Summary: The honeymoon between Nawaz Sharif and Pakistani public

opinion did not last long; now Sharif faces his inability to control or
restrain the army and the failure of both his policies towards India and
towards the Pakistani Taliban. On the economic front the IMF loan is only
providing temporary respite, as the currency remains under heavy
pressure and efforts to resolve the power generation sector crisis seems
to be leading nowhere.
Honeymoon over
Nawaz Sharifs insistence in improving relations with India is creating a lot
of trouble for him, as the Pakistani army is expressing its hostility to his
plans by pursuing an increasingly aggressive policy in Kashmir, where
cross-border raids are more and more common. Out of 150 violations of
the ceasefire since 2003, 40 have taken place in just 30 days this autumn.
The Indian government is particularly upset because there are elections in
2014 in India and the nationalist BJP is mounting a serious challenge for
the ruling Congress, so Indian Prime Minister Singh is publicly attacking
Sharif for his failure to restrain his own army. It all looks likely to end up in
a miserable failure for Sharif.
Sharif is also achieving little in terms of reaching a peace settlement with
the Pakistani Taliban; the killing of Hafizullah Mehsud in November might
have been the nail in the coffin of negotiations; cynics say that the
Americans deliberately killed him in order to forestall an agreement, which
would have diverted the Pakistani Taliban towards Afghanistan. Then later
in November another strike killed some commanders of the Afghan
Haqqani network, a protg of the Pakistanis, and one of the Haqqanis
himself was assassinated in Pakistan by unknown hands. In Washington
there is dissatisfaction for what the Pakistanis have been able to bring to
the table in recent months in terms of negotiations with the Afghan
Taliban and some suspect the Pakistani game is to buy time, appease the
Americans but without really delivering much to them, just enough to get
the IMF to release the US$ billions Islamabad needs. Perhaps the
Americans have decided to up pressure on a beleaguered Pakistani
government?
Sharif also faces pressure from Iran. After relations between the two
countries improved greatly under the PPP government, Sharif is suspected
by the Iranians of being too dependent on Saudi support. In November a
raid carried out from Pakistani territory by a radical Sunni Islamist group
killed 14 Iranian border guards. Perhaps the Pakistani authorities had no
role in it, but questions will surely be asked, particularly at a time when
Islamabad is trying to convince the Iranians to fund the whole cost of

building the planned Iran-Pakistan gas pipeline, because Islamabad dos

not have the money itself, even if it desperately needs the pipeline to
start addressing its energy shortages. Inside Pakistan there is
considerable opposition to the project anyway, in part motivated by the
desire to please Washington and the Saudis, but also by the belief that
there are more viable alternatives, like investing in renovating hydropower
dams. Dams are expensive, but run cheaply once they are built, while
Iranian gas would be relatively expensive compared to Pakistans own gas.
But the IMF is happy
At the same time the Pakistani rupee is under growing pressure and the
government has been responding by selling dollars, but critics argue that
this is a short term response which does not address the roots of the crisis
of confidence. The government remains committed to high interest rates
to defend the ailing currency, but this inevitably goes at the expense of
economic growth. The 35% reduction in subsidies, enforced by the
government under IMF pressure, is driving inflation up; the rate hit 9.1% in
October, the highest level in 16 months. Inflation has been concentrated
mainly in the food (18.6%) and clothing and footwear (14.6%) sectors.
Only the IMF is praising Sharif, even revising the GDP growth forecast for
2014 upwards, from 2.5% to 2.8%. The IMF also praised the plan to
privatise 32 state-run companies, including two large gas companies, the
state oil company, a few banks, Pakistani International Airline, and the
power distribution companies.

Summary 2013
Pakistan has been anything but a frequent source of good news in recent
years, but the start of the year was quite catastrophic for the country, to
the point that some observers are beginning to think that what seemed
unconceivable a few months ago, a new military takeover, is perhaps not
so unrealistic anymore. Even some sections of the press are voicing their
disappointment in democracy and their hope for a benevolent dictator
but the last one of that description General Musharraf is currently under
arrest by order of the judges and worse, has inevitably now become the
object of the revenge of the current prime minister Nawaz Sharif, whom
he displaced during his takeover of the state, in which ever-present
corruption had apparently reached the depths, with the then Sharif
government leading the way.
Incidentally, over the years when Musharraf was in charge, he had a firm
hand with the Islamist terrorists as well as with public corruption. It was
the last time in which Pakistan looked to the outside world, as though it

might have a future as a nation state, rather than the crippled,

dysfunctional, disaster that it has become.
The headlines in the dying days of the PPP government, were first and
foremost the news that the Supreme Court had ordered the arrest of yet
another Prime Minister, this one being Raja Pervaiz Ashraf and 14 others,
on the ground of corruption. This was the third Prime Minister in a row lost
by the PPP and the first one to be effectively arrested. Some PPP faithful
saw a conspiracy against their party in this (of course, not without some
justification), but many Pakistanis saw instead the demonstration that the
political elite cannot find a prime minister clean enough to keep his job.
Although these incidents to some extent strengthened the opposition PMLN, in reality many Pakistanis are perfectly aware that that party too in
terms of corruption, is just as deeply mired as the PPP, probably on their
record, worse.
The crisis of the political establishment is offering opportunities to political
entrepreneurs who had been on the margins until now. One is the great
cricketer Imran Khan, who was expected to do well in the forthcoming May
polls, but did so-so, his popularity already seems to be peaking out and he
is seen by some as altogether too cosy with the Pakistani Taleban, in his
mountainous Khyber constituency. Another is Tahir Al Qadri, a moderate
cleric who has been trying to kick-start a grass-roots anti-corruption
government and advocates a government of technicians and
professionals; he led the occupation by thousands of protesters of
Islamabads centre, asking for the government to quit straight away. The
fact that the armed forces leadership remained silent during the
demonstrations suggests some sympathy for Qadri and his aims; perhaps
rather than taking power directly, the army would find it more convenient
to support a non-political civilian experts government. Qadris
mobilisation effort was well funded and he openly praised the judiciary
and the army, while bashing politicians. Qadri had also backed
Musharrafs coup in 1999. The malaise is felt at all levels of Pakistani
society. Despite Pakistans massive investment in the security sector,
Pakistanis feel more and more insecure. There are now hundreds of
private security companies in Pakistan, employing 300,000 armed guards!
It is another post-retirement career for army officers. Most of these
companies are owned by former generals.
The Zardari government was also under fire because of the terrorist attack
in Quetta, targeting the Hazara minority, which caused a slaughter. There
were allegations that the intelligence services had some information about
the forthcoming attack, but did not manage to pre-empt it. In reality,

these indiscriminate terrorist attacks are difficult to prevent, but in an

electoral campaign everything is licit to gain some ground with the voters,
so the opposition is lambasting the government.
On the political front the most widely noted development back in April was
the judiciarys move against the renascent Musharraf. The former
dictator and Army Chief of Staff returned to Pakistan to run in the
parliamentary elections, (not normally the behaviour of a dictator), but
anyway the judiciary issued an arrest warrant against him and banned
him from running. The move was widely seen as a sign of defiance of the
judiciary vis--vis the army, these being the two most powerful sectors in
the state, way ahead of the elected politicians.
In the May elections the PML-N got almost a third of the vote and just
under half the seats, while the former governing PPP with less than 15%
was actually overtaken by the shiny new PTI of Imran Khan, in terms of
the popular vote (16.7%). In terms of seats the PPP did marginally better
thanks to the concentration of its votes in Sindh; it took 31 seats to PTIs
28. The PTI did not do as well as some expected, but still had only one
seat in the previous parliament; it took most of its seats in the KP region,
where its campaign in favour of supporting jihad in Afghanistan struck a
chord. Given the very weak performance of the PPP government in the
context of deep economic and political crisis, the punishment inflicted by
the voters is hardly surprising. The PML-N will now probably form an
alliance with some of the smaller parties as the PTI does not seem inclined
to enter a coalition. The PML-F, a splinter faction of the PML which
contested the elections separately, and the small National Peoples Party
agreed to join in. While people celebrate Pakistans first successful
democratic transition after some 60 years, expectations of the now-inoffice PML-N government were muted, given their past record in office.
Some of the first positions taken by the incoming PML-N have created
some surprise and seem to augur a new season of friction with the armed
forces. They have for example stated that they want the process of
normalising relations with India to resume from where they left it in 1999
(when they were removed from power in a military coup). Nawaz Sharif,
the Prime Minister, has also promised an enquiry into the Kargil operation
(1999), which started a border war with India and could easily have
escalated further, (they will blame General Musharraf).
Finally he seems also intentioned in keeping the defence ministry for
himself, a sure sign that he has something in mind. Soon the chief of staff
of the armed forces, Kayani, will be up for replacement and there is

interest in what Sharifs choice will be.

The real hurdle for Sharif will be the nomination of the new Chief of Staff
of the army in November. Sharif still retains the Defence Ministry for
himself, in an attempt to show his determination to keep the army under
control. The names being circulated for the November appointment
include Lt Gen Rashad Mahmood, currently chief of general staff; Lt Gen
Tariw Khan, known for being in favour of better US-Pakistani relations; and
Lt Gen Haroon Aslam, currently the armys number 2.
Otherwise Nawaz Sharif is for now enjoying a honeymoon with Pakistani
middle class opinion even the liberals are willing to give him a chance as
the best hope the country has got, after the greatly disappointing PPP
government. The honeymoon is not expected to last long, however. Sharif
is unlikely to do much to extend the tax base of the country as a
billionaire with roots in the steel industry, he pays just US$10 a year in tax
himself! But some argue that Sharif, as an industrialist, should do better
than Zardari and his team, at managing the economy. Sharif and the PMLN have said they will prioritise the resolution of the power shortage crisis
and have already a team led by businessmen working on a plan to
increase the productivity of the energy sector, which has in theory the
capacity to produce enough energy for Pakistan. In general the PML-N has
promised to appoint a number of technocrats to key ministries like energy,
or at least people with a technical background. On the political front,
Sharif has long had a record of appeasement with militants and terrorists,
which his region (Punjab) produces and exports to the rest of Pakistan.
From Sharifs statement, he is likely to continue along his old line of
appeasement.
With the PPP in disarray and Imran Khan hospitalised, Nawaz Sharifs
political position appears very safe. Could the army find another vehicle to
threaten Sharif without having to stage a military coup? Former dictator
Musharrafs return to Pakistan has so far failed to re-launch his political
career. The Chaudry brothers, who helped him set up the PML-Q during his
years in power, have kept their distance from him, forcing him to form a
new political party as his vehicle, towards taking back a role in Pakistans
politics, the All Pakistan Muslim League (APML). In fact even the PML-Q is
now quite marginal in the Pakistani political scene, with just 2 seats in
parliament, but it was always a vehicle for Musharraf..
The new governments international policies are only beginning to take
shape. Despite strong US pressure, the Sharif government has decided to
go on with the Iran-Pakistani gas pipeline project. Sharif has also

reiterated his promise to end US drone strikes on Pakistani territory.

Despite expectation of tensions with Washington, relations improved
rapidly after Sharif took charge. After initially agreeing to a US$5.3 billion
loan to Pakistan (Islamabad had asked US$7.2 billion), the IMF decided to
raise its loan to US$6.6 billion, conditional on fiscal reforms being
implemented. So far the Pakistani government cut electricity subsidies
and started chasing up tax evaders. Although Nawaz Sharif has been more
successful than expected with the IMF, the worry in Pakistan remains that
the ruling elite might once again fall into the trap of relying on foreign
borrowing, to fill the gap in public finances. With foreign debt at over
US$50 billion already, half of the state budget is already funded with
foreign loans and with just 2% of the population paying any tax, the path
is clearly unsustainable. Most tax revenue comes from the oil and mobile
telephone sectors. There is now pressure on the government to tackle the
issues of loss making state run enterprises, which altogether are costing
the country 500 billion rupees annually. The IMFs generosity was the
result of pressure from Washington and might in part be a reward for
Pakistans greater collaboration in trying to open up negotiations with the
Afghan Taliban.
The Sharif government is playing an active role in connecting the Afghan
Taliban to Washington. Islamabad has been hosting meetings between US
and Taliban representatives and has been putting pressure on the Taliban
concerning the need to open formal talks with Washington. Sharifs
government has been able to assert its own role in these talks and in
handling the Afghan Taliban vis--vis the army. Whether these talks will
achieve anything or not is too early to say, but the Pakistanis have been
making some significant concessions, including the release of Mullah
Baradar, the most senior Taliban detainee, whom they had always refused
to release previously. Washington seems set to further reward Islamabad
with the release of US$1.6 billion of military and civilian aid. Despite the
hostility of public opinion, therefore, Sharif seems to intend to keep
moving down the road of dtente with Washington.
Saudi Arabia too is coming to Pakistans succour: the Saudi Islamic
Development Bank Group Ltd pledged a US$997 million credit line and a
$200 million trade facility for Pakistan to buy petroleum products. In this
way Islamabad should be saved from a default: it has now only US$5
billion in reserves left, which would last only for five weeks. There are
many who see Nawaz Sharif as Saudis man. He spent years in
comfortable exile there before returning to Pakistan. The issue of the
Sunni bomb seems to have been concluded with him whereby if Saudi

came under nuclear threat from Iran or whoever, and the Saudis needed
a credible response. Then there are warheads assigned to them in
Pakistani military depots, giving the Kingdom a credible nuclear response
to any threat, without having to go through the internationally supervised
process of seeking to develop their own hardware, that is at the source of
US Iranian standoffs. The Kingdom after all largely paid for the Pakistanis
achieving nuclear status
As a reward for growing Pakistani collaboration, the White House seems
open to a deal over drone strikes inside Pakistani territory. In fact in recent
months US drone strikes in Pakistan have declined considerably, probably
a result of deliberate restraint. Nawaz Sharif has also a reputation of being
genuinely keen on pacification with India, in the hope of allowing trade
between the two countries to grow many fold from the current US$2.35
billion (already up on 2011 when it was US$1.94 billion), but on this front
he has so far been far less successful, as the Pakistani army is opposed to
any such opening and has made its views clear by stoking up tension on
the Indian border. The renewed violence could well get much worse as
militant groups are believed to be getting ready to redeploy away from
the Afghan border towards Kashmir once again.
In the meanwhile Sharif is also intent on strengthening ties with China. In
July he visited China and signed several economic agreements, which will
bring more Chinese investment to Pakistan. Trade between the two
countries already reached US$12 billion last year. Sharif remains also
committed to his policy of appeasement with Pakistans militants and
proposes peace talks, which have proven controversial in the past.
The June IMF forecast saw the Pakistani economy growing 3.5%in 2012/13,
a low rate for a country like Pakistan, whose population grows at 1.8% per
year. The most immediate problem of the new government, however, is
that foreign currency reserves are shrinking so fast that Pakistan might
not even be able to meet its US$6.5 billion debt repayments due in the
2013/2014 fiscal year. Currently the reserves stand at US$6.5 billion, but
they halved over the past year and continue falling at the rate of about
US$500 million a month. The Nawaz Sharif governments economic plans
are being viewed favourably by rating agencies and lenders. The plan is to
boost investment through cutting 34.5% of the money spent on subsidies
and improved tax collection; the latter should be achieved by relying on
energy consumption to identify large firms and tax them. There is also talk
of closing tax loopholes. Sharif wants to cut by a third the nondevelopment federal budget. The government also has plans to turn
around loss- making state firms such as Pakistan international Airlines;

Pakistan Steel Mills; and National Shipping Corporation. In the energy

sector, Sharif wants to make an emergency cash injection of US$5 billion
to resolve the issue of payment arrears, which has paralysed the sector
for years. He hopes to fund the plan through the sale of treasury bills.
Finally if the reforms get under way, Sharif plans to approach the IMF
again and negotiate a new loan. The hope is that three months from now
the scope of the reforms will become clear and therefore convincing the
IMF to come back, would be easier. Pakistan will probably seek US$4.5
billion from the IMF, followed by another US$6 billion to be borrowed from
other international lenders.
Some commentators however point out that the planned structural
adjustment, corresponding to 2.5% of GDP, will negatively affect an
already struggling economy and further reduce growth. The new
government also plans to increase tax collection back to close to 10% of
GDP in the short term and to 15% by 2018, despite the slowing economy.
In part this is to be achieved through an increase of the general sales tax
from 16% to 17%. The corporate tax rate, however, is to be cut from 31%
to 30%. These are key IMF demands, on which the previous government
failed to deliver. The plan also assumes that US$3.1 billion, owed to
Pakistan by the US government, Etilasat and others will be recovered. It
appears likely that the IMF will also ask Islamabad to allow for a further
devaluation of the rupee, which has already lost 40% of its value to the
dollar. Electricity tariffs will be increased and expenditure on health and
education, already very low, have been cut further. An attempt to freeze
public sector wages caused a huge outcry and the new government was
forced to concede a 10% pay rise (still below the 13% inflation rate).
The budget presented to the National Assembly plans to spend US$36.4
billion, over a quarter of which is to be borrowed. Public spending has
been slashed by US$3.8 billion, in order to bring the deficit to 6.3% of
GDP, from 8.8% of the previous budget. The government promises that by
2016 the deficit will be down to 4% of GDP. The military budget, in a
reminder of where real power lays in Pakistan, got a 15% increase.
Some disagreement between the World Bank and IMF in forecasting the
Pakistani economy emerged in October. The World Bank estimates that
GDP will grow at 3.5% next year, while the IMF believes growth will not
exceed 2.5%. The Asian Development Bank situates itself in between, with
a 3% growth forecast. While the IMF and the ADB believe that the
austerity requested by the IMF will slow the economy down, the World
Bank believes that the strong message that these measures represent will
encourage investment. In the meanwhile however foreign reserves are

down to just 1.2 months-worth of imports, due to debt repayments.

