Pakistan

RISK ASSESSMENTS

POLITICS

Government Stability
Dim Prospects for Greater Stability
President Asif Ali Zardari and his Pakistan People’s Party (PPP) remain in control of the government, but the risk of instability remains quite high, as both the president and Prime Minister Yousaf Raza Gillani struggle to maintain their grip on power while attempting to fend off crises on multiple fronts.  The government has become paralyzed in the face of competing pressures to address the growing threat of terrorist violence, relieve economic hardship, and move ahead with unpopular reforms, and its problems have been compounded by maneuvering by parties within the unwieldy governing coalition and a steep drop in the PPP’s popular support.
A large portion of the electorate has come to doubt the government’s competence owing to its poor handling of a flood disaster in 2010, and the main opposition Pakistan Muslim League-Nawaz (PML-N) has wasted no opportunity to fan the fires of discontent over the administration’s tolerance of US drone attacks against Taliban and Al Qaeda militants encamped in Pakistan’s western frontier provinces.  The content of classified US documents made public by Wikileaks has merely reinforced negative sentiment toward the president, as well as already strong anti-US sentiment, which has become overwhelming following an incident in which a US diplomat (who more recently has been revealed to have been a US intelligence operative) shot and killed two Pakistanis he claimed were attempting to rob him.
PML-N leader Nawaz Sharif, himself a former prime minister, is not exactly revered among large sections of the population.  Like Zardari, he too is closely identified with the problem of endemic corruption in Pakistan, and the revelations contained in the Wikileaks documents did little to improve his public image.
Even so, there is little doubt that Sharif and his party could topple the PPP-led government if they had any strong desire to do so.  The fact that they have not suggests that Sharif is biding his time, most likely in the hope that the PPP will continue to incur political damage as long as it remains in power, thereby increasing the PML-N’s chances of claiming an indisputable mandate at presidential and parliamentary elections that must be held by September 2012 and January 2013, respectively.
Another consideration that is undoubtedly discouraging hostile moves against the PPP-led government is Sharif’s fear of provoking intervention by the military, which brought an early end to the PML-N leader’s previous turn in government in 1999.  Indeed, there is reason to believe that the military might be inclined to take pre-emptive action to prevent the PML-N’s return to power.
Thus far, Gen. Ashfaq Kayani, the top commander of the armed forces, has honored his pledge to respect civilian rule.  However, he has used his substantial influence to apply pressure on the current regime.  In late September 2010, Kayani met with President Zardari and Prime Minister Gillani to discuss the government’s inadequate response to the flooding disaster.  Local reports indicated that Kayani warned the civilian leaders that the military brass was losing patience with the current regime.  Tellingly, Zardari’s office felt compelled to issue a statement following the meeting to the effect that there was no imminent threat of a coup.
However, US diplomatic cables released by Wikileaks indicate that military leadership already has a plan in place to engineer a transfer of power if Zardari cannot meet the responsibilities of his office.  According to a cable from March 2009, the general told the US ambassador that he would prefer to keep the military on the political sidelines, but he “might however reluctantly” push Zardari to step down, in which case the presidency would be filled on an acting basis by Asfandyar Wali Khan of the Awami National Party.  Beyond the obvious implications of the communication, the cable corroborated the widely held suspicion that Kayani views Zardari to be unsuited for his position, but that he distrusts Sharif.
Investment Profile
Aid Jeopardized Following Retreat on Tax Reform
Despite revelations that US diplomats are deeply skeptical of the Pakistani government’s willingness or ability to fulfill its bilateral obligations, US President Barack Obama has confirmed his commitment to maintaining the flow of aid to Pakistan.  However, as with much of the disaster-related aid pledged by the international community in the wake of last year’s deadly floods, the promises of new funds from Washington have been accompanied by demands for improved transparency in the use of foreign financial support, a substantial portion of which is lost to corruption.
International donors have also demanded that the government increase its own contribution to the rebuilding effort by raising tax rates.  At less than 10%, Pakistan’s tax-to-GDP ratio is among the lowest in the world.  In November 2010, the Cabinet approved a temporary flood surcharge and a reformed goods and services tax (RGST) that the National Planning Commission estimated would push the tax ratio up to 11% by 2013.
Unfortunately, two of the parties in the governing coalition defected in protest over the tax measures and a planned reduction in fuel subsidies, costing Gillani his parliamentary majority.  One of the parties returned, restoring the government’s majority, after Gillani agreed to renew the fuel subsidies and drop the RGST.
While the government’s retreat has bolstered its chances of survival, it has jeopardized Pakistan’s relationship with the IMF, which has agreed to a nine-month extension of the two-year, $11.8 billion standby agreement concluded in late 2008, but is withholding the last two tranches of the loan (totaling about $3 billion) pending the approval of tax reform.  The effective suspension of IMF support has prompted other multilateral agencies to withhold aid and loans, a development that will make it all the more difficult for the government to address the needs of those displaced by last year’s flooding, and increases the likelihood that the budget deficit for the fiscal year ending in June 2011 will significant overshoot the target established under the standby agreement with the IMF.
Although the IMF has displayed a great deal of flexibility with Pakistan, the resumption of financial support will require some show of good faith on the party of the PPP-led government.  The sad truth is that the regime appears to lack the ability to follow through on even a token gesture of reform.
ECONOMY
Economy Struggling
Delays in accessing foreign aid will worsen an already troubling economic outlook.  The damage caused by the flooding in August 2010 all but precluded any chance that the growth rate in the fiscal year to June 2011 would come close to the 4.1% pace set in 2009/2010.  The budget deficit is on track to top 7% of GDP in the current fiscal year (compared to a revised target of 4.7% set by the IMF), and total foreign debt stood at more than $55 billion as of January 2011, an increase of 37.5% in the three years since the PPP-led government came to power.  The central bank has warned that Pakistan will be courting economic disaster unless immediate steps are taken to rein in the fiscal deficit and check the growth of the debt burden.  Unfortunately, the government will be too busy fighting for its survival to devote much energy to heading off a crisis.
The chronic problems that have long held economic performance below potential will be evident again this year.  Security concerns will deter investment, rampant corruption will siphon off funds that might otherwise have been put to productive use, power shortages will disrupt manufacturing operations, and high inflation will dampen the positive contribution of private consumption.  The post-disaster rebuilding program holds the potential to boost public consumption and investment, but the uncertain timetable for the disbursement of IMF and donor funds points to reduced benefits on that score in the current fiscal year.  Overall, real GDP growth is forecast to slow to just 2.3% in 2010/2011.
Double-digit inflation will persist in 2011, reflecting the combined effects of flood-related supply shortages, the depreciation of the rupee and higher commodities prices, and heavy spending (and domestic borrowing) by the government.  Healthy inflows of remittances have contributed to the accumulation of foreign-exchange reserves, providing the central bank with some room to intervene to stem the decline in the value of the currency.  On balance, the inflation rate is expected to ease to 11.1% this year, but the risks to the forecast are heavily weighted toward the upside, as a prolonged delay in securing fresh international financial support could send the rupee into a steep slide.
The trade deficit is expected to widen in 2011, as prices for key imports rise and external demand weakens.  Continued strong flows of remittances will limit the risk of a dangerous expansion of the current account shortfall, which is forecast to grow to $4.2 billion this year, equivalent to less than 3% of GDP.