs and close the tax-gap. In this regard, the government aims to reduce the filing frequency for sales tax for all firms from monthly to quarterly (Trigger 5 DPF-III). This action will reduce compliance costs significantly while not impacting revenue collections. The fiscal framework presented in Section 2.2 reflects the revenue impact of this measure. 85. Expected Results: These reforms will contribute to the harmonization of the GST laws and administration across the federation. This is expected to contribute to the reduction in the number of GST filings by businesses in all jurisdictions from 60 to at most 12. This will significantly reduce compliance costs by eliminating double taxation, reducing administration costs, and closing the tax gap. Financial sector transparency and deepening Prior Action 7: The Federal Board of Revenue has Trigger 7 DPF-II: The Finance Division converts all notified the Benami Transaction (Prohibition) Rules of bearer prize bonds into registered instruments through 2019, mandating all commercial banks to conduct biometric identity verification; and the SECP issues a biometric verification of all bank account holders, as notification on the establishment of the secured instructed by the State Bank of Pakistan transactions collateral registry to enhance SME access to finance Trigger 6 DPF-III: The Economic Coordination Committee approves the Development Finance Reform Framework (including governance arrangements for all DFIs, investment policy, and disclosure requirements) submitted by the SBP to optimize public funding for long term finance 86. Low investment and savings in Pakistan can, in part, be attributed to the very limited intermediation by the country’s financial sector. Current intermediation channels most financial sector funds to the public sector. Credit Page 36 The World Bank Resilient Institutions for Sustainable Economy (P171850) extended by the banking sector to the government has increased by 223 percent between FY11 and FY19. The private sector access to credit grew at less than half that pace (104 percent) during the same period. Concurrently, financial inclusion in Pakistan is low compared to peer countries. Only 21 percent of Pakistani adults have a bank account, compared to 80 percent in India and 51 percent in Indonesia. This means that the banking sector has a very small depositor base, which further limits the amount of funds available for intermediation. 87. There are integrity risks in the banking sector. Two key risk factors are unregistered prize bonds and benami 46 accounts. Prize bonds are bearer instruments with individual values of up to US$260. There is a prevailing practice of using them as a currency substitute. Data suggests that the total volume of prize bonds circulating in the system amounted to approximately US$7 billion by the end of Feb-2019. The use of prize bonds as both a medium of exchange and store of wealth (under the radar of the tax authorities), means that not only do these instruments pose significant AML/CFT risks, they also serve as direct competition to bank deposits. As such, for banks to meaningfully increase their depositor base, the distortive financial instruments must be phased out of circulation. The risks associated with benami accounts made international headlines in October 2018 when US$18 million was discovered in an ice-cream seller’s bank account, opened and used without his knowledge. There have been many similar discoveries, exposing significant risks of money laundering in the country’s banking system. This affects the transparency of the financial system. If Pakistan’s financial system is to grow and play a more meaningful role in growth and investment, its integrity must be maintained and widely accepted. 88. Enhancing transparency and deepening of the financial sector is being achieved through biometric verification of bank accounts and a registration drive for prize bonds. In the previous Finance for Growth DPF, the World Bank supported the enactment of the “Benami Law” in 2017, which criminalized the establishment of benami accounts and anonymous asset transactions. This reform builds on the previous measure. The Law criminalizes all benami transactions (for both parties, i.e. the beneficial owner and the fictitious owner); whereby parties can serve up to 5 years in jail and have to pay hefty fines. Holding assets and accounts in benami was quite a rampant practice in Pakistan and posed significant AML and tax evasion risks. The passing of this Law has been a key development and the FBR has been charged with its implementation. The FBR has notified the Rules under the “Benami Law”. Under the Rules, the SBP must monitor the banking sector benami risks. As such, the SBP instructed all commercial banks to conduct biometric verification of open bank accounts to ensure a one-time clean-up and more robust Know Your Customer (KYC) due diligence at account opening going forward (Prior Action 7). 89. Further reforms aim to deepen the financial sector and develop an ecosystem for more productive financial intermediation, including steps to unlock sources of long-term finance. The private sector access to credit remains very limited - it has consistently remained below 20 percent of GDP for the past decade (reaching a high of 29 percent of GDP in 2004-05). Whatever credit is available to the private sector, it is heavily tilted towards large companies, with a mere 0.4 percent of borrowers accounting for 65 percent of all bank loans. 47 Additionally, the annual extension of long-term loans is well below the level required for meaningful investment and long-term financing gaps are particularly acute for large productive and infrastructure investments in Pakistan. The loan book of domestic banks is low and mostly consists of short-term facilities to large corporates and the public sector. Loans with maturities exceeding 5 years correspond to approximately US$ 4 billion, accounting for only 3 percent of banking sector assets. 46 When a property is transferred to, or is held by, a person but it has been paid for by another person – a trustee and wife, child, brother or sister; A transaction or arrangement of a property made in a fictitious name, or a transaction or arrangement of a property where the owner is not aware of, or denies knowledge of such ownership or; A transaction or arrangement of a property where the person providing the consideration is not traceable or is fictitious. 47 State Bank of Pakistan – National Financial Inclusion Strategy. Page 37 The World Bank Resilient Institutions for Sustainable Economy (P171850) Investments are also limited to short-term sovereign paper, with only 9 percent of domestic bank’s assets used for financing longer than 5 years (both private and public). 90. The establishment of the secured transactions collateral registry will serve to enhance SME access to finance (Trigger 7 DPF-II). At present, SME’s share of credit is merely 7 percent of the overall outstanding credit to the private sector. SMEs employ 90 percent of Pakistan’s labor force and can be leveraged better to foster employment and sustained growth. The collateral registry is an essential part of the financial sector’s market infrastructure that can pave the way for greater access to finance for SMEs in Pakistan, which has suffered from limited growth and productivity. SMEs are typically more “opaque” than large firms because they have less publicly available information. As a result, banks have more difficulties in assessing their creditworthiness, which can discourage lending to these firms. Lenders can substitute the lack of information on SMEs with higher requirements for collateral. Movable assets (such as machinery, and accounts receivables) account for most of the assets of a SME. However, due to the lack of a moveable collateral registry in Pakistan, banks are reluctant to accept these assets as collateral. As such, the establishment of the collateral registry will increase access to finance for SMEs and will also lower the cost of borrowing for these firms as the loans will be collateralized. 91. Not only does the private sector have limited access to finance, it also suffers from limited access to long- term finance. Only 36 percent of the private sector’s credit from banks constitutes loans with a tenor of more than one year. Longer-term financing is required to fund capital investments to enhance productivity and foster growth in the private sector. Limited long-term finance in the system can be attributed to limited long-term retail savings, government borrowing skewed to the short-term Treasury bills (which has meant no effective long-term yield curve), public sector long-term refinancing schemes that are sub-optimally configured, shallow capital markets and public sector Development Finance Institutions (DFIs) not delivering on their mandates to foster long-term finance. In this regard, the Economic Coordination Committee will approve a Development Finance Reform Framework which will be grounded in the principle of increasing supply of long-term finance for productive investment (including governance arrangements for all DFIs, investment policies of the public sector institutional investors, leveraging SOE balance sheets, among others). These reforms will be critical to support the recovery phase following the COVID-19 pandemic and unlock public long-term finance to the economy (Trigger 6 DPF-III). 92. Expected Results: Inadequate integrity of the banking system, limited sources of long term finance, and lack of a functional secured transactions registry are impediments to increasing access to finance to the private sector, especially to SMEs. These reforms are expected to lead to the verification of all bank accounts. In addition, the government will also be able to register all prize bonds, equivalent to 12.7 percent of currency in circulation. Increasing the use of digital payments Prior Action 8: The State Bank of Pakistan has: (a) Trigger 8 DPF-II: The SBP issues implementing regulations issued regulations for Electronic Money Institutions, for the National Assembly and Senate amended enabling non-bank institutions to issue electronic Payments Systems Electronic Funds Transfer (PSEFT) Act, money; and (b) granted five (5) licenses to Electronic and updates to the Payment Services Provider/ Payment Money Institutions System Operator (PSP/PSO) Regulations and Foreign Exchange Manual to modernize the regulatory and supervisory framework applicable to payments systems; and, the Finance Division issues regulations to mandate the use of digital payments to vendors Trigger 7 DPF-III: The Finance Departments at all provincial levels issue regulations to mandate the use of Page 38 The World Bank Resilient Institutions for Sustainable Economy (P171850) digital payments to vendors from FY22 93. Digital financial services can contribute to economic growth by leveraging innovative combinations of traditional financial services, big data, and technology. The fintech sector is at the core of this innovation with considerable potential to unlock new products, channels, and risk assessment tools to reach underserved segments such as women, micro and small enterprises, and agricultural value chains. Increasing financial inclusion and bringing more funds into the formal financial system are essential if Pakistan’s financial sector is to play a more meaningful intermediation role going forward. However, limited policy and regulatory support is available to new entrants to capitalize on this potential and challenge conventional banking models. This fact has inhibited the growth of the fintech sector in Pakistan, which currently accounts for less than 1 percent of the financial sector, although it has the potential to globally disrupt over 20 percent of the financial sector and the ability to reach consumer adoption levels of over 80 percent of the population. 