| On the Ground |

Analyst
Sayem Ali, +92 21 3245 7839
Standard Chartered Bank (Pakistan) Limited
Economist
Sayem.Ali@sc.com

Pakistan’s FY11 budget – Debt and taxes

08:30 GMT 08 June 2010

FY11 budget targets reducing the deficit to 4% of GDP from 5.3% to limit public debt, inflation
GST rate raised to 17% from 16%, introduction of VAT delayed to October 2010
Energy subsidies reduced by 50%; investment spending raised to 3.9% of GDP from 3.5%
Budget aims to support growth of 4.5%, bring inflation down to 9.5%; we see inflation of 12%

Breaking out of the debt trap

The government’s debt position has become unsustainable, with debt-servicing costs and military spending accounting
for nearly 80% of tax revenue in FY10. This has left the government with no option but to continue funding its large deficit
by creating new debt at high interest rates – public debt rose to 60% of GDP in FY10 (ends June 2010) from 58.1% in
FY09. Facing a severe cash crunch, the government has resorted to printing money for deficit financing, almost PKR
178bn (1.2% of GDP) by 21 April 2010. This has fuelled inflation – CPI inflation rose to 13.3% y/y in April 2010 from 8.9%
in October 2009.

The FY11 budget aims to break out of this debt trap. It proposes tough new measures to increase tax revenues and cut
subsidies in order to reduce the deficit to 4% of GDP from an estimated 5.3% in FY10. Tax revenues are targeted at PKR
1.67trn (10.5% of GDP), an increase of 20% y/y. This will be achieved by increasing the general sales tax (GST) rate to
17% from 16% and raising federal excise duty (FED) on natural gas and consumer durables. However, the introduction
of value added tax (VAT) – the cornerstone of the IMF-funded stabilisation plan – has been delayed until October 2010 in
the face of opposition from provincial governments. The government is also targeting a sharp reduction in energy
subsidies to PKR 87.3bn (0.5% of GDP) in FY11 from PKR 180bn (1.2% of GDP) in FY10.

While the FY11 budget includes all the right elements, questions remain about its ambitious targets, especially since the
government missed all of those set in the FY10 budget. The budget also lacks focus on resolving the debilitating power
crisis that cost the economy 2.2% of GDP in FY10, with the government allocating spending of only 0.2% of GDP to the
power sector. While the huge losses posted by the state enterprises and bailouts funded by taxpayers’ money featured
prominently in the finance minister’s speech, the budget included no tangible measures to improve their financial health.

Inflation remains the overriding concern, and the FY11 budget measures are likely to push it higher. The 1ppt increase in
the GST rate and the reduction of energy subsidies via power tariff hikes of another 12% will lead to higher inflation. The
massive 50% salary hike for all civil servants by the cash-strapped government will also fuel demand-side inflationary
pressures. We believe inflation will remain high at 12% in FY11, significantly above the government target of 9.5%,
leaving no room for the central bank to lower policy rates. The FY11 budget is targeting lower deficit financing from the
banks, which will exert downward pressure on T-bill rates. However, in our view, financing from banks will remain
significantly higher than targeted, limiting the downside for rates.

Important disclosures can be found in the Disclosures Appendix

All rights reserved. Standard Chartered Bank 2010 http://research.standardchartered.com
Ref: GR10JA
 On the Ground | 08 June 2010

Chart 1: Public debt rises to 60% of GDP Chart 2: Debt and military spending consume 80% of
% of GDP tax revenue (% of tax revenue)

80% 100%

70%
80%
60%

50% 60%
40%

30% 40%

20%
20%
10%

0% 0%

FY03

FY04

FY05

FY06

FY07

FY08

FY09

FY10
FY03

FY04

FY05

FY06

FY07

FY08

FY09

FY10

Domestic debt External debt Debt payments Defence spending

Sources: Ministry of Finance, IMF staff report Source: Ministry of Finance

Taxing times ahead

Pakistan has one of the world’s lowest levels of tax collection: tax revenues were a dismal 10% of GDP in FY10, even
lower than the 10.3% collected in FY09, reflecting a small tax base and large exemptions for key sectors of the economy.
The government is targeting a sharp 20% y/y increase in tax revenues to PKR 1.67trn (10.5% of GDP) in the FY11
budget. Key tax measures outlined in the budget are discussed below.

