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•  Floods have hit economy hard; preliminary estimates put losses at USD 4bn (2% of GDP)
•  Expected FY11 GDP growth forecast to 2.5% from 4.5%
•  Expected FY11 inflation forecast to 15% from 12%
•  Higher remittances, FX aid inflows cushion PKR; IMF funds critical to medium-term stability
•  Fiscal deficit could jump to 6.5% of GDP from 4% target; tax reforms and cuts in power subsidies
   are high on the agenda

Floods cause widespread damage
Heavy floods in the Indus River resulting from monsoon rains have caused widespread damage to the economy. The scale of the devastation caused by the floods is staggering. Nearly 20mn people have been displaced, making this one of the worst natural disasters in history. Nearly 1.25mn houses have been completely destroyed, leaving most of the affected households without shelter.

Losses to the economy are estimated at close to USD 4bn (2% of GDP). We now expect a significant slowdown in GDP growth in FY11 (ends June 2011) and lower our growth forecast to 2.5% from 4.5%; this would follow growth of 4.1% in FY10. We also now expect FY11 inflation to jump sharply to 15%, versus our earlier forecast of 12%, depending on the extent of damage and the measures taken by the government to reconstruct and rebuild the affected areas. However, the details will be known only after the completion of a damage assessment report jointly initiated by the World Bank and the Asian Development Bank (ADB), due in October.

Table 1: Pakistan - key macroeconomic indicators

Losses to agriculture and livestock
Floods have caused widespread damage to the standing crop. The Ministry of Food, Agriculture and Livestock (MINFAL) estimates losses to the agriculture sector at USD 2.8bn, while another USD 450mn in losses are estimated in the livestock sector.

1. The cotton crop, the country’s main cash crop, has suffered the most, with an estimated 2.25mn bales destroyed, a loss of USD 835mn. Initial estimates for the cotton yield this year were close to 14mn bales, but the current estimate is closer to 11.75mn bales.

2. Rice crops of close to 1.6mn tonnes were destroyed in the floods, inflicting a loss of USD 660mn. Initial estimates for rice production were 6.9mn tonnes in FY11, but this has been revised to 5.3mn tonnes.

3. The sugar crop also sustained significant damage, with an estimated 7.6mn tonnes of sugarcane destroyed in the floods. The economy will lose USD 226mn from this. Initial estimates for sugarcane crop were 58.4mn tonnes; this has now been revised down to 47.2mn tonnes.

4. Damage to the production of vegetables, fruit and pulses is estimated by MINFAL at USD 1.14bn. The total area under plantation is 2.8mn hectares and the devastated area is 0.6mn hectares.

5. The livestock sector has also been hit hard, with MINFAL predicting losses of USD 450mn. Nearly 2mn head of livestock have perished in the floods, while the hit to the poultry sector is estimated at USD 100mn.

Infrastructure damage
The floods have also damaged public infrastructure, with road links cut off, power stations shut down, and gas and petroleum supplies suspended. More than 2,500 schools, 175 health centres and 1,000 water-supply facilities have been damaged, according to the National Disaster Management Agency (NDMA). The National Highway Authority (NHA) estimates countrywide losses incurred from the recent floods at USD 70mn, with several of the country’s main highways badly damaged and in need of urgent repairs. 36 key bridges have been destroyed, disrupting the supply of goods to many villages and towns.

Pakistan Electric Power Company (PEPCO) has stated that it suffered a loss of more than PKR 10bn (USD 120mn) to its installations across the country owing to the floods. Three water-hydel generation stations – Jigran (30 MW), Malakand (80 MW) and Chashma (160 MW) – suffered significant damage and have been shut down. The floods also hit three thermal power plants: Pak-Gen (350MW), ASE Lalpir (350MW) and KAPCO (1386MW), although the exact nature of the damage is unknown. This could exacerbate the demand-supply gap, which is estimated by the National Electric Power Regulatory Authority (NEPRA) at 4052MW. This gap could widen to 5000MW, further damping economic growth prospects.

Inflation on the rise
We now expect inflation to average 15% in the current fiscal year, up from our previous forecast of 12%. This is because of the damage to the food crop and the disruption of supply of essential food commodities to various flood-affected parts of the country. The government’s chief economic advisor issued a warning that without urgent measures, the impact of the floods could cause inflation to sky-rocket to close to 25%, from 12.4% in July 2010. The other risk to inflation comes from the government’s printing money to finance spending on rehabilitation and reconstruction, adding to the money supply. During the first six weeks of the current fiscal year, the government printed PKR 134bn (0.8% of GDP) of new money from the central bank to finance its deficit.