48 Growth in Pakistan’s fintech sector is predominantly in digitizing payments and transaction data, activities that serve as the precursor to innovative credit scoring and lending models. There are gaps in the regulatory framework that limit modern fintech business streams, the definitions in the existing legal framework are narrow, and the licensing and approval processes are lengthy. The key elements of the legal and regulatory framework governing digital payments need to be modernized: (a) the Payments Systems Electronic Funds Transfer (PSEFT) Act, (b) the Electronic Money Institutions (EMIs) Regulations, (c) the Payment Services Provider/Payment System Operator (PSP/PSO) Regulations; and (d) the Foreign Exchange Manual (for cross-border payments). 94. EMIs offer more dynamism to the conventional institutional structure of the financial sector and the government has taken important steps to allow innovation in this space. EMIs are entities that offer innovative, user- friendly, and cost-effective low-value digital payment prepaid instruments like wallets, prepaid cards, and contactless payment instruments including wearables. Globally, these innovative payment instruments have been instrumental in promoting cashless payments across the economy. Specific EMI regulations aim to reduce entry barriers, provide a risk management approach, address consumer protection, and facilitate investments. In parallel, the licensing process for EMIs and fintechs overall must be agile to allow business models to develop and iterate faster. In this regard, the SBP has: (a) issued regulations for EMI enabling non-bank institutions to issue electronic money, and (b) has granted 5 licenses to EMIs (Prior Action 8). 95. Looking ahead, the SBP will address the remaining elements of the legal and regulatory framework to harness the disruptive potential of the fintech sector. In this regard, the PSEFT Act will be amended to: (a) unify SBP’s oversight function to all payment systems, services and instruments – an essential component of leveling the playing field, and (b) apply finality and netting to all digital payment systems – to make digital transactions frictionless. The PSP/PSO regulations will be updated to clearly differentiate between the requirements for PSPs and PSOs and contextualize these requirements in line with the National Payment Systems Strategy 2019 and the micro-payment gateway in 2020. Finally, the Foreign Exchange Manual will be amended to follow a risk-based approach to restrictions on cross border flows (including retail transactions, earnings for freelancers and other services, and venture capital investments/repatriations into fintech businesses) – Trigger 8 DPF-II. 96. In addition, the government will digitize payments to businesses, thereby increasing the quantum of digital money while improving efficiency and transparency. Government transactions are worth about 35 percent of GDP, but they are largely manual; only 16 percent of them are digitized. In Pakistan, government-to-business (G2B) payments account for around 30 percent of total consolidated Government spending. A small number of the G2B payments are associated with large government payment programs. Most of them are one-time payments, in the sense that each payment is made and authorized separately. The Government currently lacks the means to conduct G2B payments 48 PricewaterhouseCoopers Financial Services. Technology 2020 and Beyond: Embracing disruption; Ernst & Young Global FinTech Adoption Index 2019. Page 39 The World Bank Resilient Institutions for Sustainable Economy (P171850) electronically. The absence of electronic payment mechanisms affects the ability of individuals, vendors, and the overall government machinery itself, to make prompt payments. The Government has committed to use digital payments at the federal and the provincial level. The Departments of Finance at all provincial levels will issue regulations to mandate the use of digital payments to vendors from FY22 (Trigger 7 DPF-III). The Government’s accounting system has the capacity to process electronic batches of payments to all vendors including employees, pensioners, and contractors. The accounting system will be linked to all recurring expenses and development projects. Payments will be processed in batches and sent electronically to SBP, which will make payments immediately to the beneficiaries after applying some automated real-time verification and validation checks. This system will work for both payments by the Government and its receipts for all levels of Government. 97. Expected Results: Reforms are expected to improve the regulatory framework governing digital finance, allow greater interoperability to banks and fintechs, and increase the quantum of e-money through greater digital payments. All salary, pensions, and vender payments made by federal and provincial governments will be digital by FY23. The goal is to increase the use of digital payments within the public sector and facilitate the rapid growth of digital payments in the private sector. The reforms supported are expected to contribute to an increase in the volume of digital transactions per year from 0.7 billion in FY18 to at least 1.8 billion by FY23 and digitize all government vendor payments by FY23. Creating an enabling environment for developer finance Trigger 9 DPF-II: The Ministry of Housing/SECP issues implementing regulations following the promulgation of the National Real Estate Regulatory Authority (RERA) Act (2019) Trigger 8 DPF-III: The PM’s Office and respective provincial Chief Ministers establish through respective notifications the Federal and Provincial Real Estate Regulatory Authorities based on respective Federal and provincial legislations 98. Rural to urban migration and the expansion of off-farm opportunities in the informal sector have been key drivers of poverty reduction in Pakistan over the past 15 years. Nonetheless, poor public service provision, risky housing conditions, and weak kinship-based safety nets expose urban migrants to risks of falling back into poverty due to shocks, including from the COVID-19 pandemic. The poor livability of Pakistan’s urban centers affects the poorest segments of the population the most. Increasing congestion costs due to urban sprawl and poor public transport infrastructure limit labor mobility options within urban centers, possibly contributing to the expansion of informality. 99. There is a large and growing housing gap in Pakistan, estimated at 10 million units, with approximately 47 percent of the urban population living in informal housing. Various factors limit house supply, and limited developer finance is an important one. Limited developer finance has a greater effect on smaller developers, who are traditionally the providers of low- and middle-income housing. Financing to developers through commercial banks and other financial institutions is low, and where it is available, it is captured by the top-tier developers who cater to the high- income groups. At present, developers are completely unregulated—a fact that creates a performance risk that banks are just not willing to accept. Therefore, most developers fund their projects from their equity, investor advances, and customer installments. The land is purchased on the equity of one or a pool of developers, while the construction costs are covered through advance payments and installments by buyers. Additionally, as the developers are unregulated, Page 40 The World Bank Resilient Institutions for Sustainable Economy (P171850) funding construction through installments by buyers has immense consumer protection implications: in many cases developers have absconded without completing the construction, a default that affects the lower- and middle-income groups most. 100. Real estate prices in Pakistan have risen significantly, not because of the rising cost of construction materials, but mostly because of speculative markets. Land is bought and resold many times before any construction begins, an activity that persistently pushes the prices upward. Many of the inefficiencies in the real estate market can be attributed to limited land records. Recent measures by the tax authorities to create more transparency in the land market (including the enactment of the “Benami Law”), should create more efficient property and land markets as the financial incentives for speculation will become limited. However, there is still a need to regulate the real estate sector. Real estate transactions are often informal or undervalued to avoid taxation as real estate agents operate outside any regulation. 101. In Pakistan, the regulatory responsibility for real estate and construction has been delegated to the provincial level. The enactment of federal and provincial Real Estate Regulatory Authorities (RERA) laws and subsequent issuance of implementing regulations (Trigger 9 DPF-II) 49 will fill a significant regulatory gap. The RERA at the Federal and Provincial level will regulate developers, real estate agents and set construction standards. Developers and projects will have to be approved by the relevant RERA before construction can commence. This will unlock access to finance for developers as banks will now have greater comfort in lending to regulated developers and projects while providing more security of ownership rights for buyers. This will improve access to housing, particularly low- and middle-income housing which will enhance the competitiveness and livability of Pakistan’s cities. In this regard, the Federal government and provinces have agreed to establish through respective notifications the Federal and Provincial RERAs (Trigger 8 DPF-III). 102. Expected Results: Reforms aim to create a fit-for-purpose regulatory regime for developers so that real estate can be developed and the rights of owners effectively protected. Through these reforms, the number of licenses issued to real estate developers are expected to increase from zero in FY19 to at least 5 by FY23. Reducing the anti-export bias of the National Tariff Policy Prior Action 9: The Cabinet has adopted the National Trigger 10 DPF-II: The reduction of the unweighted Tariff Policy, transferring responsibility for trade tariff average import duty rates by 5 percent and its dispersion setting to the Ministry of Commerce and simplifying by 5 percent with respect to the import duty schedule in and rationalizing the tariff structure the FY21 budget is gazetted Trigger 9 DPF-III: The reduction of the unweighted average import duty rates by 10 percent and its dispersion by 10 percent with respect to the import duty schedule in the FY22 budget is gazetted 103. For over a decade, Pakistan’s import duty structure has created an anti-export bias, considerably reducing the country’s ability to integrate into global markets. Over time, the country’s trade policy has reverted to protectionism and discretion, shrinking the contribution of exports to GDP to a meager 11 percent. 50 Pakistan’s taxes on imports 49Land is a provincial subject. However, to develop land certain federal laws need to be harmonized and amended. 