The budget deficit reached, according to the International Monetary Fund
8.5% of gross domestic product in the last fiscal year, more than double
the official target. The IMF also projects GDP growth at 3.5% for the
current year, versus 4.3% forecast by Islamabad. Foreign currency
reserves, one the most closely watched indicators of Pakistani economic
trends, are declining. The IMF estimates that they reached US$10.8 billion
in the last fiscal year. This grim economic picture is not what the
government wants to hear in an election year, the more so since the main
problem (insufficient power generation) is also in part the fault of the
corruption of PPP politicians, who pocketed the money instead of making
sure that efficient power plants were being installed.
The IMF expects the budget deficit to reach 7-7.5% of GDP this year, a
much higher figure than the Pakistani government estimates. The new
government is unlikely to change much in that regard unless it is that of
Imran Khan; Nawaz Sharif of the PML-N is no keener on raising taxes on
the wealthy, for the same reasons than the PPP has been. The new
government however might afford to spend less, once the elections are
out of the way. Foreign currency reserves will drop further to US$7.4 billion
in the current year, ending in June. The key problem, which constrains
economic growth no matter how cheap Pakistani labour might be, is power
shortages. These cannot be resolved quickly, even if the plans approved
by the current and future governments were implemented in a flawless
way - and that would be a first! Hence the IMFs pessimism is justified.
By mid-February Pakistans foreign exchange reserves were down to just
over US$13 billion, down US$350 million in just a week. The downward
trend in foreign currency reserves therefore continues, worsened by a rare
decline in the remittances of Pakistani workers abroad, which in January
declined to US$1.089 billion from US$1.11 billion in January 2012. This
rapid erosion of foreign exchange reserves seems to promise a major
crisis for just after the forthcoming parliamentary elections.
Foreign direct investment continues to decline, down 9.7% during the first
8 months of the fiscal year. That makes minus 85% over 2008. External
commentators say that Pakistan is reaching a critical balance of payments
situation and that a new International Monetary Fund rescue package
might be necessary after the elections. It makes little relief that the
Karachi stock exchange is doing well, up 33% since 2008, because the
Karachi exchange is tiny and not very representative of the economy as a
whole. Foreign currency reserves are down to US$8.1 billion, the

equivalent of about two months worth of imports and there are US$2.7
billion worth of debt repayments scheduled between now and end June. So
far this year foreign exchange reserves have been eroding at the rate of
about US$500 million a month. The risk is that of a crisis of confidence
and a run on the Pakistani rupee. In this context it is easy to understand
why, despite clear indications of the country shifting closer and closer to
China in its long term economic planning, in the short term Islamabad has
to warm up to Washington in order to secure new loans. Efforts to expand
Pakistans tax base are not achieving much in part because more and
more of the economy is going under cover. The informal share of the
economy seems to be growing, with even relatively large companies
disconnecting from the state. New estimates place the size of the informal
economy at 74% to 91% of the formal economy.
Over the last 12 months the Karachi stock exchange soared 44%, making
it one of the best performers in the world, despite its reputation for
instability and lack of adequate regulations. What justifies this
enthusiasm? Difficult to say, as the economic predicament remains very
challenging. The Sharif government promises to reduce the fiscal deficit to
4% from the current 8.2%, as well as to reduce the debt from 63.5% of
GDP to 58% without introducing any new taxes. But Pakistan will have to
spend 30% of its GDP in 2013-14 to pay back maturing debts, up from
25% in 2012-13; this makes it the financially most exposed amongst
developing countries.
Despite clear indications of the country shifting closer and closer to China
in its long term economic planning, in the short term Islamabad has to
cosy up to Washington in order to secure new loans. Efforts to expand
Pakistans tax base are not achieving much in part because more and
more of the economy is going under cover. The informal share of the
economy seems to be growing, with even relatively large companies
disconnecting from the state. New estimates place the size of the informal
economy at 74% to 91% of the formal economy.
The other chronic illness of the Pakistani economy, power shortages, also
promise to get worse soon, as Pakistan State Oil is on the verge of
bankruptcy because of a liquidity crisis, and will be forced to cut sales on
credit to Pakistan state agencies, a development which will in turn lead to
a reduction in power supply and more blackouts. Pakistan State oil is owed
by electricity companies US$1.5 billion, while having debts to suppliers for
US$1.23 billion.
The main effort of the government is based on price increases, which

should reduce consumption and offer incentives to industry to produce

more. However, many observers believe that this is not adequate to meet
Pakistans rising needs, given that energy demand is expected to be rising
at the annual rate of 2.2% a year in the future. The country mainly relies
on natural gas, but its own internal production is set to start declining
soon, not long after 2015 the country will become an importer of natural
gas. It is expected that Pakistans gas production will fall from 38.4 billion
cubic metres (bcm) now to 13 bcm in 2035. For this reason the gas
pipeline from Iran, despite stern opposition from Washington and from
Saudi Arabia, remains a priority for the Sharif government.
The outflow of foreign direct investment is becoming more and more
worrying for Pakistan. It is now badly affecting even the
telecommunications sector, which had dominated the foreign investment
flow in the past. In the last eight months of the current fiscal year the
sector lost US$320 million, the net result of flow limited to just US$136
million and outflows of US$456 million. Telecommunications is not the only
sector from which divestment is going on. The chemical industry is also
suffering heavily, with an outflow of US$89 million. The only sectors which
keep attracting large foreign direct investments is the oil and gas one,
with a net inflow of almost US$340 million, and the financial sector, with a
net inflow of US$202 million. The critical power sector, where investment
is dramatically needed, saw a net inflow of less than US$16 million.
Overall, net inflow was just around US$0.5 billion. The fiscal deficit stood
at 2.6% last year only because of US$1.8 billion of US Coalition support.
The trade deficit was reduced thanks to falling imports and cheaper
commodity prices.
The fact that the modest growth that Pakistan is still experiencing is
driven by private consumption is also telling; private consumption
expenditure grew by 11.6% in the latest fiscal year, while fixed investment
is falling. It stood at 10.9% of GDP in the latest financial year, one of the
lowest levels in all Asia. Car sales, for example, are growing at the rate of
14% a year, while new shopping malls are opening all the time. The
growth in private consumption is in turn driven by the remittances of the
almost 10 million Pakistanis who work abroad. In four years the level of
remittances has almost doubled to US$13 billion a year. Many Pakistanis
who benefit from them invest in the construction sector, which is also
doing well.
Criticism of the government for its handling of the power crisis is
mounting. A bipartisan report highlighted how the minister of water and
power did not even attend any of the meetings of the committee dealing

with energy shortages. The subsidies system discourages power

generation and the government has also been unable to bill all
consumers, or to get them to pay their bills. The room of manoeuvre for
finding additional resources to invest in power generation is limited, as
long as 3% of GDP is spent on the armed forces (in a country where the
state collects less than 10% in tax revenue).
Pakistan is also trapped in a foreign policy environment, which it must be
said, it has designed itself. The obvious avenue to faster economic growth
is better relations with India, a huge potential market for Pakistani goods,
and they are willing, but the various Islamist and jihadist lobbies nurtured
for so many years by the Pakistani army, would not buy better relations
with India; the army itself, oversized for a country like Pakistan, has no
interest in peace with India, as that would remove the justification for a
quarter (at least) of the budget going to the armed forces. So it is not
clear, who, what and how, is going to drag Pakistan out of its state of
permanent crisis. Sadly, it has all the hallmarks of a failing state, selfinflicted at that!.
On the diplomatic front, a major step was been taken by Islamabad in
formally giving China the contract for operating the Gwadar port; this was
a major concession to China, as Bejing has long sought control of this port
to facilitate its trading operations. Reportedly, President Musharraf in his
time had decided not to give control of Gwadar to a Chinese state
company, in order not to upset Washington, despite the major role played
by the Chinese in funding the construction of Gwadar. Although for the
moment there is no plan to open a Chinese naval base in Gwadar, the
Indian government is expressing concern that this might eventually
happen.
Perhaps the Gwadar move can be seen as a sign of Pakistans economic
despair; another sign is Islamabads determination to move forward with
the deal over the construction of a US$1.5 billion gas pipeline with Iran.
Aside the fact that Washington is very displeased at this development too,
it is also a risky investment as nobody knows how the nuclear crisis with
Iran will end. Observers believe that the deal was an expedient of the PPPled government to reassure voters that something is being done about
resolving the energy crisis, while there is little appetite in Pakistan for any
action which would alienate Washington, whose cash is needed now more
than ever.

Summary 2012

Relations with the US started showing some sign of improvement in May

after the longest crisis in the history of Pakistan-US relations. However,
after signs that the re-opening of the Pakistani border with Afghanistan to
US and NATO supplies was about to happen, new problems have emerged
and President Zardari cancelled a planned meeting with Defence
Secretary Panetta. Panetta had commented that Pakistans request for
much higher transit fees for the supply trucks (a 1000% increase on the
fees practiced before the border closure) was too much. Now of course the
issue includes the matter of the US Armys heavy equipment coming out
of Afghanistan, through Pakistan, once the exodus commences as the US
presence in Afghanistan runs down.
The negotiations over the re-opening of the American supply route into
Afghanistan and through Pakistan, which seemed close to a successful
outcome in May, then stalled again over the American refusal to apologise
to Pakistan over the killing of Pakistani troops along the border, and also
over the increase in the fees that the Pakistanis want to charge. The
Pakistanis are also restraining the movement of CIA operatives inside
Pakistan. The Americans are trying to signal to the Pakistanis that they
have had enough and that time is running out to re-build a relationship
with Washington. The Americans are openly inviting the Indians to play a
greater role in Afghanistan, as Panetta declared in his recent visit to Delhi,
knowing how irritating this is to Pakistani ears, particularly since it is going
to happen in the security sector. The message to Islamabad and
Rawalpindi is: this way you are going to get exactly what you dreaded, an
Afghan-Indian axis. The reaction of the Pakistanis, however, seems
oriented towards further escalation of their support for the insurgents in
Afghanistan.
The attack against Minhas airbase in August was the fourth of this type.
Although not the most successful, the very fact that the insurgents can
repeatedly attack the countrys main air base (where reportedly a part of
the nuclear warheads are stockpiled) is a cause of much worry, and
highlights how the countrys security services are not committing the
same energy to fighting internal terrorists, as they do in sponsoring
terrorists and insurgents abroad! Political parties are also to be allowed to
operate in the area.
Perhaps the continuing terrorist threat is helping revise US-Pakistan
dialogue, which indeed seemed to be showing some progress in August.
The long-awaited bilateral investment treaty is now said to be close to
being signed, with paperwork almost complete. There are rumours that
even the Strategic Dialogue between the two countries, suspended since

2010, might be resumed soon, probably in the second half of September,

when Zardari will visit the United States.
The latest economic data show Pakistani GDP for the past year down to a
mere 2 .4% growth, due to the floods as well as to electricity shortages and the slow down of the world economy. For the current year, the main
concern is the widening current account deficit, which during the first half
of the year reached US$2.15bn, which does not compare well with the
US$8 billion surplus for the same period of the previous year. Foreign
currency reserves have dipped to US$16.9 billion from US$18.3 over the
last 6 months. The fiscal deficit for the first 6 months of the current year
reached 2.6%, slightly less than the 2.9% of two semesters ago, but still
more than economists would like to see.
GDP growth is expected to recover moderately during the on-going
financial year, ending at 3.6-3.9%% depending on the forecaster, (not
much for a country neighbouring India and China, and with a fast growing
population). The government still thinks that it can achieve 4.2%, but few
observers believe that this is do-able, the more so as the world economy
is not expected to do very well either. The fiscal deficit is forecast at 4.7%
this year, down from the 6.6% of GDP of the previous year, but still
worryingly high for a country which struggles to collect 10% of GDP in
taxes. It is also a revision upwards of the previous 4% forecast and many
observers believe even 4% is not attainable, particularly given the
forthcoming elections. Moreover, rising oil prices mean that the
government will have to spend more in fuel subsidies, or increase prices
and make itself even more unpopular. There are also several debt
repayments due and external aid is not forthcoming.
The tax-to-GDP ratio is estimated to reach 9.2% in 2012, a very low level
but an improvement compared to the low of 8.6% reached in 2011. It is
against this low tax intake that the Pakistani budget deficit has to be
compared: it has reached 8.5% of GDP in 2011-12, so it is close to the taxto-GDP ratio.
In other words, the Pakistani government spends almost twice as much as
it earns, contrary to even the most profligate European government
whose deficit spending rarely reaches one third or even one quarter of
their tax intake (as in Greeces case).
As a result public debt has more than doubled in five years and is now
eating up much of the tax revenue in interest payments. This year is
expected to be a bad one for state finances, because of the forthcoming

elections. In the first two months of this fiscal year, the government has
already borrowed 33 billion rupees more than the corresponding period
last year from the banks.
The government now hopes that foreign direct investment will rise this
year to $2.5 billion, as a number of deals seem to be in the making,
particularly in the energy sector, where foreign investment is particularly
needed. In 2011-12, foreign direct investment was just US$813 million,
from US$5.4 billion in 2008. Among these projects is a US$600 million
wind power plant, to be built by the Norwegians, while investment seems
to be forthcoming from South Korean, Chinese and Indian companies. On
the energy front the Iranians have offered in July to complete the gas
pipeline to Pakistan, which is already being completed on the Iranian side
of the border. The sanctions against Iran make it unlikely that foreign
companies will show interest in the project, hence the Iranian offer. The
Iranians are so keen on completing the project that they have also offered
credit to Pakistan for US$500 million to complete the pipeline. These
developments are important because resource generation inside Pakistan
remains highly constrained and only foreign investment can provide the
level of funding required to resolve infrastructural problems and increase
economic growth.
Despite the long crisis, consumer spending remains high in Pakistan, at
US$75 billion (40% of GDP). Much of it fuelled by growing remittances
from abroad, now reaching US$11.2 billion a year. As the professional
skills of Pakistan labour migrants grow, so do their remittances. This
translates into purchases of luxury items like high-end cars, which might
seem at odds with the general state of the economy. The increasingly
difficult position of the Pakistani state is the worst aspect of the crisis.
Whilst revenues are affected negatively by economic downturn at home,
expenditure on subsidies has increased dramatically. The government
insists in constantly underestimating the amount it is going to spend on
electricity subsidies; in fact the gap between government plans and reality
has been widening fast. In 2008-9, it allocated Rs 77 billion but spent Rs
99 billion; in 2010-11 it allocated RS 32 billion and spent almost RS 285
billion. Now the government expects GDP growth to bounce back
somewhat in 2012, to 4%, a projection endorsed by the UN (ESCAP) but by
few others. USAID, for example, projects it at 3%, from 2.4% in 2011.
The Asian Development Bank believes that growth in Pakistan will
accelerate in 2012 because of the growing volume of remittances from
Pakistanis working abroad. Workers remittances have increased by 11.9%
in the first 11 months of the current financial year, reaching almost US$16

billion. In the meantime however, Pakistans sovereign debt and bonds

have been downgraded to junk by Moodys, which revised the ratings
from B3 to Caa1, that is one notch down. There are several reasons for the
downgrade, ranging from the deterioration in Pakistan's balance of
payments, to the decline in foreign-exchange reserves, the repayments
soon due to the International Monetary Fund (IMF) yet more in general to
the unstable political situation. Pakistans current account deficit stood at
US$3.8 billion in May, due to falling exports to Europe.
The Pakistani government says that the GDP is growing 3.7% this financial
year, a slight improvement on the previous year, but even if the
government claims that tax collection is going up 25% this year, the fiscal
deficit is rising from 5% last year to about 7% this year, at a time when
Pakistan find it difficult to obtain credit. This expansion in the deficit is in
part at least due to a populist budget, meant to prepare the ground for
parliamentary elections: tax cuts, public sector salary increases,
investment in infrastructure and public sector and the creation of 100,000
new government jobs. Military expenditure, already very high, has been
increased as well. Still no progress is being made in fighting tax evasion;
some international organisation officials noted that only 4,000 of the
34,000 commercial users of electricity pay any tax it would be very easy
to track down these evaders if the political will was there. The inflation
rate is also growing and has reached 12.3%. The power cuts are getting
worse as the summer sets in and people can be observed in some cities
bathing in the dirty water of the canals to seek some cool. Violence
continues unabated in Karachi, in Baluchistan and in the KP, while the
police seem unable to stem the wave of extortion which is affecting the
countrys business sector, particularly in Karachi where the bulk of the
countrys GDP is produced.
Although consumer inflation statistics in Pakistan are not very reliable due
to an imbalance in the basket of products being monitored, it should be
seen as good news that in July consumer prices grew by 9.6% on a yearly
basis, down from 11.3% a month earlier. The real concern remains the fast
rise of public debt, which has been increasing at the rate of 22% yearly
from 2007-11, which compares very unfavourably to an average rate of
6.6% yearly in 2000-07. Even more worrying is that it has been short-term
debt, which has been growing even faster: about half of domestic debt is
short term now, mostly 3-6 months. This exposes the government to the
risk of suddenly rising borrowing rates and forces it to constantly refinance its debt, which ends up being more expensive.
To add to the bad news, exports continue to do poorly. Even concrete

exports to Afghanistan are going down because of Iranian competition:

Iran can produce cheaper concrete than Pakistan, thanks to lower energy
costs.
The Pakistani government has tried to re-launch the economy by lowering
the policy rate of the State Bank. However commercial banks have not
responded positively, as they prefer to lend to the government.
Businesses consider the cost of lending to still be too high. Now the
government is launching some new Special Economic Zones, where
investors will be exempt from taxes for the first 10 years of activity. The
declining exports result in dwindling foreign exchange reserves: from the
US$18 billion of December, to the US$14.8 billion of August, despite an
inflow of US$1.1 billion from the Coalition Support Fund. Moreover, of
those US$14.8 billion almost US$4.4 billion is kept with commercial banks
and around US$2-3 billion has been borrowed from the banks.
On the economic front once again there is little in terms of good news to
report. Data on foreign direct investment shows that it continues diving. In
the last quarter it was a mere US$287 million coming in and US$200
million leaving the country; a year before, the inflow was US$580 million
and the outflow US$317 million. By now only the oil and gas sector
register a positive figure; even the communications sector, once one of
the best performing in terms of investment, showed in the last quarter a
new outflow of US$101 million. The latest IMF GDP growth forecast is
3.5%, slightly lower than previous forecasts. On the energy front,
Pakistans imports of energy continue to eat away almost two thirds of its
annual foreign exchange earnings. Just to maintain the gap between offer
and demand where it is (that is in the presence of massive shortages
especially during the summer), about US$4 billion should be invested
every year as demand is forecast to grow by 2% yearly. Since the country
does not seem to be in any condition to meet that requirement, we should
expect the gap to grow wider. Foreign currency reserves continue to be
slowly eroded, being at US$14.3 billion in October; debt repayments more
than offset the continuing increase in remittances from workers abroad; in
the last quarter remittances were US$3.6 billion, 9.2% more than a year
earlier.
The timing of the next elections remains uncertain. The government
seems inclined to have them in the autumn, the army would like them
sooner as it would like to get rid of the PPP in power. The likely outcome of
the elections will be a PML-N led coalition, with Imran Khans party as
main partner; that will please the military, who have 'a soft spot' for Imran
(an internationally popular, former captain of Pakistan's successful cricket

team), at least compared to the two main parties. Whether Imran and
Nawaz Sharif (two big egos) can get along is however difficult to say. More
importantly, would that make much of a difference for Pakistan? It would
likely lead to better relations with Saudi Arabia and probably worsen
relations with the US further. The relationship with China would of course
remain steady, as political parties have a consensus on that.
It seems that the PPP government now hopes to thread along until the
forthcoming elections, perhaps in the expectation that the judiciary,
increasingly perceived by the public as being hand in glove with the PML
opposition party, will overplay its hand and discredit its anti-corruption
campaign as fractionally biased. Even so, President Zardaris legal
defence against the Supreme Court appears very weak. Most observers
believe that he has something to hide. Some observers now even believe
that the Supreme Court might collude with the military in dissolving the
democratically elected government and replacing it with an extended
caretaker government. Such a development would fall not much short of a
coup, but it is not very likely because of the fact that the Supreme Court
and the military do not like each other very much, and have clashed in the
past. Moreover, elections are not that far away and the opposition is
widely expected to win them, so why not wait?
President Zardari has been busy consolidating his partys influence in
Sindh, in order to make sure that even if it were to lose a majority in the
parliament it would still have a base from where to fight back. The
profligate spending of the government might have helped in this regard.
In recent weeks Zardari has wooed away from PML-N and PML-Q highly
influential notables in parts of Sindh, where they are able to elect national
and Sindh Assembly representatives. He also worked to re-establish
connections with old allies and most importantly negotiated a new deal
with the MQM, which controls the bulk of the votes in Karachi. The deal
with the MQM might have been a bit too generous, as other Sindhi parties
have been complaining vociferously; Zardari is now engaged in damage
limitation, but the MQM commands more seats in the parliament than any
of the rivals.
In September finally Prime Minister Ashraf has agreed to the Supreme
Court demand that he seek the reopening of corruption investigations
against the president by withdrawing the earlier direction to the Swiss
authorities that they freeze graft probes against Zardari. In fact Zardari
seems unlikely to face prosecution anyway, as under international laws he
can expect to be granted immunity. Before Ashrafs move, law minister
Naek visited Switzerland to assess the implications of reopening the

