Pakistan: Contractionary FY25 budget to bring Pakistan closer to securing IMF deal
Metodi Tzanov
Helping finance professionals understand what is going on in Emerging and Frontier Markets
The federal government on Jun 12 unveiled a contractionary federal budget for FY 2024-25, which was seen broadly in line with IMF guidelines as the authorities made an all-out effort to meet prior conditions set by the global lender to secure a "longer and larger" bailout package. With a total outlay of PKR 18.9tn, the budget laid out an ambitious tax collection target, which the government seeks to achieve through expanding the tax base as well as by further burdening the already taxed sectors. In a post-budget press conference, FinMin Muhammad Aurangzeb expressed his aim to increase the tax-to-GDP ratio to 13% over the next three years, from 9.6% recorded in FY24, which he termed "unsustainable" for a country like Pakistan.
The government also showed some prudence in expenditure, with most of the increase in spending estimated to come on the back of a surge in the cost of debt servicing. Some populist measures were also included in the budget, such as an up to 25% hike in public sector employees, a 15% raise in pensions, and a marked increase in the size of the cash transfer program for low-income households.
Subsequently, the budget gap has been pegged at 5.9% of GDP in FY25, significantly down from an estimated 7.4% in the outgoing fiscal year, though much of it also depends on the provinces' ability to produce a cash surplus.
Having said that, the government avoided radical reforms that were anticipated in the run-up to the budget announcement, such as an aggressive privatization push. Instead, it appeared cautious in its approach as it sought to appease the IMF without agitating its coalition partners, such as the Pakistan Peoples Party (PPP) which already registered a strong protest with the ruling Pakistan Muslim League-Nawaz (PML-N) for not being consulted on the budget.
Hence, we believe that the proposed budget is likely to see some changes before it is approved by the National Assembly as PML-N incorporates some of the proposals from its key allies.
Macroeconomic Framework
After missing its GDP growth target for FY24 by a wide margin, the government has set a rather reasonable target of 3.6% for the next fiscal year, which would be an improvement from an estimated 2.4% growth in FY24. Industrial activity is expected to gain momentum, driven by strong development outlay, easing of supply chain woes amid further withdrawal of import curbs, and a decline in borrowing costs. Moreover, services sector growth is also forecast to accelerate sharply on the back of an overall uptick in economic activity. These gains would help offset an expected slowdown in the agriculture sector.
Political stability, absence of exchange rate volatility, steady global oil and commodity prices, and securing an IMF deal would be crucial to achieving the FY25 growth target. There is a broad consensus that an agreement is likely to be reached with the IMF for an Extended Fund Facility, most probably by August, which would help keep forex liquidity and external sector vulnerabilities at bay. Although the PPP, a key partner in the ruling coalition, would put up opposition to the government's policies every now and then, we foresee a sense of political stability to prevail, at least over the next year.
On the price front, the government projects inflation to moderate sharply to 12% y/y in FY25 from an estimated 25% y/y in FY24, largely owing to high base effect but also due to better farm supplies, restrictive monetary policy, increased availability of industrial raw materials and semi-finished goods, and exchange rate stability.
Federal Government Budget
Revenue Receipts
The government seeks to raise PKR 17.8tn in revenue in FY25, an ambitious target that will be challenging to achieve given the dampened economic activity. It represents an increase of 46% from the revised estimates of FY24. The Federal Board of Revenue (FBR) has been tasked to mop up nearly PKR 13tn in taxes, up by PKR 3.7tn collected in this fiscal year. The agency failed to meet its tax collection target of PKR 9.4tn in FY24, falling short by PKR 163bn.
While more than half of the increase in tax revenue in FY25 is seen accruing on account of inflation and GDP growth, the remaining PKR 1.8tn would be generated through new taxation measures, mainly through the withdrawal of exemptions from sales tax and customs duty as well as an increase in personal and corporate income tax. Key measures include:
Meanwhile, the government has pegged non-tax revenue at PKR 4.8tn, up 64.4% from the revised estimate of FY24. More than half of the revenue will come from the State Bank of Pakistan as surplus profit. Another PKR 1.3tn is expected to be collected from fuel tax, also known as petroleum development levy (PDL) as the maximum PDL limit on diesel and petrol has been hiked by PKR 20 to PKR 80 per litre.
The federal government will transfer funds worth PKR 7.4tn (up by 37.1% y/y) to the four provinces from the divisible pool taxes in FY25. As a result, its net revenue is projected at PKR 10.4tn in the next fiscal year.