50The increasing use of regulatory duties (RDs) is an example. RDs have become an important source of customs revenue for the government (17 percent in 2016) and added protection to more than 80 percent of products where tariffs had been previously liberalized, neutralizing the potential positive impact of a reduction in tariffs. Recent examples include SRO 568 (I)/2014 that instituted RDs on more than 400 tariffs lines, Page 41 The World Bank Resilient Institutions for Sustainable Economy (P171850) display three features that prevent firms from leveraging regional and global value chains (GVCs). Firstly, Pakistan’s import duties are high. Trade taxes account for one-fifth of tax revenues, high by most international standards. Pakistan is the world’s seventh-most protected economy, as measured by the Overall Trade Restrictiveness Index (OTRI) 51. Secondly, the tariff structure is complex. Pakistan has one of the highest weighted average tariff rate differentials (between consumer goods, intermediates, and raw materials) in the world, with an average difference between consumer goods and raw materials of 10.4 percentage points in 2016. Thirdly, import duties hurt high-performing firms as well as the poorest households. Tariffs on intermediates are high, placing exporters at a disadvantage. Having access to high-quality intermediates at world prices is crucial for firms that compete globally and produce more sophisticated products. However, these firms that rely on imported intermediates are penalized with high input tariffs, which substantially increase production costs. 104. The government has started undertaking corrective measures to reduce the anti-export bias of the national tariff policy and respond to the COVID-19 pandemic. First, the Cabinet adopted the National Tariff Policy, transferring responsibility for trade tariff-setting from the FBR to the Ministry of Commerce and simplifying and rationalizing the tariff structure (Prior Action 8). This is a very significant step toward reorienting tariff policy objectives away from revenue collection to trade promotion. Second, to ensure the continuity and sustainability of this reform, RISE II and III will support the reduction of the unweighted average import duty rates and their dispersion by 5 percent and by 10 percent, respectively (Trigger 10 DPF-II and Trigger 9 DPF-III). In addition, the Government has responded swiftly to the COVID-19 pandemic: (a) import duties were eliminated on 61 COVID-19 essential items, as in 76 other countries in the world that have taken a similar approach; and (b) export restrictions that were initially introduced on PPE and sanitary products have been lifted, except for N95 and surgical masks. 105. Expected results: These measures are expected to contribute to institutional changes conducive to reducing the anti-export bias of the trade policy framework and lead to a reduction in the average import duties from 12.6 percent in FY19 to at least 10.8 percent by FY23. Concurrently, the average dispersion (measured as the standard deviation) is expected to fall from 15.4 to at least 13.2 by FY23. Table 6: Prior Actions and Analytical Underpinnings Prior Actions Analytical Underpinnings Pillar 1: Enhancing the policy and institutional framework to improve fiscal management Prior Action 1: The Finance Division has: (a) Pakistan@100: Shaping the Future assigned fiscal coordination responsibilities to the World Bank Technical Assistance National Finance Commission Monitoring Policy Note–Fiscal Federalism Issues and Public Committee, which comprises federal and provincial Financial Management finance ministers, based on the decision of the Council of Common Interests; and (b) established the Macro-Fiscal Policy Unit to be responsible for developing the medium-term fiscal and budget framework and fiscal risk management Prior Action 2: The Finance Division has: (a) TA on Debt sustainability at national and sub- transferred domestic and external debt national levels SRO 1035(I)/2017 that consolidated eight previously issued resolutions increasing RDs, and SRO 640(I)/2018, by which RDs on various items increased by 2-10 percentage points. By increasing protection at home, these duties reduce incentives to export. During FY19, for example, exports only contributed 1.3 percentage points to GDP growth. 51 The OTRI quantifies the uniform tariffs that, if imposed on imports instead of the existing heterogeneous structure of protection, would leave aggregate imports at the current level. Page 42 The World Bank Resilient Institutions for Sustainable Economy (P171850) management and issuance of guarantees to the Debt Sustainability Analysis Debt Policy Coordination Office; (b) mandated the Medium term debt sustainability publication of a medium-term debt management Annual borrowing plan strategy; (c) mandated the semi-annual publication Credit risk framework of a debt bulletin; and (d) required the issuance of Support to sub-nationals on Guarantee Valuation, sovereign guarantees for all SOEs to be contingent Debt legislation, Cash flow tool development upon publication of previous year’s audited financial statements and submission of a detailed plan to achieve financial stability Prior Action 3: The Federal Board of Revenue has: World Bank – Tax Policy Review 2018 (a) increased the immovable property valuation to Policy Note—Domestic Revenue Mobilization in eighty-five (85) percent of the market value for Pakistan withholding income tax and capital gains tax; (b) World Bank – Reform of the Taxation of Capital reduced the personal income tax thresholds; and (c) Gains under the Income Tax Ordinance 2001 – 2015 removed the special treatment on general sales tax Tax Gap Analysis for five (5) sectors TA on revenue mobilization under TAGR Prior Action 4: The Cabinet has approved the Circular Debt Issues and Solutions, Senate of Circular Debt Management Plan, which includes Pakistan, 2018 policy measures to minimize the flow, gradually Learning from Power Sector Reform: The Case of eliminate the stock of circular debt, and improve Pakistan, World Bank, 2019 DISCO efficiency; and the Finance Division has Implementation Completion and Results Report for issued a notification to transfer the PHPL debt to Power Sector Reform Development Policy Credits I & the public debt stock II, World Bank 2017 State of Industry Reports, NEPRA, Various Years Policy notes on Energy Sector Task 1: Dispatch Diagnosis Report, Final DRAFT, March 2019 Task 2: Demand & Generation Forecast Analysis, March 2019 Pakistan Pakistan Discos Performance Review (Draft for Discussion, Oct 2018), World Bank In the Dark – How Much Do Power Sector Distortions Cost South Asia, World Bank, 2019 Addressing Power Sector Financial Crisis (Draft for Discussion, Oct 2018), World Bank World Bank technical assistance under TAGR Prior Action 5: The Council of Common Interests Policy Note—Moving Towards a Viable and Efficient has approved the Renewable Energy Policy, which Energy Sector includes the adoption of competitive bidding as the Reforming Electricity Subsidies in Pakistan: Measures main procurement method to Protect the Poor. World Bank: Working Paper 93762. On-Going Technical Assistance under the “Energy Sector Reform Support” activity Variable Renewable Energy Integration and Planning Page 43 The World Bank Resilient Institutions for Sustainable Economy (P171850) by M/s Lahmeyer International for World Bank and Government of Pakistan Pillar 2: Improving the regulatory framework to foster growth and competitiveness Prior Action 6: The National Finance Commission World Bank – Tax Policy Review 2018 Monitoring Committee has approved a general Policy Note – Options for Harmonizing GST sales tax harmonization framework with common World Bank technical assistance under TAGR taxation principles, harmonized definitions of goods TA on revenue mobilization under TAGR and services, common place of supply rules, and a single rate Prior Action 7: The Federal Board of Revenue has FATF Nomination notified the Benami Transaction (Prohibition) Rules FATF Action Plan of 2019, mandating all commercial banks to conduct biometric verification of all bank account holders, as instructed by the State Bank of Pakistan Prior Action 8: The State Bank of Pakistan has: (a) National Payments Systems Strategy issued regulations for Electronic Money Institutions, Policy Note on Digital Payments enabling non-bank institutions to issue electronic Technical reviews of payments systems money; and (b) granted five (5) licenses to infrastructure, interoperability and Guidelines for QR Electronic Money Institutions Codes Prior Action 9: The Cabinet has adopted the World Bank–Pakistan: Note on Tariff Rationalization National Tariff Policy, transferring responsibility for 2018 trade tariff setting to the Ministry of Commerce and World Bank – Pakistan: Unlocking Private Sector simplifying and rationalizing the tariff structure Growth through Increase Trade and Investment Competitiveness 2018 4.3. LINK TO CPS, OTHER BANK OPERATIONS, AND THE WBG STRATEGY 106. The proposed operation supports three of the four pillars of the FY15-FY20 Country Partnership Strategy (CPS) and two of the four pillars of the WBG COVID-19 Crisis Response Approach. Firstly, it supports the first CPS pillar of transforming the energy sector through actions aimed at improving the performance of DISCOs and, in turn, reducing the fiscal burden on the government. Secondly, the program aims to increase competitiveness, reduce informality and create an environment conducive for private sector development in Pakistan which supports the second CPS pillar. Third, by creating fiscal space and institutionalizing better coordination between the federal and provincial governments, the operation supports improving the quality of service delivery across Pakistan, the fourth CPS pillar. The proposed operation is part of the World Bank’s second phase of support to the government to cope with the COVID-19 pandemic. The operation is aligned with the pillar four of the WBG COVID-19 Crisis Response Approach through actions aimed at improving fiscal management and reducing regulatory impediments which constrain private investment. 107. This operation supports progress towards the WBG’s twin goals in Pakistan. The Systematic Country Diagnostic (SCD) for Pakistan has identified restoring macroeconomic stability, improving energy sector performance, and strengthening public governance as the top priorities for the country to sustaining progress towards the twin goals. The additional reform priorities identified by the SCD include increasing competitiveness and promoting equity and Page 44 The World Bank Resilient Institutions for Sustainable Economy (P171850) inclusion. This DPC series supports critical reforms for restoring macroeconomic stability through establishing institutions for effective fiscal and debt management, strengthening coordination between the Federal government and provinces on taxation matters, reducing distortions in tax policy through harmonizing the general sales tax and eliminating tax exemptions which benefit the elite while making the economy less competitive. The DPC also supports reforms for improving the financial viability of the power sector through addressing the circular debt in the sector and better targeting of public subsidies to the poor. The policy reforms supported by this DPC series also support improving competitiveness through reducing taxation related compliance costs for taxpayers, incentivizing banks to expand their lending base beyond the government and some established corporates to small and medium enterprises, and reducing the anti-export bias of the national tariff policy, so that firms are able to access more credit and obtain inputs at globally prices while being incentivized to produce globally competitive products. Taken as a package, these reforms will improve the investment climate and incentivize the private sector to ramp up investment as the COVID-19 pandemic abates. 