Pakistan : Oil prices pose challenge to outlook

After two years of strong growth, low inflation, and strengthening fiscal and external accounts the Pakistan economy faces a number of challenges. Inflation is at a six-year high, the trade deficit has trebled, the current account surplus has more than halved. The current major threat to the outlook is high global oil prices.

Inflation has very clearly trended sharply higher in the past couple of months. According to data for June, the annual rate of consumer price inflation ended FY03/04 at 8.45%, pushing average annual inflation to 4.57% for the year, as against an official target of 4%. In July annual inflation hit 9.3%, more than double the target of 5% for FY04/05.

Two key factors are responsible for the increase: sharply higher food prices; and increased fuel costs. In the case of food, the problem stems from difficulties with wheat production, which have been compounded by the government's slow response to supply problems. In terms of fuel costs, inflationary pressures are unlikely to go away. Since May the government has subsidised domestic fuel prices, a policy that cannot continue indefinitely. Beyond these two key items, core inflation is less of a concern, although with economic growth projected to accelerate to nearer 6.6% in FY04/05, the risks to the inflation outlook are likely to remain on the upside.

High global oil prices are partly responsible for the dramatic deterioration in the trade and current account positions in FY03/04: oil accounts for approximately 28% of Pakistan's import bill. The end of the Saudi Oil Facility under which Pakistan imported around 60-80,000 barrels a day of oil on a deferred payment basis is a further factor. However, the overall pace of economic activity and attendant strong demand for imports, is also swelling imports. Despite continuing strong remittance inflows the current account surplus, which slumped to USD 1.8bn in FY03/04 versus USD 4bn a year earlier, is likely to deteriorate further this fiscal year (ending June 2005).

Concerns about inflation and the current account have been felt in the currency markets where the Pakistan rupee has fallen to two-year low against the US dollar in recent weeks. It is expected to remain under pressure due to high oil price and hefty debt repayments scheduled for the Oct-Dec quarter. Despite such pressures the SBP will seek to hold down long-term interest rates, though short-term TB rates will remain under pressure.