corruption investigations; it would appear that he was reassured about the

low risk involved for the president.
The Supreme Court is now targeting the military for payments made to
politicians in the 1990 elections, aimed at befriending the politicians.
Inter-Services Intelligence has been humiliated by the sentence, but the
Court may be trying to show its fair-handedness at a time when it is
bringing very heavy pressure to bear on Zardari. Among the politicians
getting paid off was Zardaris arch-rival Nawaz Sharif, although this this
being Pakistan, the scandal will not affect his chances too much, as
allegations against Zardari are much heavier. The PPP has celebrated this
rare victory in the courts, but it has also been hurt by the Courts order
that the presidency should not be politically aligned and should behave
impartially, in effect, banning Zardari from being both President and PPP
Chairman. Should he refuse to step down as chairman of the party, the
Court could decide to take action against him. Should he step down, he
will not be able to campaign in the forthcoming elections.
The PPP government is also negotiating with the opposition about the
possibility of a caretaker government to handle the elections; this is a key
request of the opposition and if honoured it would reduce the chance of
the PPP distributing patronage in the immediate run up to the polls. It is
not clear whether this will happen, but in August a positive sign was the
appointment of a widely respected former judge as chief election
commissioner.
The PPP government is also trying to re-launch its reform agenda. Clearly
with an eye to the elections. Zardari has recently announced plans to
incorporate the FATA tribal region into the rest of Pakistan with the
extension of local government to the region, which until now has been run
through a system of political agents. The government is also investing
US$3 billion in the rescue of Pakistani Railways, which has long been on
the verge of complete collapse. Right now no freight service is running
and just one third of passenger trains; only 76 of 520 locomotives are
operational because of lack of maintenance and repairs. In order to relaunch the railways, the government is borrowing more money from Japan.
The big issue remains that of power generation. Power shortages are
restraining economic growth and are the main reason why reaching or
exceeding a GDP growth of 4% in 2012 is unrealistic. Demand usually gets
worse during the summer and already in May there have been riots
protesting power cuts in Punjab. Some of the PPPs allies are already
hinting that power cuts might be what decide the future parliamentary

elections and they might not want to join a losing team. This was the
position articulated recently by the PML-Q, which demanded that the
power crisis be resolved before 2013; this is of course technically
impossible because investments take time to produce results and they are
mostly still at the planning stage. President Zardari has long neglected the
issue and is now trying to convey an image of concern and commitment to
increase power generation.
Such is the despair, that Pakistan is not just negotiating electricity imports
for 1,100 MW with Iran, but also discussing imports of 500 MW with India.
There are also talks of electricity imports from Central Asia and Russia,
which have surpluses of electricity, but these are far away countries and
such plans might not make much sense. Currently Pakistan produces most
of its power from oil, which is expensive because of the high prices. Other
plans being discussed include the building of wind farms and of coalbased power stations. In short, the government is desperately trying to
catch up after long inactivity.
The PPP, however, had in recent months gained some new lease of life
because of former prime minister Gilanis greater assertiveness vis--vis
the military and the judiciary. From December onwards Gilani had been
making the point that the army cannot be allowed to be a state within the
state, while the party as a whole has started accusing the judiciary of
being much more heavy-handed towards the PPP than towards the PML-N,
or the army itself. These accusations have found some support among the
public.
The disqualification of Prime Minister Gilani by the Supreme Court in June
came as a surprise as Gilani seemed to have survived his court
appearance earlier this year unscathed. The Supreme Court move takes
Pakistan into uncharted constitutional territory, but in political terms it
does not necessarily weaken the PPP-led government: many PPP
sympathisers were already arguing that the Supreme Court was
specifically targeting the PPP in a political vendetta. This feeling was
strengthened when the first replacement candidate chosen by the PPP,
Makhdoom Shahabuddin, former minister of health, was immediately
charged by the Supreme Court in connection with a scandal in the
procurement of medicines and had to be dropped. Then another PPP
figure, Raja Ashraf, was selected. This is not the end of the crisis however,
as presumably the Supreme Court will not place the same demands on
Ashraf that it placed on Gilani: to help the investigation on allegations of
President Zardaris corruption. In any case, the crisis does little good to
Pakistan and is not likely to encourage foreign investors, who have already

been deserting the country.

The Iran-Pakistan-China pipeline project, however, shows that the
relationship is not invulnerable. In March the Industrial and Commercial
Bank of China announced that it was withdrawing from the project, which
is therefore left without funding. The withdrawal is the result of the threat
of American sanctions, for a bank which has important interests and great
ambitions in the US.
On the political scene there is a sense that the charismatic and wellconnected Imran Khan, until recently not taken seriously as a political
player, is beginning to attract a wider constituency, out of dissatisfaction
with the corruption of the two main parties (PPP and PML-N), and thanks to
his fiery anti-American rhetoric. Recently he has managed to attract large
crowds to his rallies and observers estimate that come the elections he
might raise his presence in the parliament from a single MP (himself) to
about 20, becoming therefore a key coalition ally for either of the two
main parties (most likely next time PML-N). It is not clear however to what
extent Imran can transfer his growing popularity to his badly organised
party.
Interestingly, Imran Khan has recently received an official invitation to
China, (not a cricketing nation), usually reserved for heads of state. Being
Captain of Pakistan as he was at cricket - more of a national obsession
than a mere sport, Imran Khan has a status throughout the former British
empire in no way diminished by his international jet-set life, faithfully
recorded by the better class of celebrity publications. He is notably closely
supporting the move of the judiciary against President Zardari, while even
the PML-N, which initiated the move, now has reservations against the
growing intervention of the judiciary in politics the PML-N certainly does
not have any better a record than PPP in terms of institutional and
personal corruption. It would be a race to the bottom
to closely compare the two.
The allegations of Zardari plotting with the Americans against the
Pakistani army, have certainly mobilised nationalist opinion against him.
However, after a moment of panic when the PPP seemed to believe that a
military coup was imminent, the leaders of the party have regained some
composure, and are playing their cards in the reasonable assumption that
the army has no appetite for taking power, at a time of economic crisis.
The army was clearly trying to force Zardari and Gilani to resign; that
would achieve its aims without a coup. Prime Minister Gilani counterattacked however, sacking defence secretary Naeem Khalid Lodhi, a

retired general still close to the military establishment. This move

strengthened the PPP governments hand against the army and might,
even have brought about the sacking of the chief of Inter-Services
Intelligence Gen. Pasha. The PPP in other words seems to have decided to
stand and fight rather than meekly bowing to the armys will and be
removed from power, one way or another. The army is not as popular as it
used to be, so the PPPs choice might earn it back some lost popularity.
Gilani openly accused Pasha and Chief of Staff Kayani of defying the
constitution by violating procedures, in submitting a memo against the
government to the judges investigating the allegations of conspiracy
against the army.
The army is not just under pressure from the courts. The Americans are
making clear that they are closely watching the replacement of Gen.
Pasha, at the head of the Inter-Services Intelligence, the countrys main
security service. Washington wanted a reformer to be appointed, willing to
take more radical steps in confronting the extremists who roam around
the country. The new man, Lieutenant General Muhammad Zahir ul-Islam,
from the country's military aristocracy, is personally close to Chief of Staff
Kayani. Pasha was rather appreciated by the Americans for his
professionalism, even if he did little to help them
The senate elections of early March in part surprised observers because of
the better than expected performance of the ruling coalition and of the
PPP in particular. Because the senators are elected by the provincial
deputies, these results do not represent in any way the current will of the
electorate, but the result is nonetheless that the PPP-led coalition is going
to retain control of the senate until 2015. Therefore, even a 2012-13
defeat of the PPP in the popular polls would not be enough to completely
marginalise the party and change the constitution without first agreeing
with the PPP what it should look like. Imran Khans PTI has boycotted the
senate elections, knowing that it could not do well, but by doing so it has
lost momentum and has caused the upsurge of support recorded in recent
months to stall. Imran Khan might have thought that a boycott would
demonstrate his integrity to the electorate, but now the issue of the
recruitment into the party of figures compromised with Musharaffs regime
and with the old political parties (PPP and PML-N) is wearing that image a
little thin as well.
Focused as it is primarily on the forthcoming parliamentary elections, the
government continues to rely on raising money through further
indebtedness to keep the economy afloat. Between July and February, the
government has borrowed Rs916 billion to support the budget, compared

to Rs590 billion for the whole of the previous financial year. The
government has already announced that in the 2012-13 budget there will
be no tax rises, but expenditure will go up to soften the impact of the
crisis on the people (and to win back votes for the government). Now
many fear that further rises in oil prices might make the economic
situation fully unsustainable, particularly if any military action against Iran
were to take place. A good cotton harvest is expected to push economic
growth up to 3.5%-3.8%, compared to a mere 2.4% last year, but the
investment rate is expected to fall further from the 13.4% of last year, the
worst rate in almost 40 years. Some observers therefore foresee a budget
deficit reaching 7% of GDP. The exchange rate to the US dollar is expected
to worsen, compounding the problems created by the high price of energy
sources. The government might then be forced to go back to the IMF, but
it is unlikely that the austerity measures that the IMF will demand can
ever be implemented. The fact that in recent years, the country has been
relying more and more on oil and less on gas, for energy generation also
compounds the vulnerability to oil price shocks the reliance on oil has
gone up from 82% in 2009 to 86% today.
Although the rupee lost 7.3% against the dollar over the last year, it is
now under further renewed pressure, as international aid dwindles and the
trade deficit worsens. Inflation reached 10.8% in March. Exports are
crumbling due to the European economic crisis and by March they were
down 18.8% over a 12 month period. Although foreign currency reserves
have increased slightly in March to US$16.6 billion, this was largely due to
a strong increase in remittances from abroad, which reached US$9.73
billion in July-March 2012, compared with $8.02 billion in the same period
last year.
Petrol prices have crossed the Rs100 per litre mark for the first time in the
history of Pakistan. Still the countrys landlord elite is spared the trouble of
paying tax, while the countrys powerful and expensive army is courted by
the politicians of the main parties and receives greater and greater budget
allocations. Even in 2012-13 military expenditure will rise by 50 billion
rupees, compared to an existing military budget of 500 billion rupees.
The sense of economic decline is reinforced by the endless succession of
scandals. The most recent scandal concerns the illegal sales of a drug
named ephedrine, which has caused shortages of various medicines in the
countrys pharmacies; the son of former Prime Minister Gilani is implicated
in the scandal. Reports of corruption in the postal service have also
emerged recently, which might contribute to the terminal crisis of yet
another state agency (after the railways and the PIA airline).

The perception of a political class irredeemably corrupt, is reinforced by a

recent decision of the government to go ahead with an order by Pakistani
Railways for 75 locomotives. The order had been blocked because a lot of
rules had been violated in drafting it, raising obvious suspicions of
corruption. Already in the past Pakistani Railways had passed orders in
allegedly corrupt ways, resulting in the purchase of faulty or inferior
equipment. The high level of corruption in procurement, and nepotism in
hiring practice, are two key reasons why Pakistan Railways is on the verge
of collapse.
Perhaps the best example of the level of corruption in Pakistan is the state
of Pakistan International Airlines, once the pride of the country. The
company is so badly run now that it loses hundreds of millions of dollars
each year, and is forced to keep a quarter of its fleet from flying because
of the lack of cash to buy spare parts. Losses in 2011 have doubled on
2010 and the company is hoping that the Pakistani government will once
again come to the rescue. Nepotistic recruitment practices have left PIA
overstaffed (450 employees to each aircraft, a very high ratio) and badly
managed. The security of flights is reportedly also being endangered.
In an unexpected twist, Pakistans assertive courts have taken up a
confrontation with the powerful military establishment; over issues of
illegal detention, disappearances and torture and death in detention, as
well as illegal funding for the countrys political parties. How far the courts
will be able to go is unclear; meanwhile their apparent willingness to take
on the army legitimises their campaign against the political class, and in
particular the government. Some liberal members of the intellectual class
are however beginning to get worried about the assertiveness of the
courts, an unelected body, vis--vis the political class.
Islamabad is in the process of negotiating an agreement with some of the
militant TTP factions; the indications are that finally the army and the
intelligence services have manage to break the TTP up and convince a
substantial portion of it to make peace with the establishment, as well as
refocusing their violent efforts on Afghanistan.
Whether or not that will lead to an improvement of the situation in the
tribal areas, remains to be seen. In Baluchistan, the government has de
facto ceded control of all but useful Baluchistan (the main cities and the
gas fields) to the nationalists, who do not seem to have the military
strength for going further; this stalemate could therefore be expected to
persist.

The killing of Badruddin Haqqani by an American drone in the summer however

unleashed a wave of resentment and anger among the Afghan Taliban, including
of course the Haqqanis who had in the past been the closest to the Pakistanis, of
all the Taliban networks. Although sympathy for the Afghan Taliban among the
public continues to run high, the attempted assassination of schoolgirl Malala
Yousafzai by the Pakistani Taliba
nleashed a wave of protest around the country - and the world! In fact the
Pakistani Taliban were already pretty unpopular outside the tribal areas, so

this mobilisation might not change much. It might, however, help the
campaign of the PPP versus Nawaz Sharif and the PML-N, who argue in
favour of appeasing the Pakistani Taliban and making a deal with them.

Forecast and summary 2011

It is not easy to be optimistic about Pakistans short term prognosis. The
Zardari government is almost universally recognised as ineffective and
corrupt, but significantly nobody seems to be willing to replace it: neither
the army nor the parliamentary opposition. The reason seems to be that
nobody seems to know how to tackle the multiple crises affecting Pakistan,
which as a consequence get worse. The only path seems to be to follow the IMFs
advice, an unpopular route which opposition politicians prefer to leave to Zardari.
Although the government seemed at the beginning of 2011 to be weaker and
weaker, it is therefore impossible to predict whether it will fall in 2011: in a sense
its weakness is its source of strength, its enemies think they can bring it down at
any time, so they have no reason to hurry in doing that now.

The Gilani government was once again on the verge of collapse in January,
as another coalition partner quit the ruling coalition. The MQM officially
quit over the inability of the government to tackle the rising prices of fuel;
the party holds 25 seats in the parliament and is decisive in retaining a
majority for Gilani. The government had decided to raise the price of fuel
by 9% as a result of an increase in international fuel prices, but the move
immediately proved very unpopular. Consumer prices as a whole rose
15.5% in 2010, putting a lot of pressure on the poorest (largest) strata of
the population. Negotiations started after the MQM quit and it was not
long before the government rescinded its decision to raise the price of
fuel; then the MQM decided to re-join the government. The opposition
PML-N tried to benefit from the situation, presenting itself as a reasonable
opposition which negotiated with the government to convince it to abolish
the price increase. In reality the opposition was not likely to call for a no
confidence vote, since in that case it would have needed to prove that it
had a majority of its own. The PML-N would probably have struggled to

gather the smaller parties around itself and even if successful, it would
then have needed to form a government in the middle of a very difficult
economic situation. The issue of how to pay for the growing cost of fuel
remains of course unaddressed. The American government and the IMF
protested against the decision to reverse the price increase; the
economists, including some who until recently were advising the
government, are also disappointed with the move and see it as a further
indication that the ever weaker government is no longer able to take
rational economic decisions, one of its few selling points until the end of
2010. The budget deficit will increase by 0.2-0.3 percentage points as a
result of this decision; the budget deficit for the current financial year if
projected by some analysts as high as 8%.
In February the Gilani cabinet resigned in order to allow a major overhaul
of its own structure, from one of the largest governments of the world (54
ministers) to a more modest 22-members cabinet. Many observers have
judged this a cosmetic move meant to distract attention from the failure
of the government to implement more serious reforms; the Pakistani
public does not seem impressed either. The key ministers are still all
there, except for Foreign Minister Qureshi. Another populist measure that
the government has been discussing with the opposition PML-N is a 25%
cut in the salaries of government officials working in grade 17 or above.
The salaries had just been increased by 50% in the 2010-11 budget. On
most other issues government and opposition remain divided. Nawaz
Sharif and the PML-N are opposed to the introduction of the planned
general sales tax, insisting instead that the government should cut
expenditure and curb corruption.
On the internal political front the two branches of the PML, PML-N and
PML-Q (the pro-Musharraf faction) are trying to form an alliance for the
future parliamentary elections. This is a very opportunistic move, as the
two parties were bitterly at odds when Musharraf was still around. With
him going, however, the PML-Q had nowhere to go. The Islamic parties,
sensing the weakness of the government, are once again trying to come
together to contest the next elections as a coalition. The assassination in
March of Pakistan's minorities affairs minister, Shahbaz Bhatti was another
blow to the government and once again exposed its inability to contain
the wave of terrorism shaking the country. Quite the contrary, the
government responded to the murder by announcing that it has no
intention of reviewing the blasphemy laws, against which Bhatti had been
campaigning. In the FATA, the government is struggling to maintain the
support of the various tribal militias which sprang up to contain the
Taliban; feeling neglected by Islamabad and forced to take the brunt of the
Talibans attacks, some of these militias are now threatening to drop out.

One of the consequences of the rift over the fuel prices has been the
postponement of a decision over the planned sales tax. Opposition to the
new tax is also strong and the MQM is opposed to it too. Still the
government is under international pressure to get out of the impasse
somehow, if for no other reason that it needs the next tranche of the IMF
US$11 billion loan to be released. Government and opposition are
negotiating a reform programme, which the PML-N insists should be
focused on a 30% budget cut. On the table are the restructuring of stateowned money-losing companies and a new price mechanism for electricity
and gas. Among the best known companies that face restructuring are
Pakistani Airlines and Pakistan Steel. The government welcomes the
dialogue with the opposition, because whatever decision will be taken will
not be very popular, and it would like to spread the blame! The opposition
however demands as a prize for its co-operation the ouster of corrupt
politicians, a concession which could fragment the ruling coalition even
further. One wonders how far that could go (and still be able to ensure a
quorum in the parliament)?
In July the governor of the Central Bank Shahid Kardar resigned over
major differences with the cabinet, in particular concerning the failure of
the government to reduce expenditure. The determination of Prime
Minister Gilani to launch a public bank in Sindh, was also opposed by
Kardar. This is a new hit at the credibility of a government which floats at
very low levels of public support. The government also suffers because of
the renewed power supply crisis; the blackouts are more and more
frequent and last longer and longer. The power generation and supply
sector is a mess, with 30% of the electricity produced still being stolen not an environment where investing is an attractive proposition! People
and businesses increasingly have to rely on electricity generated by small
diesel generators, but that is a major additional cost and an inefficient
way of producing power.
Islamabads relations with Washington will likely continue to fluctuate in
2011; Washington knows what the Pakistanis are doing in Afghanistan, it is
very upset but cannot figure out how to convince the Pakistanis to
downsize their ambitions there. Now Washington says that it does not
necessarily plan to leave Afghanistan in 2014 or 2015 (but few in Pakistan
or elsewhere believe that the Americans will not disengage). The Pakistani
army is more and more upset with the Americans, because they do not
want to play its game, but at least in the short term, Pakistan needs the
US as much as the US need Pakistan. The difference is that the Pakistani
military are infinitely more at ease with playing and living in a permanent

state of brinkmanship, than are American politicians.