108. World Bank operations in the areas of tax administration and trade and business environment complement this DPF series. The Pakistan Raises Revenue project, a 5-year IPF with DLIs, aims to address key constraints to domestic revenue mobilization in Pakistan. Approved in June 2019, the project’s DLIs are targeted at facilitating tax compliance, widening the tax base and transforming FBR into a technology driven, modern tax administration authority. In addition, the Public Finance Management PforR operation is assisting the country improve core public financial management systems, eProcurement, and cash management. The World Bank is also financing projects in provinces on tax administration, governance, and improved service delivery. Preparations are underway on a Trade and Competitiveness focused project called Pakistan Goes Global, which aims at strengthening institutions for trade and investment competitiveness. Reforms aimed at improving the business climate are also being supported through World Bank led technical assistance and policy dialogue. Finally, a new DFID Trust Fund (Pakistan@100) jointly executed by the Government and the World Bank will support reforms in tax policy and administration, the energy sector and SOE reforms, fiscal and debt management, as well as trade and investment. The extensive support being provided is in line with experience that policy-lending operations are more likely to succeed when policy reforms are also supported with other engagements. 4.4. CONSULTATIONS AND COLLABORATION WITH DEVELOPMENT PARTNERS 109. The government has held consultations with various stakeholders on the proposed reforms. The government has consulted with the private sector, political parties, development partners, and national think-tanks the Federal and provincial levels on the proposed reforms being supported under this DPF series. 110. The growth enhancing measures supported by the government is an outcome of extensive consultations, including with the private sector. The government has set a target of creating 10 million jobs and has engaged the private sector extensively on policy reforms needed in this regard. The private sector has highlighted the importance of the country to function as a harmonized tax jurisdiction, a single regulatory entity, and have a competitive and stable trade policy. The government has incorporated these priorities in its structural reform program aimed at eliminating distortions in the tax and trade policies, conducting a nationwide regulatory reform, establishing institutions for effectively coordinating fiscal policy between federating units, addressing circular debt in the power sector, and providing greater autonomy to the State Bank of Pakistan in monetary and exchange rate policy. This view is shared by federal and provincial governments including Sindh which is the only province governed by another political party. 111. The World Bank is coordinating closely with development partners in Pakistan. The World Bank team has joined IMF technical meetings, conducted joint missions on debt management reforms, and has closely coordinated with the IMF on their EFF program, which focuses on fiscal reforms, monetary and exchange rate management reforms, Page 45 The World Bank Resilient Institutions for Sustainable Economy (P171850) energy and SOEs reforms. The World Bank has also had extensive consultations with the ADB, and the US and UK governments in its support for economic reforms, and with the Japan International Cooperation Agency on private sector reforms. DFID is financing technical assistance through a new trust fund, the Pakistan@100 Trust Fund with a focus on revenue, investment and trade. The EU is providing TA on medium term budgeting and the Department of Foreign Affairs and Trade is financing support to the Government in trade and regional integration. All legislative action reforms supported by this operation went through a rigorous consultative process. 112. Partnership with Asian Infrastructure Investment Bank: RISE is expected to mobilize financial resources from other financiers also. AIIB has shown intent to parallel-finance RISE to create fiscal space for the government to design response measures for economic recovery and offsetting the impacts of COVID-19 pandemic on health and social sectors. AIIB’s financing will be under its COVID-19 Crisis Recovery Facility and assist Pakistan in dealing with the COVID- 19 crisis by addressing urgent economic, financial and public health pressures. This is expected to scale-up the results under the government’s COVID-19 response plan which includes measures to arrest adverse impacts of the pandemic and financial inclusions programs targeting women and vulnerable. 5. OTHER DESIGN AND APPRAISAL ISSUES 5.1. POVERTY AND SOCIAL IMPACT 113. The reform program supported by this operation is expected to have positive poverty and social effects in the medium-term, but it is likely to have some negative effects in the short term. Most prior actions are not expected to have a significant negative effect on the poor, rather they can potentially have positive effects by encouraging economic growth. This PSIA delves in detail into Prior Action 3, broadening the tax base and reducing distortions in tax policy, which is expected to have a small negative impact on the poor in the short run and Prior Action 9, reducing the anti-export bias of the National Tariff Policy, which is expected to have a positive welfare impact on Pakistani households. An analysis of the welfare impact of Prior Action 4 – addressing the stock and flow of circular debt in the power sector - will be conducted once the new HIES 2018-19 becomes available in FY21 and it will be used to inform ex-ante the reforms on energy subsidies, and tariff determination, which will be supported by the DPF-2. 114. This PSIA uses data from the latest available Household Integrated Income and Consumption Survey (HIICS) 2015-16 conducted by the Pakistan Bureau of Statistics (PBS) to assess the poverty impact of Prior Action 3. The dataset contains information about household consumption levels across a wide set of items 52 as well as information on asset ownership, including immovable property. In particular, estimates of these welfare effects relate to the following reforms: (a) an increase in the immovable property valuation to 85 percent of the market value for withholding income tax and capital gains tax; (b) a reduction in the personal income tax thresholds; and (c) a removal of the special treatment on general sales tax (GST) for 5 sectors (textile, leather, carpets, sports goods and surgical goods) through revocation of the Statutory Regulatory Order No. 1125. 115. The increase in property valuation for the purpose of withholding income tax and capital gain tax is not expected to have a sizeable impact on poorer segments of the population. According to household survey data, home ownership is quite widespread in Pakistan’s urban areas, including among the poorest segments of the population. In particular, 70 percent of households in the poorest quintile and 71 percent of households in the second poorest quintile own property in urban areas and could in principle be impacted by the increase in FBR property valuation for the 52The survey collects information on consumption of 451 items, grouped in 12 categories, namely: Food; Alcohol Beverages, Tobacco; Clothing and Footwear; Housing, Water, Electricity, Gas and Other Fuels; Furnishing; Health; Transport; Communication; Recreation & Culture; Education; Restaurants & Hotels; Miscellaneous Goods & Services. Page 46 The World Bank Resilient Institutions for Sustainable Economy (P171850) purpose of withholding and capital gain tax 53 . Several factors and legislative provisions are likely to mute the impact on poverty. First, at present, there is no tax if a property is held for more than eight years, 54 and if the property is received as a gift from blood relatives (parents or siblings), the tax is levied only on 20 percent of the property valuation rate. Given the high price of urban property 55 and the lack of access to credit of poorer segments of the population, it can be safely assumed that sales and purchases of property are infrequent for households at the bottom of the welfare distribution. 56 Second, based on information on the quality of housing amongst the poorest, it could be assumed that most poor households own property in informal settlements. 57 Informal settlements (katchi abadis) consist of large clusters of mostly temporary houses, mostly built on encroached public land. 58 Market transactions on such properties, lacking formal property rights to the land, would therefore happen informally, outside the reach of tax authorities. 116. The reduction in the personal income tax threshold is not expected to affect the poorest segments of the population. Recent years have seen several changes in personal income tax, involving exemption thresholds, tax rates, and definition of income brackets (B). For the purpose of this analysis we will compare the 2015-16 baseline of the tax regime to the one supported by the prior action and to the one immediately preceding (Finance Amendment Bill of 2018). At baseline, in 2015-16, the income exemption threshold was set at 400,000 for both salaried and non-salaried persons. Through the Finance Act of 2018, the threshold was increased to Rs. 1,200,000, thereby increasing the pool of exempted taxpayers. The prior action supports the revision of the threshold of taxable income to Rs. 600,000 for salaried person and 400,000 for a non-salaried person. This action restores the thresholds for non-salaried person to the levels prevailing at baseline, while increasing it (from Rs. 400,000 to Rs. 600,000) for a salaried person. 59 As shown in Table 8, the revision of exemption thresholds supported by the prior action brings back the share of tax-filers to the one prevailing at baseline, with 1 percent (2.3 percent) of individuals qualifying for income tax payment in the poorest (second poorest) quintile. However, as shown in Table 8, the revised rates and income brackets definitions which accompanied the reduction in income exemption threshold supported by the prior action would lead to a decline in the average value of income for tax filers compared to baseline and compared to the 2018 regime. Table 7. Share of Individuals Above Exemption Threshold, by Quintile Baseline Finance Act 2015-16 2018 Prior Action Poorest 1.0 0.0 1.0 2 2.3 0.1 2.3 3 6.3 0.2 6.3 4 13.1 0.3 13.1 Richest 44.1 5.9 44.1 53 Both taxes are federal. Capital gain tax consists of 1 percent of FBR’s property valuation, while withholding income tax consists of 1 percent (2 percent for non-filers) of FBR’s property valuation. 54 Previously, a property sale would qualify for exemption only if held for more than three years. 55 (World Bank, 2014) reports that nominal land prices in Lahore had risen by more than 100 percent, with residential property values rising six- fold and commercial land values growing four-fold, over the preceding 20 years. Per UN-HABITAT’s Global Report on Human Settlements 2007, the housing price to income ratio, which measures affordability, was 7.1 for Lahore in 2007, and it was 13.7 for Karachi in 2007. These two cities have among the highest housing price to income ratios in South and Southeast Asia. 56 See Dowall & Ellis (2009) for a discussion of the incomplete urban housing market in the Punjab. 