Monetary policy will remain hawkish given inflation concerns. The central bank hiked policy rates at its July 2010 meeting in a pre-emptive move to counter inflationary pressures; we see a further 100bps of rate hikes in the current fiscal year. However, the central bank will balance inflation concerns with concerns about the slowdown in growth, and will likely wait to hike further until there is more clarity on the extent of the economic damage from the floods.

Fiscal deficit likely to be higher, at 6.5% of GDP
Government finances were already in bad shape before the floods hit: the FY10 deficit touched 6.2% of GDP, versus the target of 4.9%. The FY11 budget initially targeted a deficit of 4% of GDP, but the central bank has voiced scepticism about this target and estimated that even in the best-case scenario, with the government achieving its ambitious tax targets and FX aid commitments, the deficit would be 5% of GDP. The costs of relief, rehabilitation and reconstruction will be significant. We now expect the fiscal deficit to rise to 6.5% of GDP in FY11, depending on the scale of the damage and the inflow of foreign grants.

The government will need to create fiscal space to pay for relief, rehabilitation and reconstruction expenditures and limit the build-up of public debt. The immediate measures announced by the government include freezing investment spending to FY10 levels and allocating PKR 153bn (0.9% of GDP) for flood-related spending. However, the government will need to undertake significant fiscal reforms, including introducing a sales tax aimed at boosting tax revenues by PKR 86bn, to fund reconstruction activity. Power-sector subsidies are also expected to be phased out, bringing an additional savings of PKR 127bn (0.7% of GDP).

Increased downside risks to the PKR
Downside risks to the Pakistani rupee (PKR) have increased considerably because of the floods. The trade deficit is anticipated to rise sharply on account of higher imports of food and other essential commodities. Exports of rice, cotton and value-added textiles are all likely to decline as a result of damage to crops. The impact of the floods on the current account deficit could be as high as USD 2bn, depending on the scale of the devastation and on private and official FX aid inflows. So far, the PKR has remained stable thanks to higher worker remittances, as expatriates send more cash to affected families and for flood relief activity.

Large FX aid flows may be able to cushion the economic impact of the floods. So far, the response from donor agencies has been slow, according to the NDMA. Aid of only USD 142mn has come in, against pledges of USD 952mn made during a recent UN conference. The ADB has committed to a USD 2bn soft loan for reconstruction spending, and the World Bank has committed USD 1bn. However, this aid money has been diverted from other projects, and does not constitute new aid commitments. Hence, the downside risks to the PKR are high and are likely to be only partially covered by FX aid. The key for the medium-term PKR outlook is the release of the IMF funds.

Relations with the IMF critical to medium-term stability
Relations with the IMF hit a road block in June 2010, after the government missed key performance targets in areas including the fiscal deficit, borrowing from the central bank and implementation of the value added tax (VAT). Disbursement of the remaining USD 2.6bn of the USD 11.3bn IMF loan, initially expected in September, is widely expected to be delayed. However, in the aftermath of the floods, the IMF is expected to relax some of its targets and release the next tranche of USD 1.3bn. This will provide short-term support to the PKR, but a new IMF loan facility will be badly needed to provide medium-term support for the currency. In this regard, the IMF has offered Pakistan access to the Emergency Financing facility for natural disasters, with a limit of 20% of the country’s Special Drawing Rights (SDR) quota. This comes out at close to USD 600mn, given the country’s quota of 1.85bn SDRs.

While Pakistan’s short-term economic prospects are worrisome, reconstruction spending over the medium term will provide a significant boost to domestic output. This was the case in the aftermath of the 2005 earthquake, which caused an estimated USD 6.4bn loss to the economy. The short-term impact on growth was negative, with growth slowing to 5.8% in FY06 from 9% in FY05. However, the economy received a boost in the subsequent two years, expanding by an average of 6% per annum, primarily owing to reconstruction spending.

The writer is an Economist with the Standard Chartered Bank and holds a Masters in Economics from School of Oriental & African Studies, University of London. This Article is based on a report recently prepared by Mr. Sayem Ali. Comments may be directed to editors@counselpakistan.com.