The introduction of VAT to replace the existing GST has been delayed until October 2010 due to opposition
from provincial governments. VAT was the cornerstone of the IMF-financed stabilisation plan and was expected
to raise nearly PKR 82bn (0.5% of GDP) of revenue in FY11 by removing distortions in the current GST regime,
expanding the tax base by reducing exemptions, and removing the zero-rate status granted to select industries.
The key sectors targeted by VAT are wholesale and retail, transport and storage facilities, and real estate. The
government has increased the GST rate by 1ppt to offset the revenue loss from the delay in VAT
implementation.

The GST rate has been increased to 17% from 16%. This is a temporary measure to increase tax revenues
while the federal government irons out issues with the provincial governments in order to introduce VAT by
October 2010. GST on natural gas supplied to CNG stations has been increased to 26% from 25%. Similarly,
GST on iron has been increased to 22% (from 21%) and on steel products to 19.5% (from 18.5%).

Federal excise duty (FED) is being implemented on a wider range of products, and is expected to generate
additional tax receipts of PKR 30bn (0.2% of GDP). FED will be imposed on telecommunications services (PKR
7bn) and consumer durables, including air conditioners and refrigerators (PKR 7bn). It will be increased to PKR
10/MMBTU for natural gas and by 10% for compressed natural gas. This should result in additional revenue of
PKR 10bn. The FED rate on cigarettes is also being increased, to raise an additional PKR 5bn.

Income tax rates for salaried employees will be rationalised, and the number of tax bands reduced from 20 to 12,
resulting in additional revenue of PKR 1bn. The maximum rate of 20% will now apply to annual income of PKR
4.5mn, down from PKR 8.5mn earlier.

Presumptive income tax on commercial importers will be increased to 5% from 4%, which should yield
additional tax revenue of PKR 12bn.

2
Ref: GR10JA
 On the Ground | 08 June 2010

Capital gains tax (CGT) will be levied on the sale of shares of listed companies by local and foreign investors.
CGT will be applied at a rate of 10% for shares sold within six months, and 7.5% if the holding period is greater
than six months and less than one year. The government will target PKR 5bn of additional revenue by imposing
CGT on the equity markets.

A withholding tax of 0.3% will now also be levied on cash withdrawals exceeding PKR 25,000; this will include
bank drafts, payment orders, online transfers and telegraphic transfers.

The government proposes increasing the turnover tax on loss-making entities to 1% from 0.5%.

Chart 3: Declining tax revenues Chart 4: Distortions in the tax regime

% of GDP % of GDP and % of taxes

16% 70%
15% 60%

14% 50%

13% 40%

12% 30%
20%
11%
10%
10%
0%
9%
Agriculture

Wholesale &

Finance &
Manufacturing

Communication

Insurance
Retail Trade
Transport &
8%
FY03

FY04

FY05

FY06

FY07

FY08

FY09

FY10

Total revenue Tax revenue

Share of GDP Share of taxes

Source: Federal Board of Revenue Source: Federal Board of Revenue

‘Rationalisation’ of subsidies
The other main focus of the FY11 budget will be on rationalising subsidies; the government plans to save 0.7% of GDP
by reducing energy subsidies. This will mean hiking power tariffs by another 12%, which will reduce the subsidy it is
paying – the differential between the cost of power generation and the price paid by end consumers – by PKR 92bn
(0.7% of GDP), the government estimates. Since 2008, it has increased power tariffs by 69%, from PKR 5.1/unit in
January 2008 to PKR 8.6/unit in April 2010; this has resulted in double-digit inflation since then.