57 Based on HIES 2013-14 data, which has detailed information on housing, poorer households who own homes in urban areas have limited access to public utilities. Notably, 72 percent of the poorest and 59 percent of the 2nd poorest quintile have no access to public sewage systems. 58 Public land ownership is widespread in urban areas. According to some estimates, 20-40 percent of urban land is under land ownership. In Karachi, nearly 90 percent of land is public owned. 59 In addition, the definition of salaried person has changed, expanding the pool of tax payers qualifying as non-salaried and therefore subject to the lower threshold. Previously, the tax rates for salaried persons were applicable to persons having 50 percent or more of their total income from salary. With the current reform, these tax rates are applicable to persons having 75 percent of their total income from salary. Page 47 The World Bank Resilient Institutions for Sustainable Economy (P171850) Total 12.9 1.2 12.9 Source: WB staff elaboration based on HIICS 2015-16 Table 8. Average Income Tax for Filers, by Quintile Baseline Finance Act Prior 2015-16 2018 Action Poorest 14,539 18,150 10,818 2 18,460 55,320 13,203 3 17,140 21,435 12,305 4 28,643 486,169 23,526 Richest 62,131 100,165 48,915 Total 48,636 112,573 38,311 Source: WB staff elaboration based on HIICS 2015-16. 117. The increase in GST rates for domestic sales of previously exempted sectors (SRO1125) is estimated to result in a welfare loss of approximately 1 percent on average, with marginally higher welfare losses experienced by poorer households and households living in urban areas. The largest effect of the change in GST rates is on textiles, with the rate increasing from an average of 4.7 percent across items affected to 17 percent. In 2015, households spent on average 6.8 percent of their budget on textiles. Households in the lower quintiles of the welfare distribution tend to devote a higher budget share to textiles compared to households in higher quintiles (Table 9). The other two categories affected by the reform, medical equipment, and sports goods, constitute a very limited proportion of household’s budget expenditure and therefore the impact of changes in GST rate is expected to be negligible. Overall, the increase in GST attributed to the fiscal reform is estimated to result in a 0.94 percent loss in Pakistani households’ welfare, corresponding to an average of 281.44 Rs. (2015 prices). 60 The price increase is the equivalent of a regressive tax, with poorer households suffering relatively higher welfare loss proportional to their total consumption (Table 10). The effects are slightly higher in urban areas, where textiles constitute a higher share of total consumption relative to rural areas 61 (Table 11). The regressive nature of the impact of increase in GST is likely to be mitigated by the existence of a large informal sector if prices would not adjust in informal, non-GST-registered shops. 62 Table 9. Budget Share (percent) of Consumption Categories Affected by Revocation of SRO 1125, by Quintile Quintile Textiles Medical Equipment Sports Goods Poorest 7.491 0.0003 0.004 2 7.292 0.0012 0.005 3 7.072 0.0010 0.003 4 6.770 0.0015 0.004 Richest 6.017 0.0033 0.006 60 Indirect effects should be negligible since this is a change in zero rate GST directed at end-consumers. 61 Textile items’ budget share is 7.3 percent in urban areas against 6 percent in rural areas. 62 Experience from GST broadening in other countries shows that richer households are affected relatively more than the poorer households given their higher likelihood to shop in larger GST registered operators. For example, in Kenya the lowest income quintile buys 60 percent of their maize consumption from smaller shops/kiosks while the richest quintile purchases the same share from large supermarkets (Kirimi et al., 2012). Page 48 The World Bank Resilient Institutions for Sustainable Economy (P171850) Total 6.839 0.0016 0.005 Source: WB staff elaboration based on HIICS 2015-16. Table 10. Welfare Impact of Revocation of SRO 1125, by Quintile Direct Effects (percent) Quintile Total (percent) Welfare Loss (Rs.) Textiles Medical Equipment Sports Goods Poorest 1.060 0.00000 0.0002 1.061 193.96 2 1.022 -0.00001 0.0003 1.022 231.68 3 0.978 0.00000 0.0002 0.978 251.53 4 0.925 -0.00001 0.0003 0.925 280.88 Richest 0.808 -0.00002 0.0004 0.809 391.36 Total 0.943 -0.00001 0.0003 0.944 281.44 Source: WB staff elaboration based on HIICS 2015-16. Note: Estimates assume no change in consumption as a result of higher prices (price elasticity of consumption assumed to be zero). Table 11. Welfare Impact of Revocation of SRO 1125, by Quintile and Area of Residence URBAN RURAL Total (percent) Welfare Total (percent) Welfare Quintile Loss (Rs.) Loss (Rs.) Poorest 1.09 194.66 0.94 190.48 2 1.06 234.74 0.89 221.25 3 1.02 253.45 0.88 247.37 4 0.98 283.39 0.84 277.04 Richest 0.93 384.30 0.73 396.20 Total 1.02 265.21 0.81 309.56 Source: WB staff elaboration based on HIICS 2015-16. Note: Estimates assume no change in consumption as a result of higher prices (price elasticity of consumption assumed to be zero). 118. The issuance of regulations for Electronic Money Institutions (EMI) and granting licenses to EMIs under Prior Action 8 – ‘increasing the use of digital payments’ – are expected to have a pro-poor and gender effect. This action is expected increase provision of credit to individuals and small business, which are not served well by commercial banks. Women are expected to benefit more as they tend to visit banks less than men due to traditional and cultural reasons. 119. Proposed reductions in import duty under Prior Action 9 - ‘simplifying and rationalizing the tariff structure’ - are expected to have a largely pro-poor effect. Preliminary analysis was conducted using partial and general equilibrium simulations based on a reduction to 5 perfect tariffs. 63 While these are more ambitious than the reforms proposed, the direction of impact is comparable. The reduction in import duties is projected to lead to an increase in GDP of 0.2-0.9 percent, translating into more employment and higher wages. Reductions in import tariffs are projected 63 World Bank 2018 “Pakistan: Impact of Potential Trade reform scenarios”, mimeo. Page 49 The World Bank Resilient Institutions for Sustainable Economy (P171850) to increase the import of processed foods by 5-10 percent. Given that the poorest quintile spends 52 percent of their income on food and the 2nd poorest spends 50 percent of the income on food, this increased availability and concurrent reduction in the price of food will have pro-poor effects. An increase in the import of textiles and apparel will also have pro-poor effects, as the poor spend proportionally more of their budget on textiles, 7.5 percent as opposed to 6 percent for the richest (see figure 4). The simulations project that these reforms would lift 0.17 - 0.23 million people out of extreme poverty (living on less than PPP $1.90 a day) and around 1.21 – 1.69 million people out of moderate poverty (living on less than PPP $3.20 a day). Figure 9. Impact of Reducing Import Duty on Poverty, Different Scenarios A. Poverty impact at PPP $1.90 B. Poverty impact at PPP $3.2 0.0 0.0 0.0 0.0 Number of poor (millions) Number of poor (millions) Headcount rate (pp) Headcount rate (pp) -0.2 -0.5 -1.0 -0.1 -1.0 -2.0 -0.4 -0.2 -1.5 -3.0 -0.6 -2.0 -4.0 -0.3 -2.5 -5.0 -0.8 -0.4 -1.0 -3.0 -6.0 Scenario 1 Scenario 2 Scenario 3 Scenario 4 Scenario 5 Comprehensive Scenario 1 Scenario 2 Scenario 3 Scenario 4 Scenario 5 Comprehensive reform reform Source: WB staff modeling. Note: Scenario 1: Maximum 5 percent customs duty. Scenario 2: Maximum 5 percent customs duty and elimination of regulatory and additional duties. Scenario 3: Maximum 5 percent customs duty, elimination of regulatory and additional duties, and elimination of non-FTA custom duties exemption. Scenario 4: Zero custom duties for raw materials, intermediates, and capital goods; 10 percent customs duties for consumption goods, and elimination of regulatory and additional duties. Scenario 5: Elimination of customs duties on inputs for 19 priority sectors identified by the Ministry of Commerce, and elimination of regulatory and additional duties. 5.2. ENVIRONMENTAL, FORESTS, AND OTHER NATURAL RESOURCE ASPECTS 120. Pakistan has adequate legislation, policy guidelines, and institutional mechanisms in place for managing the environment and natural resources. This operation is not likely to cause any significant effect on Pakistan’s environment, forests, and other natural resources, and there are systems in place for reducing any eventual adverse effects. Reforms in the energy sector, particularly the approval of the renewable energy policy (but also improvements in the performance of the DISCOs) are likely to have a positive effect on the environment. Other policy reforms in the first pillar that aim at improving fiscal management will have no significant effect on the environment. The second pillar seeks to foster growth and competitiveness. There is a possibility that higher growth may lead to more industrial pollution, resulting in worsening air and water quality and contamination of soils. To mitigate those risks, it is important to increase the focus on strengthening the institutional capacity of institutions. The Pakistan Environmental Protection Council, headed by the prime minister, is responsible for overall guidance on national environmental programs and policies. After devolution in 2010, the provinces have been empowered to legislate and formulate policies, including those related to the environment. At the federal level, the Climate Change Division of the Cabinet Secretariat is Page 50 The World Bank Resilient Institutions for Sustainable Economy (P171850) responsible for environmental protection. The institutional arrangements for environmental management are quite robust at the provincial level, even though implementation remains a challenge across most of the country. 121. The proposed operation is expected to lead to significant climate co-benefits. Firstly, reduction in transmission losses lower the electricity generation requirement and consequently, lower production decreases carbon emissions in the air. Secondly, the adoption of the Renewable Energy Policy aims at diversifying the energy-mix and increase reliance on low carbon energy sources. Lastly, a competitive energy market will force power producers to reduce costs and increase efficiency in electricity generation, resulting in lower use of fossil fuels. 122. The total climate co-benefits in this operation amounts to US$ 55.56 million (11.1 percent). The renewable energy policy approval has been the key action that has led to this assessment. 5.3. PFM, DISBURSEMENT, AND AUDITING ASPECTS 123. Public Financial Management and Accountability Assessment. A PEFA assessment prepared for the Federal Government in 2019 using the 2016 PEFA 64 framework noted strengths and progress in key PFM areas due to ongoing reforms for improving PFM system in the country. Strengths were noted in budget formulation and execution, which are based on classifications using GFS/COFOG. 65 PFM reforms have also contributed towards the roll-out of the Medium-Term Budgeting Framework (MTBF) to all ministries, focusing on multi-year planning and budget preparation for at least three years on rolling basis. Sector strategies are in place and preparation of a Budget Strategy Paper and the MTBF allow for communication of indicative budget ceilings to the line ministries. The recent adoption of the PFM Act in 2019 is expected to help instill budgetary discipline, improve transparency and confidence in the spending of budgetary resources, improve cash management and strengthen the internal control framework. 