In March yet another drone strike caused many civilian casualties in North
Waziristan: Army Chief of Staff (and increasingly Pakistans strongman)
Kayani was particularly furious about the raid, whether because it killed
many civilians as he stated, or because he saw the incident as an
opportunity to embarrass Washington and perhaps force them to reduce
their drone operations. Kayani has been consolidating his position at the
top of the army for some time, moving his protgs into key positions.
Pakistans protgs among the Afghan insurgents are already moving out
of North Waziristan to neighbouring agencies, but the US ability to deny to
the insurgents the ground of North Waziristan, is a serious hindrance for
the Taliban. Moreover, embarrassing Washington also allows Kayani to
build a strong position for any future need to reject American demands to
expand the area of drone operations. The Pakistanis even boycotted an
important security meeting with Americans and Afghans in protest.
In April Joint Chiefs of Staff Chairman Admiral Mullen explicitly accused the
ISI of collaborating with some groups of Afghan Taliban in attacking US
troops. In particular, he mentioned the Haqqani network as being closely
linked to the ISI. When we consider that Mullens trip was meant to ease
the tension between the US and Pakistan, such a statement acquires a
particular significance. The Americans are losing patience and the Obama
Administration is under pressure from Congress too, where loud
accusations against Pakistan of playing a double game, can now be heard.
The Pakistani army, on the other hand, is angry at the scale of CIA
operations within Pakistan and at the US reluctance to recognise a key
role to Pakistan in any forthcoming negotiations in Afghanistan between
government and opposition. The government is now demanding that the
CIA dramatically reduces the number of its operatives inside Pakistan, in
part to signal its displeasure but also to force greater cooperation in the
future the Americans will not be able to do it all alone anymore. The
Pakistani governments denunciations of the drone raids should not be
taken too seriously, as it is well known that the government secretly backs
the raids and only condemns them to appease public opinion. The
Pakistani army, however, is a different matter: the problems are not
simply the drone raids per se, but their targets, which sometimes do not
coincide with the desires of the Pakistani officers. The Pakistanis dislike
Gen. Petraeus military focus, and complain about the Americans leaving
them in the dark about Washingtons intentions and refusing to share
intelligence about the Taliban. The Americans, of course, do not trust the
Pakistanis any more and naturally do not want to share information, which
will prejudice their planned operations.

Although Washington refrained from openly pointing out how the

Pakistanis were clearly protecting bin Laden in the location where he was
killed by an American raid, they hardly needed to elaborate on what was
obvious. Nobody believed Pakistans denials and privately even top
Pakistani officers admit that they were holding him under their protection,
although with the qualification that they were about to hand him over, or
were meaning to deliver him at the right time. However, if Washington
believed that the Pakistanis would become more co-operative after bin
Ladens death, they seem to have been mistaken. If anything, the
Pakistanis are more furious than ever. Even the raid against a base of the
Pakistani Navy in Karachi, which seriously damaged the countrys
strategic reconnaissance capability, is attributed by Army officers to an
American conspiracy. The Pakistani government cannot simply change
route, lest it faces a mutiny of the army. The fact that the Pakistanis even
before the raid against bin Laden were trying to curtail CIA presence
inside the country, is highly significant: the CIA was getting to know too
much. On 23 May a raid on the Afghan border appears to have narrowly
missed Mullah Omar. Although there is no confirmation of who carried it
out, it seems to have been a combined CIA-US army operation, probably
relying on intelligence sources managed by the CIA via Blackwater in
North Waziristan. The Americans therefore would seem to have decided to
spend the intelligence capital accumulated so far, given that they have to
quit anyway. Perhaps there is also a political decision to confront the
Pakistanis and operate without their authorisation. The Pakistanis have
been calling several American bluffs, perhaps now it is Washingtons time
to try the same.
However, Islamabad is not actually ready to dump the Americans for the
Chinese as they have been hinting, mainly because the Chinese are not
that interested in baling out a sinking ship Prime Minister Gilani recently
declared China as Pakistans best friend. Islamabad has now asked China
to build a naval base in Baluchistan, no doubt another signal to
Washington that Pakistan has alternative sources of support. Chinas
reassurances to Pakistan in May, that no matter what changes might take
place in the international landscape, China and Pakistan will remain for
ever good neighbours, good friends, good partners and good brothers, do
not imply however that Beijing is about to open its coffers. The Congress
is now calling for US$3 billion of aid to Pakistan to be withheld, but the
Obama administration is against such a move, as that could be the coup
de grace to US-Pakistani relations.
One thing is certain: Pakistan will need friends with wallets well stuffed.

Following the latest meeting with the Pakistani authorities, the IMF has
stated that Pakistan needs to expand its fiscal base. The general sales tax
reform is also still waiting to be implemented and the IMF has given time
until the end of September for that to happen.
The Americans and the Pakistanis continued trading blows in July.
Washington arrested an alleged Pakistani agent, who reportedly was
lobbying in favour of the cause of independent Kashmir, amongst other
ways, by contributing illegally to the electoral campaigns of Congressmen
and Senators. In the US Congress the hatred of Pakistan is reaching new
heights; a Republican Congressman proposed an amendment which would
have banned aid to Pakistan, but it was rejected 5 to 39 because the
Democrats lined up behind the Administration. Still even Administration
officials like Admiral Winnefeld now openly discuss how Pakistan uses
proxy groups to pursue its aims in Afghanistan, mentioning the Haqqani
network explicitly. Admiral Mullen accuses the Pakistani government of
complicity in the assassination of journalist Saleem Shahzad. Secretary of
Defense Panetta indicated that Al Zawahiri, the successor to Bin Laden, is
hiding in Pakistani territory. All of this is obviously true, but even
articulating it is taken as a terrible insult by the Pakistanis, particularly the
army. The Republicans are now pushing to link civilian aid to Pakistani
cooperation, for example by handing over Bin Laden's wives, but the
Democratic majority in the Senate is aligned with the more realistic
approach of the Administration. Secretary of State Clinton recently hinted
from India, which she was visiting, that Pakistan supports terrorist groups
and this should not be tolerated, something particularly painful for
Islamabad to hear because it sounded like an endorsement of Indian views
on this subject. Most importantly, the US suspended US$800 million of
military aid to Pakistan. US$300 million of that money is reimbursement
for operations carried out by the Pakistani army, so that the state budget
will be affected directly and negatively.
The Pakistanis retaliate by hinting that the reduction in military aid will
force them to abandon their deployment on the border with Afghanistan
and therefore downgrade their counter-terrorist efforts. Pakistan has
already expelled 100 US military advisers and is threatening to close the
base from which the US drones were operating; recent drone strikes have
been launched from Afghanistan. The Pakistani authorities claim that ISAF
supplies travelling to Afghanistan have caused US$7 billion worth of
damages to Pakistan's roads and reminds everyone of the 5,000 Pakistani
soldiers and paramilitary who died fighting terrorism, as they say.
US-Pakistani relations showed no sign of recovering in August. The

Americans now accuse the Pakistanis of showing to the Chinese parts of

the helicopter which crashed on Pakistani soil during the Osama Bin Laden
raid. The helicopter was built with a new 'stealth' technology and some
parts survived a US attempt to destroy it. Commentators in the US again
point out how Pakistan is not a trustworthy ally, even if the Pakistanis and
the Chinese deny that any such access was ever given. Then US Joint
Chiefs of Staff Admiral Mike Mullen missed Pakistan, during what is
probably going to be his last official visit to the region (he is retiring soon).
Mullen had met Pakistani Chief of Staff Kayani before his trip, so it is not
clear that the Pakistanis will consider this a snub, but Mullen was within
the Obama administration one of the softest on Pakistan. Within the
Pakistani military establishment some believe that Mullen meant to
express displeasure over Pakistan's refusal to backtrack on its decision of
sending back American trainers. Others believe he was actually
displeased about the Pakistani army's refusal to carry out a large scale
operation in North Waziristan. Washington has long been insisting that
such an operation is necessary if Pakistan has to show its good will, but
the Pakistanis continue to drag their feet. They are now arguing that they
could bring the Haqqani faction within the Taliban, which is based in North
Waziristan, to the negotiating table and that therefore a military operation
would be counter-productive. At least the US ambassador to Pakistan,
Grossman, recently stated that the US does not contemplate any peace
process in Afghanistan without Pakistani participation. Reports of meetings
between US diplomats and Taliban representatives in Qatar and Germany
have irritated the Pakistanis, who see this as an attempt to bypass them
and reach a direct deal with the Taliban.
Will Washington's new, more aggressive tactics work, where trying to win
Pakistan's heart has not? The army is under pressure from society perhaps
like never before: recently the Supreme Court ordered the withdrawal of a
general after his men were demonstrated to have killed an unarmed
youth. This is something unimaginable in Pakistan even a few months ago.
Perhaps this will help the Americans, who do not want for the time being,
to drop their support for Pakistan altogether. Admiral Mullen has stated
that cutting off all aid to Pakistan would only make things worse.
The Americans continued to up their pressure on Pakistan in the latter part
of the year, in particular with regard to the Haqqani network in Waziristan.
In September Admiral Mullen has openly accused the Pakistanis of
extending their support to the Haqqanis and the Pakistani authorities have
reacted angrily to the accusations. Many believe that the Pakistani
services have even engineered the attack on the US embassy in Kabul in
September and that the same services are campaigning to shut down the

channels of communication that the Americans had succeeded in opening

with the Taliban (or some of them). The Pakistani refusal to take on the
Haqqanis is however for the first time eliciting strong criticism in some of
the Pakistani media, which point out how the country is on the verge of
economic collapse and cannot afford to irritate Washington. The mood
within the business class is sombre and some observers expect a capital
flight to start soon. Panetta and some voices in the senate argue now that
the US should not balk at military strikes inside Pakistan, particularly in
North Waziristan and aimed directly at the Haqqanis.
Secretary of State Clintons visit to Pakistan in October took place amid
low expectations of a diplomatic breakthrough. In Kabul before moving on
to Pakistan, Clinton warned that she would put heavy pressure on Pakistan
to start cracking down on the Haqqani network, which Washington openly
accuses the Pakistani army of supporting. The attack on the US Embassy
in Kabul in September, widely attributed to the Haqqani network, was read
like the Pakistani armys response to US pressure. Washington hopes that
the threat to curtail US military aid to Pakistan would force the Pakistanis
to start delivering. In case the Embassy attack was not a message strong
enough, Pakistani army chief General Kayani told a parliamentary defence
committee in October that Pakistan no longer needs US military aid. In
Pakistan some now fear that the Americans might intervene unilaterally in
North Waziristan, because of some military build-up on the Afghan side of
the border. Among the hypotheses ventilated by the Pakistani press are a
large scale bombing campaign of the region where the Haqqanis are
based. Kayani dismissed such fears by claiming that Pakistan is neither
Iraq nor Afghanistan, as it is a nuclear power. Some advisers to President
Obama now advocate starting to consider Pakistan as an hostile country
and no longer an undisciplined ally, although Clinton is still saying that
Washington has no choice but to seek cooperation with Pakistan. At
present, about 35% of NATOs supplies to Afghanistan still travel through
Pakistan. Efforts to re-route the supplies, together with the beginning of
the withdrawal of the troops, will bring that percentage close to nil within
a year or less. At that point a strategic shift from Washington would be
easier.
The Pakistanis have renewed their diplomatic effort to draw Afghan
President Karzai towards their position. In April a delegation including
Prime Minister Gilani, Army Chief of Staff Kayani and ISI Chief Pasha
visited Kabul for high level meetings. Among the Pakistani demands for
facilitating a settlement with the armed opposition to Karzai, figures the
request of capping the size of the Afghan Army at 100,000 men (it is
planned to reach 250,000). Kayani has made the achieving of a

settlement in Afghanistan in line with Pakistans interest and under

Pakistani hegemony, his key aim.
If Pakistan as a country and as a state has been treading on difficult
ground for quite some time and its future is uncertain, it has at least one
achievement to show: virtually unlimited funding from the US for the
armed forces, has according to US intelligence sources turned Pakistan
into the worlds fifth military nuclear power, after the US, Russia, China
and France and ahead of Britain and India. Pakistan reportedly has now
more than 100 atomic bombs, thanks to a 40% increase over just the last
two years, that is at a time when the economy was on the verge of
sinking.
The IMF forecasts GDP growth slowing to 2.8% in 2011, down from an
estimated 4.8% in 2010. Considering that 2010 can hardly be considered
a good year for Pakistan, the forecast is not encouraging. Recovering from
the floods will take time; in 2010 Pakistan benefited from low oil prices,
but the trend has been inverted and in 2011 Pakistan will as usual suffer
from high oil prices. Newly rising food prices could add to turmoil.
The Pakistani government holds great hopes in Chinese investment in the
Pakistani economy as a way out of the crisis; in particular it claims that
China will invest US$11 billion in the power generation sector in the near
future. Chinese companies already have a lot of experience in Pakistan
and have been among the few who invested in the Pakistani energy
sector, so Islamabads hope is not fully unfounded. For all its bravado,
however, the Pakistani government is now back to negotiating with the
International Monetary Fund for a rescue package. The conditions which
the IMF will seek to impose are going to be similar to those already
imposed in the past: create the conditions for the approval of the
Reformed General Sales Tax (RGST), eliminate power sector subsidies and
sack excess manpower from state owned enterprises such as Railways,
PIA, Pakistan Steel Mills, power distribution companies. The reopening of
negotiations with the IMF appears to have been dictated by a faster than
expected depletion of foreign currency reserves in recent months. The
Pakistani government had been expecting a depletion of such reserves at
the rate of US$1.5-2 a year, but in fact they fell by US$1.4 billion in just
the last three months, creating a potentially unmanageable situation. The
high oil prices contribute to the Pakistani malaise and to the newly found
willingness of the government to humiliate itself in front of the IMF.
The fact that the Pakistani Railways have reached collapse did not appear
to bother the ruling elite much; after all the trains in Pakistan are only

used by the lower and lower-middle classes. Now however Pakistani

International Airlines (PIA) is increasingly in the eye of the storm for
mismanagement. The cancellation of flights on security grounds, yet often
due to poor maintenance, is an indicator of a growing difficulty to keep the
PIA running. A PIA collapse would have a much greater impact on the elite.
In terms of internal politics, the main current issue in August was the
continuously escalating violence in Karachi, the economic heart of
Pakistan. The Mujahir extremists are trying to ethnically cleanse the
recently established Pashtun minority. The turmoil has led the business
community to invoke the intervention of the army. They say that the
violence is crippling the economy, with many shops closed and industries
seriously hampered. Karachi alone accounts for 79% of Pakistan's customs
revenue, 44% of tax collection and 58% of sales tax and is absolutely
crucial to the economic viability of the Pakistani state.
In less than three years, the per capita debt burden of Pakistanis has
increased by 170%, as the government has been trying to keep the
economy afloat, through borrowing and spending. As a result, debt
servicing is five times as big as the ever shrinking development budget;
total liabilities have reached US$117 billion, about half of them with
internal creditors and the rest with international creditors. The
depreciation of the Pakistani rupee contributed to compound the problem.
The main concern of the government seems now to keep borrowing. The
US$ 11.3 billion loan suspended by the IMF in July 2010 because the
government had failed to implement the general sales tax and other
reforms, is the object of a diplomatic effort to convince Washington to
intercede with the IMF, and have the loan reinstated. The government is
essentially unable to contain its spending, but has not given in to a key
IMF demand of strengthening the role of the Central Bank. Bank officials
attribute the rising inflation, now around 15%, to government borrowing.
The Bank repeatedly increased the rates in order to discourage borrowing,
but the patronage-oriented instincts of the Pakistani political class are too
strong to be fought with these measures.
Pakistan failed to get the 6th tranche of the IMF US$11.3 billion loan
released in April again. The tranche is blocked since May 2010, because
Pakistan cannot meet the benchmarks required by the IMF. This failure
also prevents the Pakistani government from negotiating more loans,
which Pakistan needs to repay earlier loans. The government believes that
it needs US$3.2 billion in the near future. Pakistan remains under scrutiny
because of the rising inflation, the widening fiscal deficit, the fiscal
exemptions and energy subsidies. The rising oil prices are now forcing the

government to announce that fuel subsidies will have to be abandoned

the coming summer and that consumers will have to bear the burden of
the increased costs. The recent 13% increase in fuel prices had to be
halved after protests and disagreements within the ruling coalition.
Another factor which might lead to further tension is the high price of
wheat and more in general foodstuffs. The government keeps the price of
wheat high to please the farmers (including the big landlords who
dominate the main party in the coalition), even if production is going up.
The result is that the poorer strata of the population cannot afford to buy
enough food. Even if production should be sufficient; malnutrition levels
are going up. The price of wheat has almost trebled from 2008; consumer
prices have increased 17.7% in the year to February.
Carrying out reforms in Pakistan is not easy, as demonstrated recently by
the resignation of Pakistani Airlines chief executive, following protests and
strikes by the airlines staff. His plan to share routes with Turkish airlines
would have helped in reducing the losses, but the personnel feared job
losses and pay cuts. Essentially, the Pakistani political class hopes that
somehow the country will stabilise again, reach a new equilibrium with a
mixture of external help, luck and adjustment by the population itself. The
partial recovery of the rupee in recent weeks (now at an eight month high
against the dollar) eases for example the situation, at least a little bit. The
rupee has been strengthening on the basis of a recovery of foreign
currency reserves and of an increase in remittances from Pakistani
workers abroad. Still, the latest GDP growth forecast for the year ending
June 2011 is 2.5%, down from the previous 4.5% forecast.
The next electoral campaign is going to be a particularly difficult one for
the PPP government, amongst other things because of the recent floods
which have hit Sindh, the main stronghold of the PPP. The fact is that the
rival MQM, traditionally based among Mujahirs, has tried to make inroads
among the Sindhi population by assisting those caught in the floods, while
the PPP stood and watched, might deliver additional damage to the
Bhuttos party. The Sindhi nationalist parties are also reportedly on the
rise.
The government seems less interested in reforms than ever; the priority
now is getting ready for the next elections. The power sector, which is the
weakest point of the whole economy, serves the PPPs electoral campaign
as a source of party workers and any reform would disrupt the ability of
the government to recruit. The government is now reportedly considering
starting to print money to plug the hole left by the end of the IMF
programme, with the certain result of unleashing inflation. The

government is also reported to have plans to abandon the idea of

entrusting the electricity tariffs to a regulator, because in that case the
government would no longer be able to manipulate tariffs for electoral
purposes.
Finance Minister Shaikh announced in June a new budget, aimed at
reducing the deficit to 4% of GDP, from the current 5.7%. While these
figures might not seem horrifyingly high by world standards, Pakistan's tax
take is one of the lowest in the world. Shaikh stated that the government
is going to crack down on fiscal evasion, that is the 2.3 million of
Pakistanis out of 3.8 million who should be paying tax. The government
hopes that with this budget and these promises the IMF will release the
US$3 billion loan which is now suspended; critics however point out that
the government is still resisting the idea of taxing the wealthy landowning
class, who as is noted above dominate the main political parties,
preferring instead to hit the business and middle classes.
The main worry of the Pakistani elite is however not the struggling
economy, but the increasingly restless army. Chief of Staff Kayani, once
the country's strongman, is losing the support of his officers. Even the
Corps commanders seem to be turning against him; reportedly they met
recently to discuss his removal. Although they decided not to proceed for
the moment, the very fact that they were discussing such a coup is a
major development nonetheless. The army is effectively between two
fires. The terrorist campaign is getting more and more daring and the
army, which unwittingly accused the Indians of supporting the extremists,
is now getting discredited because it is apparent that it cannot protect the
country from its enemies, despite taking a huge and growing share of
government expenditure. Pakistan has sacrificed everything else (from
state education to power generation) to feeding a large and well-equipped
army, which is now failing in its mission. The army is therefore becoming
very unpopular in Pakistan's streets. The last straw in public outrage was
the assassination of journalist Saleem Shehzad, who published a book
critical of the country's security services. The press once highly respectful,
is now openly critical of the army, sometimes even mocking it.
Despite rising remittances and a weak dollar, the Pakistani rupee
continues to lose ground against the US currency; in August is reached as
low as 87 to a dollar. The government is desperate to raise the funding it
needs for urgent infrastructural projects and is now ventilating the
hypothesis of an Infrastructure Development Levy to raise US$1.2 billion
for the building of a gas pipeline from Iran. It is also considering to raise
US$300 from a consortium of local banks. Pakistan desperately need to

produce more power. The government is also discussing the TAPI project
with Turkmenistan and a project of importing liquified gas, but none of
these is moving ahead fast enough. The government is also trying to send
a signal that the debts owed by the state to the power generation
companies; the cabinet has ordered the relevant ministries to pay the first
Rs25 billion to be paid out soon. If the long-standing debts are effectively
cleared, the power generation companies might be in a better position to
increase production to capacity levels. The total amount owed is
estimated at between Rs300-400 billion.
The violence in Karachi is having obvious effects on the economy: foreign
investment in Pakistan fell 77% in the first two months of the 2011/12
fiscal year. The tax-GDP ratio is in decline again and stands at 9.5%, as
the government has lost interest in the IMF as a source of funding, while
inflation is now around 14%. There have now been cases of trains
stopping on the tracks for lack of fuel: Pakistan Railways is on the verge of
financial collapse, not even Pakistan State Oil will supply diesel to it! The
government has been transferring money to Pakistan Railways to keep it
going, but the money has mostly been spent for salaries and little has
been left for repairing the trains and buying fuel. Now the government is
trying to make some money by blackmail: recently it approached the US
authorities, aware of their upset at Pakistani negotiations with the Iranians
over a gas pipeline connecting the two countries. It proposed that Pakistan
abandon the deal with the Iranians, in exchange for an American offer of a
deal for the production of nuclear energy similar to that enjoyed by India.
The Americans, who initially seemed to have had a muted reaction to the
announcement of the Irano-Pakistani deal, are now threatening sanctions
against Pakistan if the deal goes ahead.
On the other hand there is more and more turmoil within the army, where
opposition to cooperation with the Americans is reaching new heights. The
Corps commanders have now to show that they are receptive to the rage
of the junior and middle officers. Evidence of collaboration of armed force
officers with the terrorists is mounting; some decisive action was taken
when officers were arrested in June for collaborating with Hizb-ut-Tahrir,
one of many extremist Islamist organisations operating in the country.
There is no evidence the Hizb-ut-Tahrir was involved in any specific act of
violence and the move seems aimed at showing that the army is taking
action, while at the same time safeguarding its own powerful radical
Islamist networks within the armed forces. In a concession to the angry
officer corps, the army has blocked food and water supplies to US drone
bases in Pakistan. Of symbolic value is the arrest of several individuals,
accused of having collaborated with the Americans in tracking down