The tariff increases should also end the build-up of circular debt due to delays in subsidy payments to power producers
and help to bring additional power of nearly 2,200 MW online. This circular debt currently stands at PKR 216bn and
covers the entire length and breadth of the energy supply chain, including power producers, oil marketing companies, oil
refiners and financial institutions.

Sustaining growth through higher investment spending, but where is the energy plan?
The FY11 budget aims to sustain the country’s economic growth momentum, with growth forecast to rebound strongly to
4.1% y/y in the current fiscal year, driven by higher government spending and a pick-up in export growth. However, the
sustainability of the recovery remains a concern, especially given the sharp slowdown in investment spending, which
already declined to 16.6% of GDP in FY10 from 19.7% in FY09. Both government and private-sector investment have
declined sharply, with government consumption spending crowding out private-sector investment. The government has
allocated PKR 663bn (3.9% of GDP) for investment spending in FY11, up from PKR 510bn (3.5% of GDP) in FY10. For
the first time, provincial governments will get the lion’s share (56.3%) of the funds available under the Public Sector

3
Ref: GR10JA
 On the Ground | 08 June 2010

Development Program (PSDP), as agreed under the landmark National Finance Commission (NFC) award between the
provinces and the federal government in November 2009.

The most striking part of the investment plan is its lack of focus on the power sector. The economy is facing its worst-
ever power crisis, with the government estimating the power generation shortfall to be as large as 5,000 MW during peak
hours – resulting in frequent power cuts that affect the whole economy. According to the government’s own estimates,
the power crisis has cost the economy close to 2.5% of GDP in FY10. Hence, the allocation of only PKR 40.4bn (0.2% of
GDP) to the power sector raises serious questions about the government’s ability to tackle the power crisis.

Investment in domestic energy resources, including the Thar coal mines and large hydroelectric projects, is crucial to
sustaining the economic growth momentum. Such investment would also help to provide lower-cost energy to the
manufacturing industry to boost its competitiveness, and to reduce the oil import bill. Pakistan’s high oil imports put
pressure on the FX reserves and also leave the economy highly vulnerable to commodity price shocks.

Table 1: Pakistan – FY11 budget targets (% of GDP)

FY11 SCB
FY08 FY09 FY10 estimate FY11 budget
estimate
Total revenues 14.6% 14.1% 14.0% 14.3% 14.1%
Tax revenues 10.6% 10.3% 10.0% 10.5% 10.3%
Non-tax revenues 4.0% 3.6% 4.0% 3.8% 3.8%

Total expenditure 22.2% 19.3% 19.3% 18.3% 18.3%

Debt payments 5.1% 5.0% 5.6% 5.1% 5.1%
Defence spending 2.7% 4.3% 2.6% 2.6% 2.6%
Investment spending 4.4% 3.8% 3.5% 3.9% 3.9%

Fiscal deficit
-7.6% -5.2% -5.3% -4.0% -4.2%
(excluding grants)

Financing 7.6% 5.2% 5.3% 4.0% 4.2%

External (incl. grants) 1.5% 1.2% 1.5% 1.1% 1.0%
Domestic 6.1% 4.2% 3.8% 3.0% 3.2%
Non-banks 1.0% 1.8% 1.2% 2.0% 1.4%
Banks 5.1% 2.4% 2.6% 1.0% 1.8%

Memo items
Real GDP growth 3.8% 1.2% 4.1% 4.5% 4.0%
CPI inflation 12% 20.8% 12% 9.5% 12%
GDP USD bn 164.6 166.5 174.6 190.7 191.2
Public debt % of GDP 58.4% 58.1% 60.0% 61.5% 61.5%
Sources: Ministry of Finance, Standard Chartered Research

Rates to inch down on lower deficit financing from banks

The government aims to finance its FY11 deficit of 4% of GDP primarily through non-banking resources, including
national savings, corporate bonds and privatisation receipts. Financing from banks is budgeted to decline to PKR 166bn
(1% of GDP) in FY11 from 381bn (2.4% of GDP) during the period from July 2009 to 21 April 2010. This should reduce
the supply of T-bills in the market and exert downward pressure on rates. However, delays in the release of external aid
and privatisation receipts will increase government borrowing from banks. In our view, government borrowing from banks
will remain high at PKR 305bn (1.8% of GDP) in FY11, limiting the downside for rates.