124. The PEFA assessment also noted opportunities for improvement in several key PFM areas. For example, the Government could improve the internal audit function by focusing largely on financial compliance as opposed to providing support to review and strengthen the internal control framework in line departments. Continuing efforts are also needed to increase revenue collection; while weaknesses were noted in the management of cash balances that impact the predictability in availability of funds. Fiscal discipline could be improved by strengthening systems and capacity for legislative oversight, as well as compliance issues with instructions and guidelines at the budget formulation stage resulting in high-revenue and expenditure out-turns. There is also no clear requirement for budget funds to be held in a TSA, although instructions were issued to do so in April 2019. Finally, given the lack of comprehensive, transparent and effective follow-up on external audit and budget reports, parliamentary scrutiny does not support an effective or transparent accountability. 125. The Federal Finance Division discloses the Federal Budget, which is publicly available on its website. The budget document is comprehensive. It presents the budget by economic and functional classifications, estimated revenue outturns for the ongoing and upcoming fiscal year, medium term fiscal framework, output based budget estimates, and a narrative on the successful policy measures of the current fiscal year and new policy measures for the upcoming fiscal year. Supplementary budget or changes to the ongoing year’s budget made by the executive are also submitted to the Parliament alongside the budget documents for approval. Monthly execution reports are produced but not disclosed. Quarterly reports on national fiscal outturns are made available on the MOF website. Financial 64 Public Expenditure and Financial Accountability (PEFA) Program was established in December 2001 as a multi donor partnership. The PEFA PFM Performance Measurement Framework was substantially revised in 2016. 65 United National Classifications of Functions of Government. Page 51 The World Bank Resilient Institutions for Sustainable Economy (P171850) statements of the previous year are disclosed after being audited, usually nine months after the closing of the fiscal year. 126. Foreign Exchange Environment. An updated IMF safeguards assessment of the SBP was substantially completed as part of the EFF 66 in December 2019. The assessment found that the SBP has maintained a broadly strong safeguards framework since the last assessment in 2013, and the financial reporting, external and internal audit mechanisms, and an enterprise-wide risk management framework all highlight sound practices. However, legislative reforms are necessary to strengthen SBP's autonomy and governance arrangements, and a medium-term strategy is required to phase out its involvement in quasi-fiscal activities. The consolidated financial statements of SBP and its subsidiaries for the financial year ended June 30, 2019, prepared in accordance with International Financial Reporting Standards (IFRS), were audited jointly by EY Ford Rhodes and KPMG Taseer Hadi & Co., and the auditors issued an unmodified opinion on these financial statements. 127. Disbursements and auditing arrangements. The Loan and Credit will follow the WB’s standard disbursement procedures for development policy support. The proceeds of the Loan and Credit will be disbursed against satisfactory implementation of the program (specified prior actions achieved) and maintenance of an adequate macroeconomic policy framework. The WB will disburse the Loan and Credit proceeds in USD, into Pakistan’s foreign currency deposit account at SBP. The SBP will then immediately ensure that, upon each deposit in said account, an equivalent amount to each deposit will be credited in PKR into the consolidated fund of the government Account No. 1-Non-Food held by the SBP, which will become available to finance budgetary expenditures. Within 30 days of each IBRD Loan and IDA Credit funds transfer, the Government of Pakistan, through its MOF, will provide the WB with a written confirmation of each amount deposited into Pakistan’s foreign currency deposit account at SBP, and that the equivalent PKR amount has been accounted for in the country’s budgetary management system in an account used to finance budget expenditures. If the funds from the Loan and the Credit or any part thereof are used for ineligible purposes, as defined in the Loan Agreement and Financing Agreement respectively, the WB will require the Borrower to promptly return such amount to the WB. The amount refunded shall be cancelled from the Loan or Credit, as it may corresponds. No specific audit of the deposit of the Loan or Credit funds will be required given the moderate fiduciary risk rating resulted from the assessment of this operation. 5.4. MONITORING, EVALUATION, AND ACCOUNTABILITY 128. The Federal Finance Division is responsible for overall oversight of the current operation. The External Finance Wing is the main agency responsible for monitoring the implementation. Several federal government agencies (including, but not limited to, the Ministry of Commerce, the FBR and the Ministry of Energy) as well as provincial governments will implement the program. The Federal Finance Division, as the lead implementing agency, has extensive experience and is fully conversant with World Bank policies and procedures for development policy financing. The MoC, FBR and MoE also have experience with World Bank DPF through past interactions. Provincial governments have extensive experience of working with the World Bank although they have not been a part of DPF reforms in recent past. 129. The Government has adequate monitoring and evaluation systems. The government will assess timely achievement of targets, drawing on the regular supervision function of national accounting, fiscal and, household survey data. Monitoring of the achievement of results will also be facilitated by technical assistance programs, analytical work and other support provided by the World Bank. 66 IMF Country Report No. 19/380 of December 2019. Page 52 The World Bank Resilient Institutions for Sustainable Economy (P171850) 130. Grievance Redress. Communities and individuals who believe that they are adversely affected by specific country policies supported as prior actions or tranche release conditions under a World Bank Development Policy Operation may submit complaints to the responsible country authorities, appropriate local/national grievance redress mechanisms, or the WB’s Grievance Redress Service (GRS). The GRS ensures that complaints received are promptly reviewed in order to address pertinent concerns. Affected communities and individuals may submit their complaint to the WB’s independent Inspection Panel which determines whether harm occurred, or could occur, as a result of WB non-compliance with its policies and procedures. Complaints may be submitted at any time after concerns have been brought directly to the World Bank's attention, and Bank Management has been given an opportunity to respond. For information on how to submit complaints to the World Bank’s corporate Grievance Redress Service (GRS), please visit http://www.worldbank.org/GRS. For information on how to submit complaints to the World Bank Inspection Panel, please visit www.inspectionpanel.org. 6. SUMMARY OF RISKS AND MITIGATION 131. The overall risk rating for the proposed operation is high. This is because of the high degree of uncertainty associated with the duration of the COVID-19 and its impact on the economy. Pakistan experienced the COVID-19 pandemic just as the economy was stabilizing and the country was undertaking reforms. The COVID-19 pandemic has affected the pace of the implementation of the stabilization program and delayed structural reforms, including those being supported by this operation. Given the uncertainty of the duration and depth of the COVID-19 crisis, it is unclear at this moment how this pandemic will impact the achievement of the program development objectives. 132. Political and governance risks are high and tilted to the downside on account of the COVID-19 pandemic. Risks include a widespread domestic outbreak of COVID-19 requiring an extended period of movement restrictions, protracted recessions in key export markets, a significant decline in remittance inflows (particularly from the GCC region), or materialization of contingent liabilities. While the present government has won the national elections and holds a majority in the lower house of the Parliament, political risks to the operation are significant. This is driven by three factors. Firstly, the implementation of selected policy reforms (such as the harmonization of the general sales tax system, regulatory overhaul, energy policy, and coordinated fiscal management) requires political support from the provincial governments. Secondly, opposition can form within the federal government against adverse short-term developments associated with the operation. For instance, the efforts to address the anti-export bias of the national tariff policy could have short-term negative fiscal and liquidity implications that could stir resistance. Governance risks are also high as Pakistan’s system of governance is partially subject to influence by elites, undermining transparency and accountability. Thirdly, social resistance to the stabilization program. The negative impact of the ongoing economic adjustment on growth and measures taken by the authorities to restore and maintain macroeconomic stability (like electricity tariff increases) could have a negative impact on the poor and vulnerable. A preliminary analysis suggests that, in a worst-case scenario, up to an additional four million households could fall into poverty by 2023 because of the ongoing economic adjustment. This puts reform implementation at risk when reforms adversely affect the interest of certain groups. The evolving COVID-19 pandemic has put additional strain on the structural reform program, with vested interests exploiting the crisis to demand more subsidies and incentives from the government and political elites. Political risks are mitigated, in part, through extensive consultations with the government counterparts at the federal and provincial levels aimed at reaching consensus and aligning priorities. The impact of the stabilization measures can be mitigated by the policy reforms to protect the poor and vulnerable supported by the SHIFT DPF, including measures to increase the participation of women and girls in the labor market and measures to improve federal safety nets to respond to shocks in a more appropriate and timely manner. However, despite the mitigating factors, residual risks to Page 53 The World Bank Resilient Institutions for Sustainable Economy (P171850) the operation remain high. This is because the crisis could divert the government’s resources to deal with the evolving situation and this could potentially impede the successful implementation of the reforms supported by the operation. 