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Expenditure
The total outlay of the federal budget is PKR 18.9tn in FY25, up by PKR 3.7tn or 24.5% from RE of FY24. The government will continue to spend the most on debt servicing, which is projected to reach a fresh record of PKR 9.8tn on the back of still-elevated interest rates and higher debt stock. Thus, almost all of the federal government's net revenue will be eaten up by debt repayments, of which PKR 8.7tn will go to service domestic debt and the remaining PKR 1tn to repay foreign loans, both principal and interest.
Defence services will remain the second biggest component of the annual expenditure, with the government allocating PKR 2.1tn mostly for salaries of personnel, military operating expenses and procurement of weapons. The renewed surge in terrorist attacks by Islamist groups and Baloch separatists and continued tensions with neighbouring nations may have necessitated an increase in defence outlay. However, the allocation does not include pensions paid to retired military personnel, which is estimated to amount to PKR 662bn in FY25, accounting for nearly two-thirds of total expenditure on pensions. This along with the lack of transparency in running the country's nuclear programme means that the PKR 2.1tn allocation for defence services does not give a full picture of the actual amount the government would be spending on the armed forces.
The government has earmarked PKR 839bn for the running of civilian administration, up by PKR 86bn y/y on the back of an up to 25% hike in salary proposed for public sector employees. Moreover, the subsidy bill is expected to increase by 27.3% y/y to PKR 1.4tn in the next fiscal year, with a major portion going to the power sector, including PKR 558bn paid to independent power producers to keep electricity tariff lower compared to its actual cost.
Sector-wise breakdown of the current expenditure shows that spending on health and education would remain broadly steady at PKR 28bn and PKR 104bn, respectively, in FY25. While these were rather disappointing, the allocation for the cash transfer program, known as the Benazir Income Support Program, has been significantly increased by 27.1% y/y to PKR 592.5bn.
Meanwhile, the government development expenditure is set to more than double y/y to PKR 1.4tn in FY25. However, doubts remain whether the amount would be fully disbursed as the government often curtails its spending on physical and social infrastructure in a bid to rein in the fiscal deficit. The Ministry of Water Resources has been allocated the highest funds of PKR 259.6bn, followed by the National High Authority (PKR 180.3bn) and the Ministry of Power (PKR 175.9bn).
Budget deficit/financing
The federal government is estimated to face a record budget deficit of PKR 8.5tn in FY25, up slightly by 1.3% y/y. However, it will be partly offset by an anticipated PKR 1.2tn cash surplus generated by provinces, which, if realized, would mark a 125.8% y/y expansion. This would help the general government fiscal deficit to reduce to PKR 7.3tn, down by 7.2% y/y. The budget gap target is equal to 5.9% of GDP, a fiscal correction of 1.5pps over the revised estimates of FY24. On the other hand, the primary budget is expected to remain in a surplus, which will rise over six-fold to PKR 2.5tn or 2% of GDP in the next fiscal year.
The government will continue to rely heavily on local commercial banks to plug its fiscal deficit. The gap will be financed through net PKR 7.8tn domestic loans, almost all of which will come from the sale of bonds. The government's increased reliance on domestic borrowing would continue to crowd out the private sector.
In contrast, dependence on foreign sources to fund the deficit will be reduced as net external financing will amount to PKR 666.3bn, down markedly by 74.6% y/y. Unlike previous years, the latest budget document provided limited details on sources of external financing. It only showed that the government plans to raise PKR 676bn from foreign commercial banks and through international bonds in FY25. Moreover, there will be a net retirement of debt owed to multilateral and bilateral creditors. Funds from the IMF are also likely to be a part of the external receipts, in our view.
Lastly, some PKR 30bn is targeted to be generated from the privatization of state-owned assets. FinMin Muhammad Aurangzeb informed the parliament that the government aims to complete the bidding process of loss-making Pakistan International Airlines (PIA) by August. We remind that six companies are in the?race?to buy the national air carrier.
Conclusion
Overall, the budget for FY25 in its current form should be acceptable to the IMF. The primary budget surplus target for the next fiscal year is much higher than the lender's projection of 0.4% of GDP, which it spelt out in its staff report released in April. The government ticked almost all the right boxes to comply with IMF conditions, including withdrawal of tax exemptions, raising corporate tax for exporters, increasing the personal income tax rate, tightening the noose around non-filers, and hiking fuel tax.
Although the businesspeople and industrialists expressed reservation over the budget, terming it an IMF-dictated budget that would take a toll on their competitiveness, the market reacted positively to it, with the Karachi Stock Exchange hitting an all-time high on Thursday, rising by 4.7% from the previous day. However, analysts attributed the gains mostly to the government's decision not to raise the capital gains tax as expected earlier.