4
Ref: GR10JA
 On the Ground | 08 June 2010

Disclosures Appendix

Regulatory disclosure
Subject companies: --
Standard Chartered Bank and/or its affiliate(s) has received compensation from this company for the provision of
investment banking or financial advisory services within the past year: --.

Global disclaimer
SCB makes no representation or warranty of any kind, express, implied or statutory regarding this document or any information
contained or referred to on the document.
If you are receiving this document in any of the countries listed below, please note the following:
United Kingdom: Standard Chartered Bank ("SCB") is authorised and regulated in the United Kingdom by the Financial Services
Authority ("FSA"). This communication is not directed at Retail Clients in the European Economic Area as defined by Directive
2004/39/EC. Nothing in this document constitutes a personal recommendation or investment advice as defined by Directive 2004/39/EC.
Australia: The Australian Financial Services Licence for SCB is Licence No: 246833 with the following Australian Registered Business
Number (ARBN : 097571778). Australian investors should note that this document was prepared for wholesale investors only (as
defined by Australian Corporations legislation).
China: This document is being distributed in China by, and is attributable to, Standard Chartered Bank (China) Limited which is mainly
regulated by China Banking Regulatory Commission (CBRC), State Administration of Foreign Exchange (SAFE), and People’s Bank of
China (PBoC).
Hong Kong: This document is being distributed in Hong Kong by, and is attributable to, Standard Chartered Bank (Hong Kong) Limited
which is regulated by the Hong Kong Monetary Authority.
Japan: This document is being distributed to the Specified Investors, as defined by the Financial Instruments and Exchange Law of
Japan (FIEL), for information only and not for the purpose of soliciting any Financial Instruments Transactions as defined by the FIEL or
any Specified Deposits, etc. as defined by the Banking Law of Japan.
Singapore: This document is being distributed in Singapore by SCB Singapore branch only to accredited investors, expert investors or
institutional investors, as defined in the Securities and Futures Act, Chapter 289 of Singapore. Recipients in Singapore should contact
SCB Singapore branch in relation to any matters arising from, or in connection with, this document.
South Africa: SCB is licensed as a Financial Services Provider in terms of Section 8 of the Financial Advisory and Intermediary
Services Act 37 of 2002. SCB is a Registered Credit provider in terms of the National Credit Act 34 of 2005 under registration number
NCRCP4.
UAE (DIFC): SCB is regulated in the Dubai International Financial Centre by the Dubai Financial Services Authority. This document is
intended for use only by Professional Clients and should not be relied upon by or be distributed to Retail Clients.
United States: Except for any documents relating to foreign exchange, FX or global FX, Rates or Commodities, distribution of this
document in the United States or to US persons is intended to be solely to major institutional investors as defined in Rule 15a-6(a)(2)
under the US Securities Act of 1934. All US persons that receive this document by their acceptance thereof represent and agree that
they are a major institutional investor and understand the risks involved in executing transactions in securities. Any US recipient of this
document wanting additional information or to effect any transaction in any security or financial instrument mentioned herein, must do so
by contacting a registered representative of Standard Chartered Securities (North America) Inc., 1 Madison Avenue, New York, N.Y.
10010, US, tel + 1 212 667 1000.
WE DO NOT OFFER OR SELL SECURITIES TO U.S. PERSONS UNLESS EITHER (A) THOSE SECURITIES ARE REGISTERED
FOR SALE WITH THE U.S. SECURITIES AND EXCHANGE COMMISSION AND WITH ALL APPROPRIATE U.S. STATE
AUTHORITIES; OR (B) THE SECURITIES OR THE SPECIFIC TRANSACTION QUALIFY FOR AN EXEMPTION UNDER THE U.S.
FEDERAL AND STATE SECURITIES LAWS NOR DO WE OFFER OR SELL SECURITIES TO U.S. PERSONS UNLESS (i) WE, OUR
AFFILIATED COMPANY AND THE APPROPRIATE PERSONNEL ARE PROPERLY REGISTERED OR LICENSED TO CONDUCT
BUSINESS; OR (ii) WE, OUR AFFILIATED COMPANY AND THE APPROPRIATE PERSONNEL QUALIFY FOR EXEMPTIONS
UNDER APPLICABLE U.S. FEDERAL AND STATE LAWS.
The information on this document is provided for information purposes only. It does not constitute any offer, recommendation or
solicitation to any person to enter into any transaction or adopt any hedging, trading or investment strategy, nor does it constitute any
prediction of likely future movements in rates or prices or any representation that any such future movements will not exceed those
shown in any illustration. Users of this document should seek advice regarding the appropriateness of investing in any securities,