133. Pakistan’s macroeconomic risks are high. The low level of foreign reserves and high debt ratios limit the buffers that Pakistan could use to manage external risks. The global COVID-19 pandemic presents substantial economic risks. The pandemic-induced global crisis can further affect Pakistan through reduced demand for exports, import shortages, rising prices, lower revenues, and higher interest rates. Volatility in international financial markets would affect Pakistan’s financing costs at a time when it will need to access financial markets to meet its large external financing needs. Uncertainty of oil prices, given Pakistan’s reliance on imported fuel in its energy mix, and of remittances from the Gulf countries (an important source of remittances for Pakistan) add to the downside risks. Greater exchange rate flexibility and structural reforms will help mitigate these risks. The COVID-19 pandemic is causing the economy to contract and putting a significantly strain on the government’s fiscal position through a reduction in revenues and expansion in expenditures. On the revenue front, reforms to improve tax administration, widen the tax base, and facilitate tax compliance are critical to mitigate fiscal risks. The G20 Debt Service Standstill Initiative will provide some fiscal room through December 2020 and will help the external and fiscal position. Other reforms supported under the first pillar of this operation (fiscal and debt management and reducing the fiscal burden of SOEs) also help mitigate fiscal risks. Efforts to improve the regulatory framework for growth and competitiveness in the second pillar will support a rebalancing of the economy even in the case of weaker external demand. Also, the timing of this operation is aligned with the IMF program, which was approved in July 2019 and supports a policy framework to secure macroeconomic stability. In spite of these mitigating factors the residual risk is still high because of the macro-fiscal uncertainty induced by the COVID-19 pandemic. 134. The risks emanating from the technical design of the operation are considered substantial. This is because of the complexity in undertaking the following reforms: the harmonization of general sales tax systems across provinces, the establishment of a system to regularly update property valuation tables, and the envisioned regulatory reforms. Two characteristics of these reforms increase technical risks. Firstly, the reforms are complex and will require significant technical analysis, assistance, and consensus building to be implemented. Secondly, the prior actions fall partially or fully under the domain of provincial policy making. The technical design of the operation spans the federal and provincial governments, requiring a buy-in by both levels of the government and thereby raising implementation risks. In addition, the COVID-19 pandemic related travel disruptions are constraining the ability of the federal government and provinces to meet and resolve intergovernmental taxation issues. These risks are being mitigated by supporting institutions for effective intergovernmental fiscal coordination, the provision of complementary implementation support on fiscal management and competitiveness, and the use of technology to host virtual meetings of the National Tax Council. Despite these mitigating factors the residual risk remains substantial because of the challenges to implement politically sensitive reforms in the context of the COVID-19 induced crisis. 135. The risks related to institutional capacity and stakeholders are also high. Inadequate Intergovernmental coordination and weak fiscal institutions pose high risk for this operation. To mitigate these risks, the design of the operation takes a whole of country approach and supports institutional restructuring of the Federal Finance Division so that outcomes can be achieved. Staff turnover continues to be a significant problem in almost every government department. While the World Bank (and other donors) are providing technical assistance to reform institutions, the capacity needs are large, institutional rigidities are severe, and the turnover of trained and competent staff is high. Technical assistance delivered through trust funds can mitigate risks by building capacity. However, a long-term effort will be necessary to strengthen institutional capacity. Opposition from specific stakeholders also poses substantial risks to this operation. Such opposition can arise when the interests of special groups are affected by reforms supported by this operation, and these groups leverage governance shortfalls to influence decision-making. This can, for instance, arise when an update of property valuation tables adversely affects landowners who might then successfully initiate Page 54 The World Bank Resilient Institutions for Sustainable Economy (P171850) parliamentary resistance against the reforms. Mitigating these risks requires ensuring close coordination with government counterparts to ensure political support and consensus on the supported reforms. To mitigate this risk, the World Bank and development partners are providing a coordinated package of support, financing, and technical assistance, to help the government implement its COVID-19 pandemic response measures. Despite these mitigation factors, the residual risk remains high, especially in the context of the COVID-19 pandemic which has exacerbated capacity challenges and severely impact household’s incomes. 136. The fiduciary risks of the operation are deemed moderate. Pakistan has a well-developed PFM system and the Public Expenditure and Financial Accountability (PEFA) Update 2019 shows a positive trajectory of reforms. The PFM reform strategy aims to prioritize and focus the Government’s efforts on addressing the gaps identified in PEFA and other analytical work. The Bank will continue to support the government in strengthening the country systems through the PFM PforR project, TA and operational support. Table 9. Summary Risk Ratings Risk Categories Rating 1. Political and Governance  High 2. Macroeconomic  High 3. Sector Strategies and Policies  Moderate 4. Technical Design of Project or Program  Substantial 5. Institutional Capacity for Implementation and Sustainability  High 6. Fiduciary  Moderate 7. Environment and Social  Moderate 8. Stakeholders  High 9. Other  Moderate Overall  High Page 55 The World Bank Resilient Institutions for Sustainable Economy (P171850) ANNEX 1: POLICY AND RESULTS MATRIX DPF-I DPF-II DPF-III Results – Baseline Results – Target Objective Prior Actions Triggers Triggers Pillar I: Enhancing the policy and institutional framework to improve fiscal management Improving Prior Action 1: The Trigger 1: The FD issues Trigger 1: Federal and Reduction in the Reduction in the fiscal policy Finance Division has: (a) revised Rules of Business Provincial budgets for FY23 deviation between the deviation between the and assigned fiscal following the amendment will be aligned with the consolidated consolidated sustainability coordination to the Fiscal Responsibility MTFF prepared by MFPU government budget government budget responsibilities to the and Debt Limitation Act and approved by NFC deficit and the deficit and the National Finance (FRDLA) 2005 to: (a) Monitoring Committee medium term fiscal medium term fiscal Commission Monitoring provides legal mandate to framework approved framework approved Committee, which the Macro-Fiscal Policy by the NFC Monitoring by the NFC Monitoring comprises federal and Unit; and (b) provides for Committee Committee provincial finance automatic safeguards in ministers, based on the case of breach of ceilings as Baseline: No MTFF in Target: Less than 10 decision of the Council of per the FRDLA; and the place in FY20; Finance percent by FY23 Common Interests; and (b) Provincial Finance Bills approved without established the Macro- Departments have notified links to an MTFF Fiscal Policy Unit to be regulations for the responsible for developing implementation of the the medium-term fiscal Fiscal Responsibility Laws and budget framework enacted by provincial and fiscal risk assemblies, that are management consistent with the federal FRDLA’s amendments Enhancing Prior Action 2: The Trigger 2: The Finance Trigger 2: The Finance Publication of Publication of debt Finance Division has: (a) Division: (a) notifies the Division publishes an quarterly report on quarterly report on Page 56 The World Bank Resilient Institutions for Sustainable Economy (P171850) DPF-I DPF-II DPF-III Results – Baseline Results – Target Objective Prior Actions Triggers Triggers management transferred domestic and transfer of responsibility for annual report on public debt and cost-risk debt and cost-risk and debt external debt the choice and pricing of debt that compares debt indicators indicators transparency management and issuance retail debt instruments management strategy of guarantees to the Debt from the Budget Wing implementation with Baseline: No report Target: Semi-annual Policy Coordination Office; (through CDNS) to the targets published (FY19) (FY23) (b) mandated the DMO; and (b) issues publication of a medium- detailed rules for the DMO term debt management strategy; (c) mandated the semi-annual publication of a debt bulletin; and (d) required the issuance of sovereign guarantees for all SOEs to be contingent upon publication of previous year’s audited financial statements and submission of a detailed plan to achieve financial stability Broadening Prior Action 3: The Federal Trigger 3: Provincial Trigger 3: Provincial Land, agriculture Land, agriculture the tax base Board of Revenue has: (a) governments issue a governments: (a) increase income tax and income tax and and reducing increased the immovable notification adopting the the agriculture income tax property related tax property related tax distortions in property valuation to FBR valuation tables rates and thresholds to collection by collection by tax policy eighty-five (85) percent of applicable to Urban those existing in non- provinces as total of provinces as total of the market value for Immovable Property Taxes agricultural sectors; and (b) own source revenues: own source revenues: withholding income tax to keep the assessment extend land-based taxation 4.1 percent in FY19 >10 percent by FY23 and capital gains tax; (b) ratios at 85 percent of to uncultivated land reduced the personal market value income tax thresholds; and Page 57 The World Bank Resilient Institutions for Sustainable Economy (P171850) DPF-I DPF-II DPF-III Results – Baseline Results – Target Objective Prior Actions Triggers Triggers (c) removed the special treatment on general sales tax for five (5) sectors Addressing Prior Action 4: The Cabinet Trigger 4: The Cabinet Trigger 4: The Government Stock of PHPL debt Stock of PHPL debt the stock & has approved the Circular ratifies tariff guidelines implements the revised transferred to the transferred to the flow of Debt Management Plan, including a surcharge power sector subsidy general government general government circular debt which includes policy mechanism in accordance targeting mechanism debt stock: debt stock: in the power measures to minimize the with the Amended NEPRA PKR 0 billion in FY19 804 by FY23 sector flow, gradually eliminate Act (2020); the MOE signs Flow of Circular Debt: Flow of Circular Debt: the stock of circular debt, performance contracts with PKR 465 billion 1.8 billion by FY23 Electronic Money and Senate amended regulations to mandate the Institutions, enabling non- Payments Systems use of digital payments to Federal and provincial Federal and provincial bank institutions to issue Electronic Funds Transfer vendors from FY22 government payments government payments electronic