Osama bin Laden. Now many wonder what could happen if an antiAmerican coup actually takes place, or if in a more likely scenario, Chief of
Staff Kayani himself is at some point forced to go as far as demanding a
complete cessation of drone attacks inside Pakistan. The Pakistanis do
have the leverage to impose such a change, if they chose to: 70% of
supplies to ISAF in Afghanistan still come through Pakistan. When they
blocked supplies to Afghanistan in Torkham last autumn for 11 days, it was
panic in NATO. Although potentially the northern route through Russia and
Central Asia could replace the Pakistani route, surely the Russians would
demand major political concessions for this.

Background:
Formed in 1947 with the partition of British India, the Islamic Republic of
Pakistan has seen alternating civilian and military regimes throughout the
six decades of its life. It is now ruled by a semi-military regime following a
military coup by General Pervez Musharraf in 1999. Parliamentary

elections were organised in 2002, followed by local ones in 2005, but in

both cases they could not be described as free and fair and extensive
intimidation and rigging were reported. The country has fought several
wars with its neighbour India and has maintained rather bad relations with
another of its neighbours, Afghanistan, throughout most of its history. In
1973, an insurrection in the eastern part of the country, supported by
India, led to the creation of Bangladesh.
Pakistan is the only nuclear-armed Islamic state.
Summary 2006
Insurgencies have been occupying the attention of Pervez Musharraf,
developing in Baluchistan and Waziristan, two areas whose difficult
geography make it difficult for the army to control. Neither insurgency had
the potential to directly threaten the hold of Musharraf on power. Both
regions are relatively marginal in terms of contribution to the national
economy and demography and are not strategically placed. However,
Musharraf's weakness outside Punjab forced him to some compromises. In
order to diffuse the hostility of Sindh province, which was being stoked
because of the Kalabagh dam project, which would have reduced the
water flow to the province, he had to abandon the project, endangering
future water supplies for Pakistan's agriculture. The handling of the
earthquake in Kashmir has also brought much criticism.
However, the General maintains the support of the army. Furthermore,
there is still little open opposition to his rule in the core region of Punjab.
The fact that the economy is expected to perform well will help him, even
if it is slowing down compared to 2004/05, when the GDP grew by 8.4%.
The latest IMF estimates place GDP growth at 6.3% for 2005-06, while the
ADB forecasted GDP growth at 6.5-7% this year, despite a slowing of the
agricultural sector due to a decline of the cotton and sugar crops. This
would be significantly below the official target of 7.2%, but nonetheless
the IMF had words of praise for having achieved such a relatively high
level of growth.
The ADB projects GDP growth at 7% for the current year (which ends
March 2007). This would represent a modest acceleration from the
previous year, when GDP grew at 6.6%. In part this acceleration would be
due to a recovery of the agricultural sector, which was hurt by a drought
last year and is now expected to see 4.5% growth, as opposed to 2.5%
last year. Not all crops are expected to be doing well, with cotton in
particular suffering from heavy rains. However, the main factor of
accelerating growth is expected to be the industrial sector, which should

reach 9% growth from 5.9% last year. The weakest performance is

expected to come from the services sector, which should slow from 8.8%
last year to 7.1% this year. The Bank sees last year's increase in
investment continuing this year, particularly in the textiles, cement and
fertilizer, but with construction and energy also doing well. Foreign
investment is expected to boost growth in the oil and gas sectors. Even
within the services sector there will be areas of strong growth, such as
telecommunications and banking. To complete a positive economic
outlook, inflation is expected to decline to 6.5% from 8% last year, based
on the stabilisation of oil prices, the stagnation of agricultural prices due
to increased production and a tight monetary policy. Tax receipts,
traditionally a weak spot in Pakistani economic policies, are also expected
to grow significantly this year, not only because of strong GDP growth, but
also because of a series of measures taken by the government, such as
the taxation of real estate transactions and higher rates on some financial
services. There are however expected to be negative sides too in
Pakistan's economic performance this year. The ADB still sees inflation as
higher than it should be. Moreover, the current account deficit is seen as
growing further to 5.9% of GDP, from 4.4% last year. The trade balance
will be deeper into red too, at 7%. Finally, power shortages are emerging
as a significant constraint on the economy.
Economic growth is mainly fuelled by remittances, which rose from US$1.5
billion in 2001 to the current US$4 billion, triggering an investment boom,
which Prime Minister Shaukat Aziz was ready to endorse with a
privatisation plan in the banking, cement, and utilities sectors. However,
increasingly economists wonder how solid the boom is, casting a critical
eye on the rapid rise of the Karachi stock exchange, which is now
considered to be greatly overvalued, and to the rapidly expanding
consumer credit, which contributes to fund an imports boom, of which
over 60% are consumer goods.
While revenue performance remains a weak spot, the government has
been moving in the direction of creating a better business climate. The
IMF projects growth for 2006-07 at 6.5%. Inflation, however, remains
relatively high at 8.7% this year, although the IMF expects that it will be
reduced to 7.3% next year. The latest figures put inflation at 8%, down
almost two percentage points from a year ago, but the prospects for
inflation over the coming months are negative, as the wholesale price
index is rising fast and stands now at almost 10% on a yearly basis,
compared to 6.7% a year ago. Nonetheless, given the pressure on prices
caused by the high oil prices, this is considered a satisfying level, not least
because the Central Bank intervened promptly to tighten monetary policy
and forcing inflation back from a high of 11% in April 2005. Another

negative effect of the high oil prices was a rising trade deficit, which
reached a record US$6.5 billion during the first half of 2005-06, whereas
the government had projected a trade deficit of just US$4 billion for the
whole year.
Exports did well, but imports grew even faster. The latest report of the
State Bank of Pakistan shows that the current account deficit continues to
grow and has now reached 4.3% of GDP, mainly due to massive imports of
vehicles and cellular phone sets.
The current government forecast for the 2006-07 fiscal year of a US$9.6
billion deficit does not appear very realistic, even if a number of measures
to boost exports have been approved. Not least because of the
earthquake in Azad Kashmir, the budget deficit is expected to increase
this year to 3.7% of GDP, before declining to 3.3% next year. Government
debt as a percentage of GDP has been steadily declining since 2003-04
and is projected at just below 50% by 2006-07. The increase in the budget
deficit (from 3% last year to 3.7%) will be the most noticeable economic
effect of the earthquake, as the region hit by the disaster contributes only
marginally to the national GDP.
Observers were not too impressed with the new 2006-07 budget, on a
number of counts. With the forthcoming elections and the pressure from
the IMF and other international organisations to reduce the burden of
military expenditure, it was expected that the defence share of the
Pakistani budget would have gone significantly down this year.
Perhaps a reflection of the position of President Musharraf, Defence
Expenditure will rise by 12%, which will keep defence expenditure close to
5% of GDP according to most estimates. India's still growing military
expenditure is also likely to have created the conditions for this increase.
Due to the forthcoming elections, social expenditure is also going up,
pushing the budget deficit up despite the expected large increase in
revenue due to the ongoing privatisation program. The deficit is targeted
at a high 4.2% of GDP, although the 2005 earthquake is invoked as an
explanation for failing to maintain the previous, lower target. Some
observers point out that the government has understated the privatisation
proceeds by as much as US$3.4 billion, leaving space for additional
expenditure in the months preceding the elections. On the whole
expenditure is to go up 19%, with peaks in development spending (up
52.6%), especially health care, utilities and education, but the electoral
climate is also evident in the 15% increase in the wages of state
employees, the 15-20% increase in pension payments and widespread

subsidies for oil products, fertiliser, cement and foodstuff. Despite the
government's commitment to expand the revenue base, the measures
taken in the budget are modest and will deliver additional revenue
corresponding to just 0.3% of GDP.
INWARDS INVESTMENT
Foreign investment in Pakistani stocks trebled in 2005, but still stood at a
rather puny US$450 million, in a market whose total value is US$53
billion. Although Pakistani stocks grew by 60% over the last 6 months,
they are considered by analysts to still be cheaper than most other Asian
stocks. Many companies are expected to be privatised over the next two
years and this should stimulate the growth of the market. More in general,
foreign investment in Pakistan is growing and is expected to double to
US$3 billion this year. Economic growth is reckoned to be held down by
the high losses of the power sector, which is affected negatively by
corruption and inefficiency. There is currently already a power shortage of
500 megawatts, despite the fact that half of the population does not have
access to electricity, and the shortage is projected to grow to over 5,500
megawatts by 2010, increasing at the rate of 1,000 megawatts per year.
Although the country has a huge hydroelectric potential, it is not fully
exploiting it because of political issues and lack of sufficient funds to
invest.
At present, the strongest interest in investing in Pakistan comes from its
'near-abroad,' oil-rich investors based in Saudi Arabia and Dubai, who see
opportunities in industries such as building, electricity, infrastructure and
motor vehicles. Optimistic Pakistan observers estimate that as much as
US$4 to 5 billion might come yearly from these sources, out of a potential
total of as much as US$6 to 7 billion. If this potential was to be fulfilled,
that would mean nearly doubling foreign direct investment in the country,
up from US$3.5 billion in 2005-06. Indeed, this seems the only way
through which Pakistan might be able to cope with its fast rising current
accounts deficit. The optimism of these observers is for the moment being
shared by the markets, as showed by the stability of the Pakistani Rupee,
which in July was trading at around 60 to a dollar, just 1.5% lower than a
year earlier. Pakistan's central bank is hostile to the idea of devaluing the
Rupee in order to address the trade imbalance, preferring to rely on a
tight monetary policy.
One of the most daring plans on the economic reform agenda is to raise
the tax-to-GDP ratio, which currently stands at 10%, one of the lowest in
the world. On the other hand, the plan does not look so daring any more
when it is considered that the ambition is to raise it by just one

percentage point over the next five years, to 11%, when in the
neighbouring countries it is already reaches 15-19%. At present, tax
collection is actually declining and it is only because of rising customs
revenue that government income is going up. This upwards trend is only
expected to be temporary, as it reflects high oil and gas prices. For this
reason, the State Bank is calling for an expansion of the tax net, with an
improvement of collection in areas of the economy which are under-taxed,
such as agriculture, services and equity markets.
A recent World Bank report praised Pakistan for its progress during 20012005 in reducing poverty, which the Bank estimates to have declined by
five percentage points. The Bank in its report identified the privatisation of
the banking sector in Pakistan as a major factor of success in promoting
economic growth and hence reducing poverty. However, fiscal discipline
remains a key weak spot of Pakistan. For example, 11 major banks and
other financial institution, now in private hands, have not filed tax returns
for the last three years. No measure has been taken against the violators
of the law.
President Musharraf is trying to push Pakistan's economic development
towards heavier and more profitable industries and hopes that this year
Pakistan will export goods worth US$18 billion and that the same figure
will rise to US$20 billion next year. He is at the same time trying his best
to present Pakistan as full of attractive investment opportunities, including
in the energy sector, where exploration is going on at 22 different places
both inshore and offshore.
The latest two were in May: the plan to create a network of vocational and
professional schools and the creation of so-called Reconstruction
Opportunities Zones in the North-West Frontier Province. Such zones
would allow duty-free production of industrial goods and therefore
stimulate economic development in this tribal region, currently affected
by a growing insurgency movement. On the other hand, Pakistan's ranking
in the Alternate Solutions Institute's Economic Freedom Index is slipping. It
ranks now 98, compared to 90 in 2002 (out of 127 countries), a fact which
is not likely to sound attractive to investors. The main problems are
reported to be weak legal structures, security of property rights,
regulations of credit, labour and business, as well as inadequate access to
credit and limited freedom to exchange with foreigners.
Although in recent years Pakistan has received pretty positive reporting
about the status of its economy, some critical voices do exist. At the end
of April a respected former vice-president of the World Bank, Shahid Javed
Burki, warned that Pakistan risks a financial crisis of the type which hit

Mexico in 1994. His main concern was the possible convergence of a large
current account deficit, speculative business activity and a weak banking
system. Other economists agree that a further increase in oil prices could
make the trade deficit unmanageable. The latest figures show that the
trade deficit is widening indeed and was up 93.7% in July-April 2005/06
over the same period of 2004/05. Although exports continue to grow
quickly and were up almost 18%, imports grew much quicker, by over
40%. Remittances from abroad are growing very fast this year, with an
increase of 24.3% over the previous year. Over US$2 billion were sent to
Pakistan so far in 2006-7, with an obvious positive impact on the economy.
Pakistan is facing growing difficulties in securing reliable supplies of gas, a
problem which is beginning to dog other Asian economies too. Although
the Pakistani government launched three separate projects in recent years
to secure supplies, none of them seem about to be finalised. The Qatar
project seems to have completely collapsed after the Qatari government
declared that its gas reserves were insufficient for justifying the
investment required by a pipeline. The Turkmenistan pipeline through
Afghanistan will remain on hold until the security situation in that country
improves decisively. There is now a major question, after Turkmenistan
has signed a massive new supply deal with Russia as to whether they
have the remaining capacity to justify the investment and risks of a
pipeline to Pakistan and eventually India. Finally, the Iran pipeline faces
the opposition of the US government, although this project seems to be
the only one with any hope of making further progress in the short term.
The rising cost of steel is however pushing the estimated cost of the
project upwards, having now reached over US$7 billion. Moreover, Iran is
trying to extract a gas price higher then India or Pakistan would like to
pay.
INTERNATIONAL RELATIONS
In international politics, the short-term position of Pakistan seemed to be
ascending at the beginning of the year. Relations with India were slowly
improving, while the Americans still needed Pakistan. The improvement in
the relations between India and Pakistan is reflected in the trade between
the two countries, which is expected to reach US$1 billion this year, up
from US$600 million last year, thanks to the launch of the South Asian
Free Trade Area Agreement (SAFTA) and to the opening of a number of
roads and railways between the two countries. Previously, most of the
trade between the two countries was illegal. Smuggling was estimated at
US$2 billion in 2004-05, but this year estimates have fallen to about US$1
billion. Pakistan was also regaining some influence in Afghanistan, both at
the government and tribal levels. However, in the longer term Pakistan

had something to worry about. Clearly the US would like to have India as
their main partner in South Asia, a development which could only go at
Pakistan's expense. Moreover, because the relations with India are
improving only slowly, it might take a while before Musharraf has some
real gains to show for what many consider a bold move. This worries were
highlighted in march, which had started well for Musharraf, as President
Bush, during his visit to the country, had showed his commitment to the
reaffirmation of the strategic partnership between the US and Pakistan
and had praised the Pakistani counter-terrorist effort. However, a few days
later the announcement by the same Bush Administration of an
agreement to share nuclear technology with India was greeted with
dismay if not surprise in Islamabad. The announcement reminded the
Pakistani government that the strategic balance in the region is slowly
shifting in India's favour.
The Pakistani government is clearly irritated by the growing cosiness of
the relationship between India and Afghanistan and the US, as
demonstrated by Afghanistan's President Karzai's trip to that country,
which followed President Bush's own trip. Both Karzai's and Bush's trips
evidenced how India is emerging as a preferred partner in the region.
Pakistan will try its best to prevent the Indo-Afghan partnership from
taking off, for example by not allowing Indian goods to reach Afghanistan
via the land route, forcing them instead to travel by sea, which is a much
more expensive detour.
The relationship between Musharraf and the Bush Administration has been
worsening markedly over the last few months. The Americans came out
with explicit criticism of Musharraf in April, demanding free and fair
elections in 2007, civilian rule and civilian control over the armed forces,
therefore implicitly criticising Musharraf's double role as president and
chief of the armed forces. The Americans also refused to recognise the
Baluchistan Liberation Army as a terrorist organisation, sending a signal
that they might not support a ruthless anti-insurgency campaign in
Baluchistan.
While the Pakistani government reacted angrily to US criticism and
demands, at the same time it placed an order for 77 F-16 fighters, worth
US$3.5 billion. It is likely that the purpose of the Pakistanis is to test how
resolute the Americans are in their effort to step up pressure on Musharraf
and push him towards what they think is the right path. The Americans
would like to see Musharraf become a more conventional president, but it
is still not clear how far they are ready to go if he resists and remains in
full control of government. He might in fact be tempted by the possibility

of using his resistance to US pressure to strengthen popular support for

himself, as the US is strongly disliked by public opinion within the country.
However, this attitude is unnerving the Bush Administration, which
continues to send signals to Musharraf that it is unhappy about the
current trends. In June it was announced that the United States will cut its
foreign aid to Pakistan by US$350 million, explicitly citing as a reason
Pakistan's failure to improve democracy and human rights. During the
summer NATO and the UN raised the level of their criticism of Pakistan's
unwillingness to confront the insurgent groups which operate in
Afghanistan from Pakistani territory, in a move which is quite unusual of
both organisations and clearly expressed their concern at the growing
level of violence in Afghanistan.
In July, Secretary of State Rice paid a visit to Islamabad, presumably to
discuss these issues. A sign that the Bush Administration is far from ready
to dump Musharraf came when it decided to sell F-16 fighter jets to
Pakistan, as Musharraf had earlier requested, but Rice appears to have
delivered some strong message to Musharraf. During the second half of
July the Pakistani security services for the first time appeared to have
made a serious move against the Afghan Taleban, arresting a few of their
mid-rank members of the Taleban in Quetta and even hinting that they
might extradite them. During August Pakistan continued to send signals
that it has finally resolved to act against Afghan Taleban activities on its
territory. More alleged Taleban were arrested in August. Although no
known leader or prominent figure is among them, this is seen as at least a
move in the right direction by NATO and US authorities. Sceptical
observers, however, see these measures as an attempt to buy time while
hoping that increased Taleban activities in Afghanistan will soon yield
some results. By the end of the year it appeared clear that the ongoing
dispute between Pakistan and Afghanistan over the alleged Pakistani
support for the insurgency in Afghanistan has demonstrated that after all
Pakistan remains a key ally to the United States and that the Bush
Administration is not ready to put Pakistan under serious pressure in order
to have it secure the border with Afghanistan. The Afghans were then
deluding themselves that the planned 'Peace Jirgas' to be held in
Afghanistan and Pakistan will turn the situation in their favour and that
Pakistan's acceptance of the Jirga concept equals an admission from the
Pakistani side that that country is somewhat at fault. In reality, after the
announcement of the Jirgas, Pakistani officials have been as bold as ever
in their statements concerning the insurgency in Afghanistan. The
Pakistani Foreign Minister told NATO representatives in private meetings
that they should accept defeat in Afghanistan and start negotiating with
the Taleban. General Orakzai, governor of the NWFP, openly says that the