5
Ref: GR10JA
 On the Ground | 08 June 2010

financial instruments or investment strategies referred to on this document and should understand that statements regarding future
prospects may not be realised. Opinions, projections and estimates are subject to change without notice.
The value and income of any of the securities or financial instruments mentioned in this document can fall as well as rise and an
investor may get back less than invested. Foreign-currency denominated securities and financial instruments are subject to fluctuation in
exchange rates that could have a positive or adverse effect on the value, price or income of such securities and financial instruments.
Past performance is not indicative of comparable future results and no representation or warranty is made regarding future performance.
SCB is not a legal or tax adviser, and is not purporting to provide you with legal or tax advice. If you have any queries as to the legal or
tax implications of any investment you should seek independent legal and/or tax advice.
SCB, and/or a connected company, may have a position in any of the instruments or currencies mentioned in this document. SCB has
in place policies and procedures and physical information walls between its Research Department and differing public and private
business functions to help ensure confidential information, including ‘inside’ information is not publicly disclosed unless in line with its
policies and procedures and the rules of its regulators. You are advised to make your own independent judgment with respect to any
matter contained herein.
SCB and/or any member of the SCB group of companies may at any time, to the extent permitted by applicable law and/or regulation,
be long or short any securities or financial instruments referred to on the website or have a material interest in any such securities or
related investment, or may be the only market maker in relation to such investments, or provide, or have provided advice, investment
banking or other services, to issuers of such investments.
SCB accepts no liability and will not be liable for any loss or damage arising directly or indirectly (including special, incidental or
consequential loss or damage) from your use of this document, howsoever arising, and including any loss, damage or expense arising
from, but not limited to, any defect, error, imperfection, fault, mistake or inaccuracy with this document, its contents or associated
services, or due to any unavailability of the document or any part thereof or any contents or associated services.
Copyright: Standard Chartered Bank 2010. Copyright in all materials, text, articles and information contained herein is the property of,
and may only be reproduced with permission of an authorised signatory of, Standard Chartered Bank. Copyright in materials created by
third parties and the rights under copyright of such parties is hereby acknowledged. Copyright in all other materials not belonging to third
parties and copyright in these materials as a compilation vests and shall remain at all times copyright of Standard Chartered Bank and
should not be reproduced or used except for business purposes on behalf of Standard Chartered Bank or save with the express prior
written consent of an authorised signatory of Standard Chartered Bank. All rights reserved. © Standard Chartered Bank 2010.

Regulation AC Disclosure:
The research analyst or analysts responsible for the content of this research report certify that: (1) the views expressed and attributed to
the research analyst or Analysts in the research report accurately reflect their personal opinion(s) about the subject securities and
issuers and/or other subject matter as appropriate; and, (2) No part of his or her compensation was, is or will be directly or indirectly
related to the specific recommendations or views contained in this research report. On a general basis, the efficacy of recommendations
is a factor in the performance appraisals of analysts.

Data available as of 08:30 GMT 08 June 2010. This document is released at 08:30 GMT 08 June 2010.
Document approved by: Nicholas Kwan, Head of Research, East.

6
Ref: GR10JA