money; and (b) (PSEFT) Act, and updates to to vendors processed to vendors processed Page 59 The World Bank Resilient Institutions for Sustainable Economy (P171850) DPF-I DPF-II DPF-III Results – Baseline Results – Target Objective Prior Actions Triggers Triggers granted five (5) licenses to the Payment Services digitally: digitally: Electronic Money Provider/ Payment System Only salaries and All salary, pensions, Institutions Operator (PSP/PSO) pensions payments and vendor payments Regulations and Foreign made digitally FY19 made by federal and Exchange Manual to provincial modernize the regulatory and supervisory framework governments will be applicable to payments digital by FY23 systems; and, the FD issues regulations to mandate the use of digital payments to vendors Creating an Trigger 9: The Ministry of Trigger 8: The PM’s Office Number of licenses Number of licenses enabling Housing/SECP issues and respective provincial issued to real estate issued to real estate environment implementing regulations Chief Ministers establish developers: developers: for developer following the promulgation through respective Nil in FY19 at least 3 by FY23 finance of the National Real Estate notifications the Federal Regulatory Authority (RERA) and Provincial Real Estate Act (2019) Regulatory Authorities based on respective Federal and provincial legislations Reducing the Prior Action 9: The Cabinet Trigger 10: The reduction of Trigger 9: The reduction of Average import Average import anti-export has adopted the National the unweighted average the unweighted average duties: duties: bias of the Tariff Policy, transferring import duty rates by 5 import duty rates by 10 Average tariffs 12.6 Average tariffs 10.77 National Tariff responsibility for trade percent and its dispersion percent and its dispersion percent, percent, Policy tariff setting to the by 5 percent with respect to by 10 percent with respect average dispersion average dispersion Ministry of Commerce and the import duty schedule in to the import duty schedule (measured as the (measured as the simplifying and the FY21 budget is gazetted in the FY22 budget is standard deviation): standard deviation): rationalizing the tariff gazetted 15.4 in FY19 13.2 by FY23 structure Page 60 The World Bank Resilient Institutions for Sustainable Economy (P171850) ANNEX 2: FUND RELATIONS ANNEX PRESS RELEASE NO. 20/167 IMF Executive Board Approves a US$ 1.386 Billion Disbursement to Pakistan to Address the COVID-19 Pandemic April 16, 2020 • The IMF approved the disbursement of US$1.386 billion under the Rapid Financing Instrument to address the economic impact of the COVID-19 shock. • With the near-term outlook deteriorating sharply, the authorities have swiftly put in place measures to contain the impact of the shock and support economic activity. Crucially, health spending has been increased and social support strengthened. • As the impact of the COVID-19 shock subsides, the authorities’ renewed commitment to implement the policies in the existing EFF will help support the recovery and strengthen resilience. The Executive Board of the International Monetary Fund (IMF) approved a purchase of Pakistan under the Rapid Financing Instrument (RFI) equivalent to SDR 1,015.5 million (US$ 1.386 billion, 50 percent of quota) to meet the urgent balance of payment needs stemming from the outbreak of the COVID-19 pandemic. While uncertainty remains high, the near-term economic impact of COVID-19 is expected to be significant, giving rise to large fiscal and external financing needs. The IMF support will help to provide a backstop against the decline in international reserves and provide financing to the budget for targeted and temporary spending increases aimed at containing the pandemic and mitigating its economic impact. The IMF remains closely engaged with the Pakistani authorities and as the impact of the COVID-19 shock subsides will resume discussions as part of the current EFF. Following the Executive Board discussion, Mr. Geoffrey Okamoto, First Deputy Managing Director and Acting Chair, made the following statement: “The outbreak of Covid-19 is having a significant impact on the Pakistani economy. The domestic containment measures, coupled with the global downturn, are severely affecting growth and straining external financing. This has created an urgent balance of payments need. “In this context of heightened uncertainty, IMF emergency financing under the Rapid Financing Instrument provides strong support to the authorities’ emergency policy response, preserving fiscal space for essential health spending, shoring up confidence, and catalyzing additional donor support. Page 61 The World Bank Resilient Institutions for Sustainable Economy (P171850) “In response to the crisis, the government of Pakistan has taken swift action to halt the community spread of the virus and introduced an economic stimulus package aimed at accommodating the spending needed to tackle the health emergency and supporting economic activity. Crucially, the authorities are increasing public health spending and strengthening social safety net programs to provide immediate relief to the most vulnerable. Similarly, the State Bank of Pakistan has adopted a timely set of measures, including a lowering of the policy rate and new refinancing facilities, to support liquidity and credit conditions and safeguard financial stability. In this context, the authorities’ policies should be targeted and temporary. “As the crisis abates, the authorities’ renewed commitment to the reforms in the existing Extended Fund Facility—in particular those related to fiscal consolidation strategy, energy sector, governance, and remaining AML/CFT deficiencies—will be crucial to entrench resilience, boost Pakistan’s growth potential, and deliver broad based benefits for all Pakistanis. “Expeditious donor support is needed to close the remaining balance of payments gap and ease the adjustment burden.” For information on the emergency financing requests approved by the IMF Executive Board, please see a link to the IMF Lending Tracker: https://www.imf.org/en/Topics/imf-and-covid19/COVID-Lending-Tracker For upcoming discussions on the emergency financing requests, please see a link to the calendar of the IMF Executive Board meetings: https://www.imf.org/external/NP/SEC/bc/eng/index.aspx IMF Communications Department MEDIA RELATIONS PRESS OFFICER: OLGA STANKOVA PHONE: +1 202 623-7100EMAIL: MEDIA@IMF.ORG @IMFSpokesperson Page 62 The World Bank Resilient Institutions for Sustainable Economy (P171850) ANNEX 3: LETTER OF DEVELOPMENT POLICY Page 63 The World Bank Resilient Institutions for Sustainable Economy (P171850) Page 64 The World Bank Resilient Institutions for Sustainable Economy (P171850) Page 65 The World Bank Resilient Institutions for Sustainable Economy (P171850) Page 66 The World Bank Resilient Institutions for Sustainable Economy (P171850) ANNEX 4: ENVIRONMENT AND POVERTY/SOCIAL ANALYSIS TABLE Prior Actions Significant positive or Significant poverty, social or negative distributional effects positive or environment effects negative (yes/no/to be (yes/no/to be determined) determined) Pillar I: Enhancing the policy and institutional framework to improve fiscal management Prior Action 1: The Finance Division has: No No (a) assigned fiscal coordination responsibilities to the National Finance Commission Monitoring Committee, which comprises federal and provincial finance ministers, based on the decision of the Council of Common Interests; and (b) established the Macro-Fiscal Policy Unit to be responsible for developing the medium-term fiscal and budget framework and fiscal risk management Prior Action 2: The Finance Division has: No No (a) transferred domestic and external debt management and issuance of guarantees to the Debt Policy Coordination Office; (b) mandated the publication of a medium-term debt management strategy; (c) mandated the semi-annual publication of a debt bulletin; and (d) required the issuance of sovereign guarantees for all SOEs to be contingent upon publication of previous year’s audited financial statements and submission of a detailed plan to achieve financial stability Prior Action 3: The Federal Board of No Marginal negative poverty and Revenue has: (a) increased the distributional impact are immovable property valuation to eighty- expected five (85) percent of the market value for withholding income tax and capital gains tax; (b) reduced the personal income tax thresholds; and (c) removed the special treatment on general sales tax for five (5) sectors Prior Action 4: The Cabinet has Yes, positive. The Yes. Measures in the Circular approved the Circular Debt Management implementation of Debt Management Plan to Plan, which includes policy measures to measures to reduce improve the sector’s financial Page 67 The World Bank Resilient Institutions for Sustainable Economy (P171850) minimize the flow, gradually eliminate commercial loses is situation can potentially lead to the stock of circular debt, and improve expected to lead to an an increase in electricity-related DISCO efficiency; and the Finance improvement in the costs for the poor and Division has issued a notification to DISCOs efficiency and vulnerable. These effects will be transfer the PHPL debt to the public debt therefore reduce analyzed and mitigation stock energy waste measures will be identified when the revised energy tariffs and the concrete actions related to subsidy reform are determined, as part of the implementation of CDMP. The implementation of the CDMP will be supported by DPF-2 and DPF-3 Prior Action 5: The Council of Common Yes, positive. The No Interests has approved the Renewable approval of the Energy Policy, which includes the Renewable Energy adoption of competitive bidding as the Policy will lead to an main procurement method increase of renewable energies in Pakistan’s energy mix Pillar II: Improving the regulatory framework to foster growth and competitiveness Prior Action 6: The National Finance No No. The harmonization of general Commission Monitoring Committee has sales taxes across the federation approved a general sales tax should not lead to an increase in harmonization framework with common tax rates, but there is a risk of taxation principles, harmonized upward adjustments during the definitions of goods and services, harmonization process. Further common place of supply rules, and a analysis will be conducted as this single rate measure is implemented over successive operations Prior Action 7: The Federal Board of No No Revenue has notified the Benami Transaction (Prohibition) Rules of 2019, mandating all commercial banks to conduct biometric verification of all bank account holders, as instructed by the State Bank of Pakistan Prior Action 8: The State Bank of No Yes, positive. Improvements in Pakistan has: (a) issued regulations for the regulatory environment for Electronic Money Institutions, enabling digital payments will unlock ways non-bank institutions to issue electronic to reach unserved populations, money; and (b) granted five (5) licenses including the poor and vulnerable to Electronic Money Institutions Prior Action 9: The Cabinet has adopted No Yes, positive. The simplification the National Tariff Policy, transferring and rationalization of the tariff Page 68 The World Bank Resilient Institutions for Sustainable Economy (P171850) responsibility for trade tariff setting to structure will allow all firms to the Ministry of Commerce and access inputs at international simplifying and rationalizing the tariff prices and foster greater structure competition Page 69