Taleban are the genuine representatives of the Afghan people. When

President Karzai of Afghanistan launched the idea of organising Peace
Jirgas (assemblies) on both sides of the Afghan-Pakistan border at the end
of the summer to resolve the outstanding issues between the two
countries and received President Bush's endorsement, President
Musharraf felt compelled to agree. However, the Pakistanis have been
slow in organising their Jirga and have issued no clear statement of what
the composition of such Jirga will be. The pro-Afghan nationalist parties of
the NWFP seem bound to be excluded, however.
Following continuing US pressure Musharraf travelled to Kabul in
September and issued conciliating statements, such as admitting that
some of the Taleban operate from Pakistan bases. Under American
sponsorship, Afghans and Pakistanis finally began to take the first steps
towards concerted control over the common border. But Musharraf
remains the key figure in the Pakistani dimension of the Taleban
insurgency. The Americans are clearly angered by the discovery that the
Pakistani judiciary has been releasing up to 2,500 of foreign 'volunteers'
who had been arrested along the Afghan border, all potential Al Qaida
activists in US eyes. The releases occurred over the past three years and
may well still be happening, despite US warning not to do it. The handing
over of a substantial chunk of Pakistani tribal areas to the notional control
of domestic Taleban must not have impressed the Americans either, not
least because it makes restraining the Afghan Taleban even more difficult.
But Pakistan makes a clear distinction between them.
Musharraf's Indian policy is mired in similar contradictions. He is still trying
to improve relations, after the July train bombings in India almost derailed
previous efforts. At government level in India they are still responding
positively to this. India after all has a domestic Islamic militant movement
- homegrown terrorists - whom Indian security sources believe to be at
least part responsible. However the two countries are still trying to show
their muscle. On 15 November Islamabad tested a nuclear-capable
medium range missile, soon followed by India's own test of a similar
device.
Something is being achieved on the trading side. The latest development
is a new agreement which is expected to be signed soon, allowing ships of
each country to lift cargo from the ports of the other country. There is also
a proposal to cooperate with India on issues related to security and
terrorism, although this faces several hurdles before becoming reality.
Pakistan remains home to several known terrorist and militant groups and
unless Musharraf finds a way to take sufficiently ruthless action against

them, he will never build real credibility abroad.

Musharraf's strength is the weakness of his enemies. The political parties,
for example, are too weak and discredited to mount a credible challenge
to the general. His policy of wooing, intimidating and bribing has managed
to further weaken the political parties, which remain quite unpopular due
to their long history of corruption, internecine fighting and ineffectiveness.
That does not mean, however, that Musharraf can ignore public opinion.
The case of the Kalabagh dam is eloquent: even members of the proMusharraf parties felt that they could not defend his decision. US antiterrorist activities in the tribal territories at the border with Afghanistan
are another example of Musharraf's inability to ignore public opinion.
Many also suspect that Musharraf might not be completely able to impose
his own policies over the army and security services, whose willingness to
cooperate with US anti-terrorist activities is at least questionable.
However, there are also generals who criticise Musharraf from the liberal
side, as evidenced by a letter signed by a group of retired generals and
circulated in July, asking him to give up his position of chief of the armed
forces, which incidentally is also one of the American demands.
Adding to Musharraf's worries, opposition leaders Benazir Bhutto and
Nawaz Sharif announced in May an alliance to fight together the future
elections and oust Musharaf from power. It is the first time that the
leaders of the Pakistan' People Party and of the Muslim League have gone
as far as forming an electoral alliance. If the alliance will be accepted by
the electorate and if the elections will be reasonably free and fair, they
might have a serious chance of unseating Musharraf. Observers are
divided with regard to how unpopular military rule has become, although
it clearly seems to have run past its peak, but without a mass movement
behind them, the politicians might not be able to gather enough
momentum to force Musharraf to make concessions. Since the old
politicians appear to remain relatively unpopular in Pakistan, and with
good cause, their success is not a foregone conclusion, particularly as long
as the economy seems to be doing well.
Musharraf in any case has his full share of problems, including the fact
that the parties which he has formed to gather support, the PML-Q and the
MMA, are increasingly divided internally. Some members of the alliance of
Islamic parties now say that they will not even contest elections under
Musharraf, although Musharraf has been manoeuvring to split the alliance
and marginalise those elements hostile to him. The PML-Q, moreover, is
mostly opposed to Musharraf's own liberal reforms. As if that was not
enough, in recent weeks he faced an unprecedented wave of criticism

following a number of scandals related to the stock exchange, the

privatisation program and sugar shortages caused by the heavy
protection afforded to a few sugar-manufacturing industrialists who
happen to be very close to the General. Most ministers have dubious
reputations and several have even been sentenced in the past for graft.
He mostly rules by decree, often suspending the parliament, which in any
case is increasingly perceived as a mere faade. Even when in session,
the parliament is often almost empty, with MPs rarely bothering to show
up.
Finally, the political parties opposed to Musharraf are becoming more
active, after the alliance of Benazir Bhutto and Nawaz Sharif. In
Baluchistan, where the army claimed to be defeating the Baluch rebels,
even the legal nationalist parties had threatened to go over to the armed
resistance if their demands for greater autonomy are not met.
In August Musharraf launched a total overhaul of his domestic Taleban
policies. The US-sponsored confrontation brought the North-West Frontier
Province to the brink of collapse, heightening tensions within Pakistan
security services and costing the Pakistani army as many as 800 killed.
Musharraf is said to have been inclined to withdraw the army back to
India's border, but US pressure prevented him from doing so. Under a new
compromise, the army will stay in the north-west but will not leave its
barracks except in emergencies. At the same time, truces were being
negotiated with the Pakistani Taleban. The plan was to strengthen the
Pakistani paramilitary forces in the region and offer (US-funded) financial
incentives to the tribal leaders to break their alliances with the extremists.
Many argue that the deal with the Pakistani Taleban looks like total
capitulation. Not only have the government agreed to free the captured
militants, but also to return their weapons. The army agreed to abandon
its checkposts and be confined in forts, renouncing the intention to carry
out military operations. Despite all this, sporadic attacks against
government troops still cause casualties. Many observers have doubts
about the sustainability of the agreement and about the potential
consequences, not least because other districts bordering Waziristan
already show signs of advanced talibanisation. The militants seem to have
perfected an infiltration technique, whereas they eliminate tribal elders
and the small intelligentsia, effectively decapitating local communities
and assuming their leadership. Whatever the medium and long term
consequences of the Waziristan accords, in the short term it appears
bound to become a resounding success, to the extent of being proposed
as a model for neighbouring Afghanistan by quite a few observers,
including some very close to the Bush Administration. President Musharraf

himself appears to have presented the deal as an exportable model during

his travel to Washington.
After having launched the revision of the Hodood ordnances in order to
improve his standing as a liberal and progressive ruler, President
Musharraf found that his initiative was backfiring. The original plan to
abolish the worst discrimination against women in Pakistan's legislation
has now been shelved. After pressure from the Islamic parties forced him
to gradually dilute and eventually eviscerate the reform, secular parties
counter-attacked. The Mujahir Qaumi Movement, which is part of the
government coalition, threatened to quit if Musharraf changed the original
version of the bill. Faced with this dilemma, Musharraf postponed the
reform. The President appears to have been weakened by the division
within his own party, over whether to keep cooperating with the Islamic
parties or to forge a new reformist alliance with the opposition People's
Party. Finally in November the amendment of the Hodood Ordnances was
approved. The law still has to be approved by the senate, but if it is, in the
future the standard evidentiary procedures will be applied to cases of
rape. The amendment, supported by Musharraf himself, has been hailed
by secular elements as a major victory and has caused strong protests by
the Islamists, even if as a pacifying concession the latter were allowed to
introduce a law which considers sex between unmarried partners a crime.
Musharraf was clearly trying to recover political ground after the old
political parties regained credibility following an end to their petty
disputes and after corruption scandals have compromised the credibility
of some of his allies, such as the Prime Minister Aziz himself. Until
recently, the reputation for corruption of the country's two main parties,
People's Party and Muslim League, had been a major asset for Musharraf.
In this regard Musharraf was embarrassed by a new report from
Transparency International, according to which his second government is
much more corrupt than the first and what is worse, it is more corrupt
than the hated civilian government which preceded Musharraf's take
over.
This must be particularly hurtful to him since he was quite scathing, in his
recently published biography, about the depths of corruption under the
civilian governments of Nawab Sharif and the Bhuttos, before he came to
power.
While this type of report would not normally have much impact on the
internal politics of a country like Pakistan, Musharraf himself had been
hailing the good performance on corruption of his government, as shown
in older reports by Transparency. Another factor weakening Musharraf was

likely the backlash following the killing by the army of Bugti, one of the
leaders of the Baluchi autonomist movement. Throughout Pakistan the
reaction to the killing has been overwhelmingly negative and has
precipitated into action even those Baluchi nationalists who seemed ready
to work within the Pakistani political system.
Summary 2007
Since general elections are planned for January 2008, year 2007 will see a
build up to that event, with the different political groups positioning
themselves along the political spectrum. The ability of the opposition to
maintain its unity is quite doubtful and President Musharraf will no doubt
play his cards carefully in order to make it even more divided. He will
probably distribute his favours in such a way as to create jealousies and
rivalries. During late 2006 he seemed to be targeting the PPP as a possible
future partner, in line with the attempt to cast himself as an enlightened
and progressive partner of the western world. During February the
government continued its offensive to establish liberal credentials with an
eye to the forthcoming elections. The latest development is the
amendment of family laws, so to grant women forced into unwanted
marriages with the option to dissolve the marriage. He knows, in any case,
that the Islamic parties will not openly confront him as long as they think
that they will have a relative freedom of manoeuvre with regard to
Afghanistan. Signs of the difficulty with which the opposition is trying to
create an effective common front continued in January. The pro-Musharraf
front, by contrast, has already signed an agreement to jointly contest the
elections, despite some divisions within the PML. The divide and rule
tactics of Musharraf and his supporters are in part the reason for the
splintering of the opposition. The reform of the Hodood ordnances
concerning the legal rights of women has cast Musharraf as a relatively
progressive president. It contrasts, as all Pajkistanis are aware, with a
military presidential predecessor, General Zia, who put the Hodood laws
onto the statute book. Following his statements against extremism and
the need for people to vote for moderates and not religious extremists,
rumours have been circulating about the possibility of an alliance between
the ruling PML and Benazir Bhutto's PPP, although the leaders of the
former officially denied it. What is already clear is that Nawaz Sharif's PML
and most of the other parties of the Alliance for the Restoration of
Democracy are willing to boycott the elections if these are held under
Musharraf, while Benazir Bhutto's PPP is inclined to participate. Even the
MMA, the alliance of Islamic parties, is divided on whether to contest polls
under Musharraf. The Jamiat Ulema-e-Islam seems inclined to run in the
elections, while Jamaat-e-Islami has declared that it will boycott them. Of
course, a deal with the PPP would imply that the PML and Musharraf would

abandon the alliance with the MMA, a development that the Americans
and the Europeans are very likely supporting wholeheartedly. Probably the
main source of opposition to such a deal is the PML itself, as they would
have then to share a substantial amount of power with the PPP at the
expense of their own men.
In March Musharraf's self-confidence was badly shaken by what seems to
have been a major mistake in sacking the country's chief justice,
particularly for not having even bothered to present a serious justification
for the act. Commentators believe that Musharraf might have feared that
the judge might have forced him to relinquish the command of the armed
forces, despite the fact that he appointed him two years ago. Masharraf's
desire to continue to serve in both positions was clashing with Pakistan's
constitution and pro-Musharraf and anti-Musharraf forces disagreed over
whether a simple majority or a two-thirds one is needed to change the
constitution. The chief justice would have had to pronounce himself on
this matter, but most observers did not doubt that he would side with
Musharraf. Even if in the past he had taken some bold steps, such as
criticising the authorities over the disappearance of hundreds of suspects
of anti-government activists, many were surprised when in February the
judge expressed his opinion in public, that Musharraf could not continue to
serve as both President and Chief of Staff of the army. The wave of
protests which followed the sacking has shaken much of Pakistan's
population from its apolitical torpor. It is seen by quite a few as has having
the potential to develop into a direct threat to the power of the
General/President. Musharraf's efforts to build a liberal image in order to
prepare the ground for a shift in alliances (after the future parliamentary
elections) are now in tatters and attempts to rig the elections will face a
more alert population. The PPP represents the real threat, as it maintains a
fair degree of popularity, while Nawaz Sharif's PML has been greatly
weakened by the fact that most of its base has split to form a proMusharraf party. A measure of how Musharraf has been weakened is also
given by the fact that rumours started circulating concerning US plans to
dump him. Although this seems premature, it is quite possible that policy
and diplomatic circles in Washington might be exploring alternative
scenarios, given the growing difficulties of their ally. Increasingly voices
are heard in Washington, stating that doomsday will not necessarily follow
if Musharraf falls.
Internally, Musharraf's popularity was beginning to be dented by the rising
tide of terrorism and non-political crime, which the security agencies seem
unable to control. Youth gangs increasingly hold sway over much of
Pakistan's cities. Image concerns also did no good to Musharraf's
popularity, such as when European countries banned PIA planes from

landing there due to safety concerns. Even the policy of the government
in the NWFP is coming under growing criticism for its inconsistencies. After
having signed protocols with pro-Taliban elements in the two Waziristans,
the armed forces have in some occasion carried out operations against
militants, undermining at least in part the protocols. The result is a
confused situation in the region, between war and peace.
In yet another sign that Musharraf is no longer able to control effectively
the Pakistani political scene, during May bloody riots hit the city of
Karachi. The riots hurt Musharraf for two reasons. First, he had built an
image of an effective manager who was much more competent than his
civilian predecessors at maintaining law and order. The fact that the riots
had an ethnic character only made things worse. Second, the riots were
organised by one of Musharraf's allies, the MQM party, against supporters
of the opposition. As a result they probably sank any prospect of a deal
with the opposition PPP. In the new situation created by the riots, which
killed over 40, it has become politically unfeasible for the leadership of the
PPP to strike a deal with Musharraf. Some observers believe that Benazir
Bhutto and her feudal allies within the PPP might still be inclined towards
a deal, as the best alternative to outstanding corruption charges being
pressed forward. However, the urban-based leaders of the party, who
have a more social-democratic background, are resolutely opposed. That
the possibility of a deal is now off is also confirmed by Musharraf's own
statement that both Bhutto and the leader of the opposition Muslim
League are barred from returning to the country before the forthcoming
legislative elections. Last month it had seemed that the way had been
cleared for Bhutto to return. This development also represent a major
upset for Washington, which had been sponsoring a Musharraf-Bhutto
alliance as the only option able to stabilise Pakistan and offer a plausible
option to inject more 'democracy' in the system. Washington seems to
have believed that Bhutto alone would not be able to control the military
and confront the radical Islamists, while at the same time it was obvious
that Musharraf is running out of steam.
The Pakistani political landscape continued unravelling during July,
following an army attack on the Lal Masjid mosque to free it from the
control of Islamic extremists. The bloody fighting marked the beginning of
a jihad against Musharraf for the country's numerous extremists. The
militants in North Waziristan declared their truce with the government
over, while a wave of suicide attacks against Pakistani security targets
started sweeping the country. Musharraf is already arguing that a purely
civilian government would not be able to cope with the expanding terrorist
threat, while at the same time reassuring the Americans that no state of

emergency will be declared and that elections will be held on time. Many,
particularly the frustrated civilian politicians in Pakistan, are however
already accusing Musharraf of having deliberately provoked the religious
extremists in order to justify his hanging on to power.
President Bush is reportedly using the threat of a Congress under
Democratic control to scare Musharraf into delivering the goods, both as
far as relations with Afghanistan and Pakistan's internal affairs are
concerned. The Democrats have a tradition of not being very friendly with
Pakistani military regimes and Musharraf knows that, although in fact
many Republican congressmen are among the angriest at what they see
as Musharraf's betrayal.
After the Supreme Court ruled in August that Nawaz Sharif could return to
Pakistan, he did try to do so in September, only to be sent off to Saudi
Arabia after just four hours in his native land. While this outcome was not
unexpected, the attempt to re-enter the country appears to have
bolstered Sharif's popularity, particularly in his native Punjab . By contrast,
the popularity of the other main opposition leader, Benazir Bhutto, is
declining after she admitted to being negotiating a deal with President
Musharraf. At the end of August sources very close to Musharraf gave the
deal as 'almost done', following the apparent decision of Musharraf to
resign as army chief by 15 November. Musharraf apparently means to quit
as army chief if he is re-elected president, and to be sworn in as a civilian
president, a compromise between his desire to quit after being sworn in
and Bhutto's demand that he quits before the re-election. A deal might
cost dearly to Bhutto since Musharraf is becoming unpopular in Pakistan:
polls put those having a favourable opinion of him below 40%. While just a
few months ago Nawaz Sharif seemed to have very limited support, the
latest polls almost place Sharif and Bhutto neck and neck in terms of
popularity. In part because of this and in part because Musharraf further
compromised his credibility by ignoring the verdict of the Supreme Court
on Sharif's right to return, the Bhutto-Musharraf deal seemed once again
in doubt. She tried to raise her price demanding not only that Musharraf
resigns as chief of staff of the army and that corruption charges against
her are removed, but also that he drops the presidential power to sack the
prime minister. She also asked that Musharraf drops his PML-Q party and
expresses support for her PPP. The move might also be a result of doubts
concerning the durability of a deal with Musharraf. A Musharraf-Bhutto
deal would also be weak because it is seen in Pakistan as being sponsored
by the Bush Administration, which is utterly unpopular in the country.
Nawaz Sharif is also likely to hit hard at Bhutto if her corruption charges
are removed - but his own are not.

Some even within the cabinet seem to be betting that Musharraf will not
be able to maintain the situation under control. Not least because the
courts remain random pieces on the board, still with moves to be made.
Ishaq Khan Khakwani, Minister of State for Information Technology,
resigned in September over Musharraf's plan to be re-elected without
resigning as army chief first, maybe hoping to ingratiate Sharif and the
crowds. Aware that Sharif has been gaining ground after his 'brave act',
Bhutto is now planning to return to the country as soon as possible.
Musharraf in the meanwhile is also feeling under pressure from the army,
after episodes of mutiny and desertions in the NWFP. The intensified fight
against Islamic militants is not popular within its ranks. The shake-up of
the army's top positions in the second half of September might possibly
be related to this, although it mainly appears to be meant to place
Musharraf's loyalists in all key positions before he quits as army chief. It
must be remembered that if he resigns as army chief, another general will
be appointed to this powerful post!
By the second half of October it was still unclear whether the deal
between Musharraf and Bhutto was standing or had even been formalised.
Musharraf was re-elected as President with the abstention of PPP
parliamentarians. He even managed to get elected while still wearing the
uniform, contrary to what demanded by Bhutto, although he pledged to
quit the army by 15 November. The fact that he also selected former head
of intelligence Lt Gen Ashfaq Pervez Kiani as his deputy and successor in
the position of Chief of Staff seems to assure that he will indeed quit.
Benazir Bhutto was granted amnesty from corruption charges and
proceeded to return to Pakistan on 18 September, welcomed by a crowd
of at least 200,000, but uncertainty remained concerning forthcoming
rulings of the Supreme Court on the admissibility of Bhutto's amnesty and
of Musharraf's re-election. As a result Musharraf had that far avoided to
meet another key demand of the PPP, namely measures to guarantee free
and fair elections. Most observers believed that the Supreme Court would
confirm Musharraf's election.
Another question mark came from the falling popularity not only of
Musharraf but of Bhutto too. October polls put Musharraf's support at just
21%, a third of what he was polling a year earlier and half of what he was
polling this summer. The security crisis affecting the country is certainly in
part to blame for this, as many Pakistanis must have expected that living
in a soft dictatorship would at least have guaranteed a high level of
security and stability. Bhutto was at the same time being overtaken by
Nawaz Sharif as the best potential prime minister. Parliamentary polls also
placed the Sharif's Muslim League on top, with PPP a close second and

PML-Q, Musharraf's party, a distant third. Although polls are unreliable in

Pakistan, the trend was clearly that of a meteoric rise in popularity of
Nawaz Sharif and his party.
Musharraf's declaration of the state of emergency in November caught
many external observers by surprise, given that Washington had seemed
to have successfully persuaded him to backtrack in August. Given that
Musharraf's first actions were to remove the President of the Supreme
Court and arrest lawyers, it appears that he feared a sentence of the
Supreme Court against the legitimacy of his re-election, or at least that he
was not ready to take such a risk. Many outside observers had believed
that the Supreme Court would have confirmed his election, but Musharraf
to whom it was critical, might well have had better information. That
would be the most likely single factor in the decision to act in the way that
he did which he must have known would cause immense domestic and
international ramifications The state of emergency indeed proved very
unpopular among the population, which responded with demonstrations in
the main cities. Musharraf was then faced with limited options: either he
maintained the state of emergency and completely alienates Washington,
or he rapidly abolished it but faces criticism because his claim to have
acted to remedy the rising violence in the country would become
completely discredited. Moreover, any chance of a deal with Bhutto and
the PPP seemed now to have disappeared. Bhutto and Musharraf traded
violent accusations and the beating to death of two lawyers by the police
makes any prospect of reconciliation even more remote. Mass arrests of
activists of both the Muslim League and the PPP did not help either. Bhutto
regained political credibility by taking a firm stand against the emergency
rule and returning to the country after Musharraf's declaration from a trip
abroad. In the immediate aftermath of the crisis, the main economic
impact was that the Karachi Stock exchange fell, but not dramatically.
There were also rumours that the Pakistani central bank injected $80
million to protect the rupee from a speculative attack which might have
significantly weakened it otherwise. The latest IMF estimates, released in
October, forecasted GDP growth at 6.4% this year and at 6.5% next year,
while inflation is forecast at 7.8% and 7% respectively. Bad news is that
external debt and liabilities rose to a new record at almost $41.7 billion in
July-September, but this is clearly unrelated to the political situation.
Polls suggested in December that inflation is the main concern of the
electorate and that Musharraf and his governments were being blamed for
it, even in rural areas. Terrorism, law and order and corruption, all ranked
very low in terms of concerns, with unemployment being the only other
issue to mobilise voters to some extent. Musharrafs best chances might
come from the division of the opposition electorate among those who

favour a boycott and those who want to vote, but despite earlier strong
support for a boycott, polls showed that a large majority was inclined to
vote after all. Although Musharraf seemed to have recovered some
support after declaring emergency rule, presumably because he showed
himself to have recovered some decisiveness, his support rate barely
reached 30%.
Among the opposition leaders Bhutto recovered some credibility after
returning to the country in the wake of the declaration of emergency and
after having taken a more confrontational stance against Musharraf, at the
expense of Nawaz Sharif, who at the end of the summer had briefly
emerged as Pakistans most popular leader. The result of the forthcoming
elections, assuming they will not be rigged, seemed at this point to
slightly favour the PPP, which was however expected to barely improve on
the previous elections, where it obtained 28% of the votes. The MMA was
split by the decision of one of its key components, Jamaat-i Islami, to
boycott the poll and its electoral fortunes are seen to be in decline. The
PML-Q has recovered some support following the emergency, damaging
the prospects of Sharifs PML-N; the two groups now stand neck and neck
in the polls. Although Musharraf lifted the state of emergency, he did so
just three weeks before the vote.
The rising climate of uncertainty is having a negative impact on foreign
investment, which declined by 16% during July-August, to US$319 million.
The uncertainty is beginning to be reflected in internal investment too:
privatisation proceeds declined by 7.7% in July-August, to US$376 million.
Lehman Brothers now advises that the risk of a Pakistani debt default is
rising significantly, while Standard & Poor's already cut its credit rating
outlook to "stable" from "positive" after the Lal Masjid mosque's incidents.
Another question was whether a new government will succeed in
controlling the rising violence in Pakistan. The attack on Bhutto's convoy
on 19 October clearly worried investors and Pakistani bonds fell by half a
point to 92.375/93.375 cents to a dollar. The October fighting in the tribal
areas was the most violent ever and featured repeated air strikes,
allegedly with significant civilian casualties.
December registered a further worsening of Pakistans trade deficit, which
during the first 5 months of the fiscal year showed a 32% increase over
the same period of the previous year. Many now see the deficit as one of
the major threats to Pakistans economic health. The fiscal deficit of the
government has also increased to 1.6%, up from 1% last year. The
forthcoming elections probably did not help, but the biggest increase in
expenditure has been in the defence budget. Financial commentators
remain however optimistic about the safety of investment in Pakistan,

believing that Musharraf will manage to maintain the situation under

control. Only sectors linked to internal consumption are seen as
vulnerable, as the future government is expected to be forced to curb
spending. However, some external investors are becoming worried and
are postponing investment plans until the situation gets clearer.
Some analysts believe that in the long term the alliance between the US
and Pakistan is unsustainable, both because Pakistan will eventually have
to decide between its two strategic allies, China and America, and
because these theorists believe that rapprochement between India and
the US can only take place at the expense of Pakistan, although this
seems to relate to the thinking of an earlier era, given the substantial
thaw between India and Pakistan over the Musharaff years and also that
there has already been a substantial rapprochement betwen the US and
India .
That Musharraf is beginning to find the role of a constantly interfering
American ally 'pulling his strings' increasingly uncomfortable, might be
shown by his earlier reluctance to attend the joint Pakistani-Afghan Peace
Jirga in Kabul. Having initially cancelled his trip, he was then 'advised' by
Rice to attend and to deliver a conciliating speech.
Another indication that such a process of re-alignment has already
started, even if slowly, is the little commented upon decision of the
Pakistani government to apply to join the China- and Russia-led Shanghai
Cooperation Organization as a full member. Pakistani currently holds
observer status at the SCO and Foreign Minister Kasuri declared at a
recent meeting of the SCO that Pakistan will pursue full membership. One
would have guessed there might have been a long and fraught telephone
call from Secretary Rice about that!
The Pakistani government has recently announced plans to merge the
Federally Administered Tribal Areas (FATA), of which the two Waziristans
are part, into the NWFP. The move would effectively end the autonomy of
the FATA tribes but will only be implemented once the local militancy issue
will have been resolved. On the other hand, such prospects might make
the pacification of the FATA more difficult. Almost at the same time the
NWFP governor, Ali Muhammad Jan Orakzai, announced that Rs130 billion
will be spent on the development of the FATA until 2015. Already over the
past five years, the development budget of the FATA was increased from
just Rs800 million to Rs69 billion annually. A FATA Development Authority
has been formed and it will involve the private sector in its activities
through joint ventures.

Economic forecasts for Pakistan are divided. Some, like The Economist,
predict a modest slowing of the economy, to around 6% GDP growth in
2007/08. The Economist also predicts the current account deficit to keep
widening and is now seen as exceeding 5% of DGP already in the current
2006/07 fiscal year. The World Bank, on the other hand, is more optimistic
and predicts a modest acceleration of GDP growth to 7% in 2007, on the
basis of the forthcoming elections and the unlikelihood of fiscal or
monetary restrictive measures. At the same time, the World Bank sees a
rise in agricultural production and investments in both infrastructure and
textiles. The latest estimates by Merrill Lynch also see GDP growth at 7%
this year and the next, corporate tax collection is up 69% and foreign
private investment 147%. Musharraf will probably be able to afford a few
'presents' to endear himself to some sectors of the population. It was
recently announced that corporate tax will be reduced from 35% to 32%
this fiscal year. The government however received a lot of criticism in the
parliament recently; concerning the real dimensions of its economic
success. Topics of criticism ranged from a poverty rate suspiciously much
lower than that estimated by the World Bank, to the negative impact on
the competitiveness of the of high electricity tariffs. The government, on
the other hand, continues to announce economic success after success,
with the support of a rather tame press. During the first 6 months of 2006,
revenue collection increased by 27%, a surprising result given that the
government itself had projected a 17% rise. The achievement seems to be
due not only to a buoyant economy, but also to reforms which included
reduced rates and a simplified procedure.
The government estimate that foreign investment will reach US$6.5 billion
this year. Just before the riots, the Karachi stock exchange had hit an alltime high. The Lahore stock exchange showed no sign of concern for the
political situation over the last several weeks. The fact that the Pakistani
rupee has been appreciating against the dollar despite the ever-increasing
trade deficit is also a sign of enduring confidence. Following Moody's
recent upgrade of Pakistan's debt, Islamabad is even planning a new issue
of foreign currency denominated bonds to finance its infrastructural
projects, although some observers are beginning to argue that Pakistan
will have to offer a higher yield to offset a rising perception of political and
security risk. The fact that the government is exceeding its own targets in
terms of raising more revenue helps in maintaining the confidence of the
creditors, even if Islamabad continues to borrow more than most
economists would like to see.
According to the latest figures, covering the period up to 30 June,
remittances from the Gulf countries are up 28% on the previous 12

months. In part this is due to the fact that Pakistani banks offer better
rates than the banks in the Gulf, but it is also taken as a sign of hope in
Pakistan's economic performance and stability. Remittances from other
countries are also up, including from the US (+17%). However, there are
signs that this confidence might be beginning to be dented. The increase
was mainly concentrated in the months preceding the recent crisis. In
June, the average increase in the remittances was just 9%, compared to
average monthly increase of 19.5%. In November, the monthly increase
had exceeded 45%. At the same time Pakistan's trade deficit has reached
its highest level ever during the 2007 fiscal year, despite record exports
which for the first time have crossed the US$17 billion mark. The 3.4%
increase in exports is well below government's hopes and is attributed to
some analysts to the deteriorating political situation in the country.
Imports, in the meanwhile, grew even faster to over US$30 billion, a 6.9%
increase on the previous year. Some observers criticise the government
for favouring cheap credit to consumers who use it to purchase expensive
luxury items, a major factor in the continuing rise of the deficit.
Among recent releases are figures showing that the banking sector was
continuing to grow very fast. Banking is already one of the comparatively
most developed sectors of the Pakistani economy and during 2006 assets
grew by another 17%. The Pakistani banking system is considered one of
the best among emergent economies in terms of capital adequacy, asset
quality and profits. The real estate sector also seems to be holding on well
despite the international crisis, having dropped by just 3% by September.
On the other hand, the government avoid reporting on public companies
like the railways or Pakistani Airlines, which are reportedly making huge
losses.
On the economic reform front, the government has announced the
privatisation of the state oil company and three state banks. These
privatisations are part of wider plans to sell US$15 billion of state-owned
companies over the next five years, in order to contribute to the
repayment of US$36 billion of overseas debt. A previous attempt to sell
the state oil company had failed in 2004 because the bidder failed to
honour its commitments. There seems to be strong interest among
international investors for the banks, particularly from Britain where
Standard Chartered has already a stake in a Pakistani bank. The general
trend of foreign investment in Pakistan is positive. According to the
Central Bank, foreign investment in Pakistan reached US$3.3 billion during
the second half of 2006, as opposed to US$3.5 billion during the whole of
the 2005/6 fiscal year.
Pressure on Pakistan for its role in fomenting unrest in Afghanistan went

up once again during January, following the statements of CIA chief

Negroponte, according to whom 'Al-Qaida has found a secure hideout in
Pakistan', and of US Maj Gen Benjamin Freakley, who stated that a key
Taleban commander was operating from inside Pakistan.
Negroponte's statement was particularly damaging, as in the past
Islamabad had claimed success in rooting out Al-Qaida, while at the same
time insisting that the Taleban had to be distinguished from the former as
an indigenous phenomenon with which negotiations were a necessity. By
denying Pakistan's success against Al-Qaida, Negroponte implicitly hit
hard at General Musharraf and implied that he has to do more to fulfil his
obligations as the ally of the United States. Combined with unrelenting
pressure from Afghanistan and with the difficult management of the truces
in Waziristan, this contributes to threaten Musharraf's image abroad of a
benevolent yet effective dictator.
Islamabad does not seem unduly worried about US pressure, however, if
in January it signalled that it intends to go on with a plan to purchase gas
from Iran, regardless of whether India also joins or not. Some observers
speculate that India might drop out of the deal in order to please the
Americans, who are trying to cut off Iran from as many markets as
possible, but many others would think that quite unlikely. In March the
Pakistanis announced that it will repatriate 2.4 million Afghans residing on
its territory, on the ground that they represent a threat to national
security. They will be given until 2009 to leave the country. Clearly, such a
move would subject Afghan economy and infrastructure to a major strain.
Signs that Pakistan might be winning its Afghan war have been multiplying
in recent months. He seems to have succeeded in convincing the Bush
Administration that his policies work in their interest too. In turn the Bush
Administration seems to have succeeded in silencing its allies, critical of
its approach towards Pakistan. The leading pro-Musharraf figure in the
Administration seems today to be vice-president Cheney. The looming
conflict with Iran is adding to the value of Pakistan as a strategic ally of
the United States and there are already insistent rumours circulating
concerning Pakistani help to US covert action in Iran. Both in the US and in
Britain influential figures such as former ministers and former diplomats
are openly arguing that Pakistan's interests in Afghanistan must be
accommodated in order to secure its cooperation in forcing the Taliban to
a negotiating table and to a compromise which does not sound like a
defeat for Washington. Some of them are even arguing that India's
influence in Afghanistan should be reduced as part of such an effort to
have Pakistan on board, while many are saying now that Kabul should be

'convinced' to recognise the controversial Durand line which marks the

border between Afghanistan and Pakistan. Although the Pakistani ruling
elite is likely to expect more in exchange for a political deal and the end of
the insurgency, these are clearly signs that the political environment is
moving in the direction pointed by Musharraf.
Summary 2008
The result of the February Pakistani elections was mostly in line with
forecasts, except that no wave of solidarity support for the PPP in the
wake of the assassination of Benazir Bhutto materialized. With almost
33%, the PPP was by far the largest party and the closest thing to a
national party with MPs relatively well distributed among provinces, but
poste d an altogether relatively mediocre performance. In part this might
have due to manipulations by the outgoing government, which tried hard
to maintain the support of large landowners in order to secure the rural
vote and might well have indulged in election rigging too. The 24%
obtained by the PML-Q is indeed more than expected and won it the
second place in terms of popular vote, although not in terms of seats,
where the PML-N of Nawaz Sharif obtained many more despite having just
20% of the votes. The Islamist coalition (MMA) fared very poorly with just
1.3% of the votes, not least because all of its component parties except
one boycotted the vote.
The incumbents' supposed manipulation of the polls failed to deliver
outright victory, an impossible task anyway given the direction of the
popular mood, but avoided the PML-Q being wiped out and forces the new
government to be based on a wide and presumably shaky coalition. With
about a third of the seats, the PPP clearly needed to form a large coalition
to be able to rule. Despite having in the past negotiated with the PML-Q
for a coalition, in the end the PPP leadership bowed to popular pressure
and offered an alliance to the PML-N, with which they have an old enmity.
In March the opposition parties reached a power-sharing agreement over
the formation of the new government.
British and American diplomatic envoys have been repeatedly reported to
be putting pressure on the politicians to spare Musharraf and leave him as
president. The PML-N looked particularly unhappy about the British and
American stance, not least because they made of the reinstatement of all
the judges sacked by Musharraf one of their main battle horses. Public
opinion was also hostile to Musharraf staying on, as it was hostile to
British and American interference.
Syed Yousuf Raza Gilani was chosen as Prime Minister at the end of March,

surprising many as most pundits were betting on the more popular Amin
Fahimi, who indeed was quite disappointed of the choice and threatened
to leave the PPP. Although the PML-N voted for Gilani with the PPP, Nawaz
Sharif was reportedly unhappy about the fact that the PPP got both the
premiership and the presidency of the National Assembly. Both Gilani and
Fahimi belong to the feudal wing of the PPP, which shows who really
controls these parties.
On top of this economic turmoil, the ruling coalition actually split in May
over the inability to agree a strategy for the re-instatement of the
Supreme Court judges sacked by Musharraf. Nawaz Sharifs quick exit
from the coalition barely three months after the elections suggest being a
junior partner in government did not suit him; he probably sees as much
more advantageous to criticise the government from the ranks of the
opposition, particularly as high food prices and a complex economic
landscape demand unpopular decisions in Islamabad.
The new civilian government too struggled to control the wave of
insurgency and terrorism which has been shaking the country over the
last several months. Despite having talked tough be fore the elections, the
politicians seem now inclined to resort to negotiations not dissimilar to
what Musharraf had been doing and the army might be even less
motivated to adopt a more confrontational attitude versus the insurgents.
The position of the army has been somewhat ambiguous. Chief of Staff
Ashfaq Parvez Kiani has once declared his desire to stay out of politics,
then the army's support for the president. It is worth noting, however, that
until the beginning of March his line of action seemed to be diverging from
Musharraf's. While the latter seemed ready to align closer and closer with
the Americans in the effort against the militants, Kiani wanted to resume
negotiations and keep military operations to a minimum. While the army
was initially hostile to a fill fledged counter-insurgency campaign, the
rising losses are now hardening its stance versus the militants and Kiani
might have to get tougher too. Although the militants have lost much of
their popularity inside Pakistan when they started killing other Pakistanis
(as opposed to Indians or Afghans or foreigners), there is almost no
support inside Pakistan for an alliance with the Americans against the
militants. The latter, maybe sensing the shift, are now openly offering
truces to the elected politicians.
Relations with Washington and the new civilian government became soon
tense and the Americans stopped exchanging information with the
Pakistani security services about their cross border operations and have
openly accused the ISI of cooperating with the Taliban. Previously,

Washingtons privileged relationship with Musharraf represented an

incentive to withhold such criticism. Now the Americans demanded an
extensive reform of the ISI. Such an attitude is unlikely to be seen
positively in Islamabad, which feels such pressure is unfair at a time of
crisis in Pakistan, particularly when the trouble started under
Washingtons friend, Musharraf.
The difficulties faced by the government are well exemplified by the
attempt to place the Inter-Services Intelligence (ISI) and the Intelligence
Bureau (IB) under the control of the Interior Ministry: within hours the
government had to backtrack on its decision after the Army complained
about it. Within the American security establishment, pressure grows for
tougher measures against the militants in the FATA and in the NWFP and
comparisons with pre-2002 Afghanistan are beginning to become
common. In Pakistan, by contrast, collaboration with the Americans is
increasingly unpopular and cross border raids are more and more
antagonising public opinion, forcing the government to take strong formal
stands against them. When Prime Minister Gilani, on a visit to Washington,
demanded a nuclear pact similar to the one in the making with India, his
statement appeared as a provocation and an attempt to force Washington
to state its position vis--vis Pakistan as a key ally. In the meanwhile, the
situation in the NWFP continues to worsen, with the militants now having
moved out of their original strongholds in the FATA and gradually taking
over the settled area; even the city of Peshawar appears increasingly in a
state of siege.
After PML-N quitting the cabinet (but staying on in the coalition), the ANP
too started threatening to quit because their two ministers have not been
assigned a portfolio as promised. The only religious party in the coalition,
Jamiat Ulema-i-Islam, which holds just 6 seats in the parliament, also
threatened to distance itself from the government in protest at military
operations against the militants. The decision to reinstate the judges
sacked by Musharraf by increasing the Supreme Court strength from 16 to
29 was not been appreciated by the PML-N, which wanted a more
aggressive attitude towards Musharraf and was trying to capture the
frustrated mood of the population with an eye to future elections. While all
this must have sounded as good news to Musharrafs ears, it was too late
for the General to reap any benefit from it. The weight of his PML-Q
declined by the day. After long sticking to Musharraf, now even the Bush
Administration began to edge closer to Prime Minister Gilani, although not
before having contributed towards making the US ever more unpopular in
Pakistan. Incidents occurring in the border region where US forces target
insurgents operating in Afghanistan and sometimes kill Pakistani civilians

and military, also contributed to widen the gap between US and Pakistan.
According to opinion polls, in July support for President Musharraf
continued to fall and reached an all time low of 9%. As many as 83%
declared that they wanted the President out. Polls, for what they are
worth, do show that PML-N is now the preferred choice of voters, with
36%, while the PPP trails behind with 32% and is seen as losing ground.
Although this is likely an inflated figure, it did reflect a surge in popularity.
Nawaz Sha rifs approval rate was now 82%, massively up from the 46%
he polled two years earlier, as opposed to Gilanis 64%. The PML-Q
suffered from Musharrafs unpopularity and was attributed a mere 4% in
the polls. In practice it seemed to be on the verge of disintegration and
therefore it made an unattractive future partner for the PPP, let alone the
fact that PPP voters also seemed to strongly oppose such option.
The reaction of the business community to the new alignment of forces is
likely to be cautious. The assassination of Benazir Bhutto was followed by
days of rioting and violence, which severely disrupted the economic life of
the country and contributed to create a climate of uncertainty and
insecurity. In particular, power cut s got worse after the rioters damaged
transmission lines; the textile and steel industries have been damaged
particularly badly. The rail network also suffered significant damage.
Although the Karachi stock exchange did not experience any collapse after
Bhutto's killing, it is remaining for the moment muted and is no longer
breaking record after record. The State Bank of Pakistan, however, revised
its inflation forecast upwards, from 6.5% to 6.5-7.5%, while the GDP
growth forecast has been cut to 6.6-7% from 7.2%. Most foreign observers
believe that the inflation rate is higher than official figures suggest and
will climb higher than forecasts. A steep decline in services exports during
November, the last month for which data is available, might reflect the
impact of rising worries over the political situation. However, remittances
continue to grow and were up 19% on the previous period during JulyDecember, although being measured in dollars this might reflect in part
the depreciation of the American currency. In January Tullow Oil, an
European company specializing in oil and gas exploration, announced it
was leaving the Pakistani market. Although oil and gas exploration in
Baluchistan and NWFP have been hampered by the violence, the move
seemed to reflect the prospect of higher profits elsewhere more than any
concern about political risk (prices of gas in Pakistan are very low). If the
political change will appear to be leading to more stability, investors'
confidence might recover from a recent decline; however should the
politicians return to the corrupt and incompetent practices of the previous
civilian governments, such confidence might soon be eroded. On the

whole the Pakistani political system still looks vulnerable and precarious.
The general economic direction is unlikely to change, but the mood in the
streets is getting darker. Shortages in supplies of wheat and flour and
power cuts are irritating the lower strata of society. It is likely to get worse,
because so far the government has not been passing on to consumer s
higher oil prices, allowing the government deficit to continue worsening.
After the elections it will be necessary to let prices grow, hitting the
population hard.
After much hesitation and under the threat of impeachment, president
Musharraf resigned in August. The coalition government in Islamabad had
decided to get rid of him at the beginning of the month, following an
apparent compromise between PPP and PML. The coalition seemed to
have agreed that he would not be prosecuted if he resigned, satisfying the
PPPs desire to leave Musharraf a way out. It appeared that a key factor in
Musharrafs decision to resign was the advice received from the top
echelons of the army that it was time to leave. PPP President Zardari
succeeded in being elected president in September, despite the PML-N
voting for its own candidate, after a part of the opposition agreed to
support his candidacy. Some observers only give Zardari only one or two
years before the army moves in to take power again, even if Chief of Army
Staff Kayani has ordered 200 military officers to return to the army and
leave the civilian agencies to which Musharraf had appointed them,
hinting a withdrawal from politics. Compared to his predecessors (his wife
and Nawaz Sharif), Zardari lacks many of the skills of the politicians and
starts with a low credibility from the outset. Moreover, everything seems
to be conspiring against him: the faltering economy, the expanding
insurgency and the worsening relations with the Americans. Despite his
stated desire to cooperate with Washington, the latters increasingly
aggressive operations in Pakistani territory are making things very difficult
for Zardari. Did the Americans merely lose their temper after so many
frustrating efforts to cooperate with the Pakistani military establishment,
or did they lack any trust in Zardaris chances of improving the situation?
The worst incident was in September, when Pakistani soldiers shot at
American troops allegedly preparing to enter Pakistani territory. Now that
president Bush has authorised raids inside Pakistani territory without the
authorisation of the Pakistani authorities, inevitably this kind of incident is
only bound to increase. If Islamabad fails to act on its statements to
protect the national territory from such kind of incursions, its credibility
will fade quickly, giving the army a good excuse to reassert itself,
although holding power right now in Pakistan, might truly be described as
holding the poisoned chalice.

As the policies of the incoming Obama administration gradually started

taking shape, it appears likely that Islamabad will come under increased
pressure. The inclination to expand the range of US military operations
carried out on Pakistani soil has already been adopted by the Bush
Administration as its own policy, authorising Special Forces raids.
The Saudi, among others, are certainly worried by what is happening in
Pakistan. Their sponsorship of talks between representatives of the Taliban
and of the Afghan government in September in Mecca was clearly more
motivated by concerns for the South Asian country, than for its Central
Asian neighbour. That Nawaz Sharif attended those talks might also be a
hint of Saudi Arabias view of a stabilisation plan for Pakistan. Nawaz
might in their eyes be a better candidate for a negotiated settlement with
the Taliban and he is unquestionably closer to the Saudis than the PPP. In
the parliament, Nawazs PML is already arguing in favour of talks with the
Pakistani militants. Zardaris aggressive approach towards the militants,
adopted recently under American pressure, is losing support even within
the government coalition, as the Jamiat-Ulama-I-Islam denounces the
alliance with Washington.
At the end of August, Sharif and his PML-N finally quit the coalition
government, in protest at the failure to reinstate all the judges sacked by
Musharraf and to the decision of Zardari to stand for President. Only about
a quarter of the judges sacked by Musharraf had been reinstated up to
that point and few believe Zardaris promise of gradually reinstating them
all, but Sharifs decision was clearly also motivated politically. Sharif did
not try to make the government fall and guaranteed cooperation from the
ranks of the opposition. It was clear, however, that he would represent a
lingering threat for Zardari, as he would try to mobilise support exploiting
the difficult economic situation and the contradictory relationship with
Washington. Sharif, a consummate politician, has a much better pulse of
the electorate than Zardari (by comparison a political pygmy), and has
carefully been positioning himself to win the next elections - if there will
be any! It might be remembered that in his previous stint as PM he tried,
by Mussolini-type methods, to introduce Wahhabi-style Sharia law, in
place of Pakistans constitutional system. Fortunately due to the personal
courage of the old gentlemen in the Parliaments Upper House he did not
succeed.
In part responding to US pressure, the Zardari government was more
proactive than its predecessor in battling with the militants in the FATA,
although there are discordant views among observers about how effective
such efforts have been. The government is now endorsing the formation of

tribal militias to contain the militants, but many raise doubts about the
long-term impact of such a strategy. Also some tribes seem to be balking,
faced with the campaign of direct reprisals by the militants, and are
seemingly trying to find an accommodation with them.
Zardari also appointed a new boss over the military intelligence service
(ISI), with a mandate to reform the agency. The ISI, theoretically under the
control of the Pakistan military High Command, has long held a reputation
as free-wheeling highly political agency, with its own agenda.
Pakistani international politics was dominated in December by the terrorist
attacks in Mumbai. The Indian intelligence services, backed by their
government, were soon claiming that the terrorists had come from
Pakistan and accused the Pakistanis of at least negligence. They
demanded that the Islamabad clamped down on terrorist groups based on
its territory and even threatened to leave all options open should
Pakistan refuse to hand in 20 terror suspects or at least wanted
criminals who had escaped to Pakistan. Of course, the Indians knew too
well that no Pakistani government would or could, ever bow to that kind of
overt Indian pressure; the statement was political theatre, meant to force
Washington into offering benefits to India in exchange for a muted
reaction to the attacks. The Indians know that the mere threat of
gathering troops at the border would force the Pakistanis to relocate most
of troops deployed to the Afghan border back to the Indian border, a
development that Washington must avoid. Zardari refused to hand over
any suspects, but he came under pressure from Secretary of State Rice to
cooperate with India in the investigations, which he probably would have
done anyway.
He then agreed to set up a joint Indian-Pakistani commission to
investigate the attacks, an unusual step which has been interpreted as an
indicator of a strong willingness in Islamabad to mend fences with Delhi.
Economic data released in May has been providing ammunition to the
pessimists. Despite claim that Pakistani industries continue to grow well,
frequent lay-offs of staff are reported in the media. Power cuts of as much
as 12 hours a day remain a common occurrence, while rioting related to
high food prices also contributes to cast a shadow on the economic
landscape. Most importantly, capital flight is significantly weakening the
Pakistani rupee, which in May reached 70 to a dollar, the lowest level in
many years and this despite the fact that the dollar is certainly not at
peak highs. For the moment being the government continues to show a
brave face and its economic development strategy seems to be still quite

in line with that of its predecessor. For example there is now talk of
opening new Export Processing Zones, which offer facilitations to exportoriented industries.
The financial landscape of Pakistan looks increasingly worrying and
international firms have reduced Pakistans rating. The Central Bank
forecasts the fiscal deficit of 20 07-8 to reach 6.5% to 7%, well above the
target of 4%. The current account deficit of the balance of payments is
forecast to reach around 7.5% of GDP, which would be an all20time high,
while the rupee depreciated 7.3% over the last year. Foreign currency
reserves keep falling and stood at US$10.9 billion in June, down from
$16.5 billion in October. The fact that as a result of the change in
government, politicians openly criticise the economic policies of recent
years, adds to uncertainty and weakens trust in the Pakistani economic
and financial system.
Despite IMF and World Bank pressure, the Pakistani government is
delaying any move to cut its subsidies on oil, gas and electricity. The
government is committed to cut its fiscal deficit from 7% to 4.7% next
year, which arguably cannot be done if the subsidies are not cut too. The
plan is to gradually phase them out, but it is not clear when the process
will start. Islamabad thinks it can afford the delay because it does not
seeks any more loans from the IMF and the US$1.5 billion which it expects
from the World Bank, is not linked to any cut in subsidies. When the
reductions will actually starts, it is likely that they will affect subsidies on
wheat rather than fuel. Indeed the government hinted that it plans to
completely eliminate wheat subsidies, despite the current high prices.
The crisis of the stock exchange was getting out of control by July and
investors were been rioting in desperation, an unusual sight in most
countries. The index lost 35% between mid April, when it reach its peak,
and mid-July. Foreign investment into the Karachi stock exchange, which
had reached US$1.76 billion in the June 2006-June 2007 period, had
practically entirely dried up. The crisis had many sources, but a perception
of weak leadership and of a fracturing coalition in Islamabad was the main
cause. The food prices crisis has been discussed in previous updates, but
a third crisis started hitting the Pakistani public hard in July, as the
government finally was forced to transfer higher fuel prices to the
consumers. Although the government had already increased fuel prices
five times since February, such increases fell far short of the actual growth
in international prices. In July instead petrol and diesel prices were
increased by 14%, an unprecedented rise in Pakistan, which immediately
led to street protests. Another piece of bad news which comes as no

surprise is that the trade deficit has reached an unprecedented US$20.7

billion in 2007-08, a 52.9% increase on the US$13.5 billion of the previous
year, despite a strong growth in exports and a weak Pakistani rupee. In
the current situation attracting foreign investment will increasingly be a
tall order; right now only China is showing a willingness to consider major
investments20in Pakistan, including hydroelectric power plants and
refineries, allegedly valued at US$12 billion.
By August pessimism was rapidly expanding among economists, several
of whom believed that Pakistan was heading for a major economic crisis.
The limitations of an economic growth policy based on the expansion of
consumption were now becoming apparent. Inflation has been growing
very fast in recent months and has now reached 24%, the highest level
ever in Pakistans history. The situation has been compounded by the slow
reaction of the State bank to the worsening inflation; the bankers seem to
have waited for the governments approval before tightening their
monetary policy, despite having the constitutional right to act
independently. The government, in turn failed to implement a tight fiscal
policy in this years budget and the deficit seems set to rise. As
confidence in the government and in the economic prospects faded,
capital flight accelerated, a fact reflected in the decline of the currency
and in the crisis of the stock exchange.
The official inflation rate reached 25.3% in September, but some
economists reckoned that the actual one could be as high as 60%. This
represented a massive increase over just a few months earlier and was
one of the main factors behind the perception of crisis among the
population at large. The State Bank of Pakistan increased the interest rate
by one point to 13%, which is likely to be insufficient to stem the tide.
However, the Bank also fears that if it continues to raise interest rates, the
economy will grind to a standstill. In this situation, it is understandable
that the government might have hesitated to further reduce subsidies on
fuel, which stood at 12 rupees per litre. A piece of good news was
however released in September, that is a 40% increase in foreign
investment year-on-year in July, mainly due to a major upsurge of
investment in the telecommunications sector, which accounted for by far
the lions share of all investment. The Banking sector also attracted more
investment, due to some mergers and acquisitions. A massive one-off
investment by the Singapore Port Authority in Gwadar also occurred in
July, thereby having the effect of a dope on the statistics.
Pakistan appeared at serious risk of default as the end of October
approached, as its requests for help towards the governments of China,

USA and Saudi Arabia were rejected. Although the Chinese promised to
intensify their economic cooperation with Pakistan and to build two
nuclear power stations, they refused to inject US$1.5 -3 billion into the
countrys central bank, as requested by Islamabad, in the absence of
structural reforms. They only conceded a US$0.5 billion loan. The Saudis
refused to offer discounts on their oil. The government, which needs
US$10 billion to meet short term liabilities, is now considering to apply for
IMF help, a move which is considered as the last resort as it would imply, if
successful, a tightening of its economic policies: removal of subsidies,
tighter monetary policy and steps toward reducing the fiscal deficit, all of
which are expected. In mid-October the government already announced
its intention to completely abolish subsidies on fuel, a move in a direction
which must please the IMF. The World Bank and some donor countries will
cover part of the bill too.
The economic situation got rapidly worse, with electricity one hour on and
one hour off. By October the central bank had foreign currency reserves
for just two months of imports, after they had fallen by 75% in a year. The
failure to secure Chinese aid led to a further drop in the value of the
rupee, which at one point had lost almost a third of its value, making vital
imports even more expensive. The economic crisis in America is also likely
to affect Pakistan negatively, as remittances (forecast initially at US$7
billion) are expected to fall this year. Both Standard & Poor's, and Moody
have been rapidly downgrading Pakistans rating, which is now one of the
lowest in the world, and hint that they are considering downgrading again.
The balance of payments deficit, worsened markedly in the last quarter
(to end September), from US$2.3 billion to US$3.95 billion. The currentaccount deficit reached US$14 billion in September. Capital flight reached
US$1.2 billion a month over the summer and autumn. Foreign investment
in Pakistani shares more than halved and is expected to dive further. The
banking system was in deep crisis, with liquidity drying up despite the
injection of cash by the central bank. The countrys indebtedness was
rising twice as fast as one year ago. Economic forecast were constantly
being revised downwards: the IMF estimate has fallen to 5.4% GDP growth
this year and 3.5% next year. The allocation of resources to the deprived
classes, a key feature of the government0s programme, was already being
curtailed, while the focus shifted to rescuing the banking sector and
offering bank holidays to foreign investors. The government is now relaunching the privatisation programme, in the hope of raising some cash.
The Pakistani government seems to be counting on the support of Western
and conservative Gulf states to help preventing its economic collapse, but
the crisis has arrived at the wrong time. Pakistans allies will meet in
November to see what they can do, but cash suddenly is short these days,

particularly in the West.

An earthquake at the end of October added to Pakistans economic woes.
Many Pakistanis have such negative views of the economic situation in
their own country, that they are even moving money to Afghanistan, as
well as Dubai. In mid-November Islamabad formally approached the IMF
over a 5.1 billion loan: they had earlier stated that such an option would
have been their last resort, as such a move is deeply unpopular in
Pakistan. Islamabad accepts now that it needs IMF help to raise the cash
needed to service its international obligations and has already made the
politic al decision to cut the budget deficit to 4.3% of GDP and gradually
eliminate electricity subsidies, all steps which the IMF will approve. But
the attempt by the government to raise electricity prices led to
widespread protests and Islamabad backed down; the government
continued borrowing money from the Central Bank, raising doubts about
its ability to contain the budget deficit.
At the end of November the IMF agreed to a US$7.6 billion loan to
Pakistan, which Islamabad hopes will unlock assistance packages from a
number of other countries. The demand associated with the loan include a
host of internal reforms, which are politically unpopular, but the
government had little choice if it wanted to avoid default. The Karachi
stock exchange had lost 40% of its value before the imposition of a floor
to limit the slump, but it is estimated that the actual value of shares might
already be 30% of that level. Foreign investors, who had invested US$2.3
billion, have f led en masse from the stock exchange, as have many
Pakistanis. Official sources acknowledged that the economy is rapidly
slowing down. GDP growth forecasts have been revised downwards to 3.54% by the State Bank of Pakistan, while the IMF is slightly more
pessimistic and estimates 3.4% GDP growth. Not all news is bad news
though. Inflation is expected to decline somewhat to between 20-22%
from the current 25%. The drop in oil prices and the cut in subsidies
should also allow for containing the current account deficit and the budget
deficit, to respectively 6.5% and 4.7%, according to the IMF.