State Bank keeps policy rate unchanged at 12 per cent

Karachi: Central Board of Directors of State Bank of Pakistan SBP on Saturday decided to keep the policy rate unchanged at 12 percent. This was announced by SBP Governor Yaseen Anwar while unveiling Monetary Policy Statement in news conference at SBP, Karachi. “The basic challenge faced by Pakistan’s economy is financing its fiscal and external current account deficits. The size of these deficits may not be considered large given current state of falling private sector investment demand in economy. A reflection of overall low aggregate demand can be seen in declining inflation trend, contraction in real private sector credit, and falling volume of imports. SBP’s monetary policy stance in FY12 so far, a cumulative reduction of 200 basis points, has been largely framed in this context,” Anwar said.

He said lack of diversified and sustainable financing sources resulted in substantial borrowings from banking system by the government and declining foreign exchange reserves. This has squeezed availability of credit for private sector and increased pressure on rupee liquidity. SBP has been providing substantial liquidity on almost permanent basis, on average Rs230 billion during 1st July – 9th February 2012, to ensure smooth functioning of payment system and avoid financial instability. The continuation of this trend, however, carries risks for effectively anchoring inflation expectations in the medium term.

He said “uncertain market liquidity flows have lead to excess volatility in short term interest rates and increased challenges of monetary management. Main reasons for this uncertainty include: a sharper deterioration in external current account deficit, a declining trend of foreign inflows, and a higher currency to deposit ratio. However, other market interest rates, such as KIBOR and Weighted Average Lending Rate WALR, have largely followed policy rate reductions.”

A declining interest rate environment together with a relatively better growth in Large-scale Manufacturing LSM is expected to help pickup in private sector credit. LSM sector grew by 1.5 percent during July-November, FY12, which is in contrast to an average contraction of 3.1 percent during same period of last three years. Moreover, credit to private sector has expanded by Rs238 billion during 1st July – 3rd February, FY12. However, to assess its likely path few points need to be kept in mind.

“First, given continuing energy shortages, unfavourable law and order conditions, and uncertain political environment, the desired boost in business confidence and thus private sector credit may not take place. Second, profitability of textile sector, a major user of private sector credit, was better in FY11 due to higher cotton prices. This would facilitate repayments or keep demand for fresh credit to a minimum in FY12. Third, utilization of installed industrial capacity is considerably low and continues to decline, which is inhibiting credit demand for fixed investment. Fourth, all of fresh credit disbursement in H1FY12 was utilized to meet working capital requirements, which implies that a significant part of this credit will be retired in H2FY12,” he said.

Thus, full year expansion in credit to private sector is expected to remain weak for yet another year in FY12 despite interest rate reductions. Its year-on-year growth is already negative in real terms and indicates depressed private investment demand in economy. In addition, given substantial government borrowings from scheduled banks together with rising NPLs, banks are likely to continue to avoid lending to relatively risky private sector.

According to provisional data, government has borrowed Rs444 billion from banking system, during 1st July – 3rd February, FY12 to finance its current year’s fiscal deficit. This includes Rs197 billion borrowed from SBP and show a year-on-year growth of 25.8 percent. Moreover, these borrowings are significantly higher than yearly financing requirements of Rs293 billion envisaged in FY12 budget.

Provisional estimate of fiscal deficit for H1FY12, from financing side, shows deficit of Rs532 billion or 2.5 percent of GDP. Given that fiscal deficit is always higher in second half of a fiscal year, by at least 0.5 percent of GDP during last ten years, containing FY12 fiscal deficit close to government’s revised target of 4.7 percent of GDP would be difficult. Encouragingly, tax collection by the Federal Board of Revenue during H1FY12, at Rs840 billion, has shown a strong growth of 27.1 percent. Similarly, announcement of auction of 3G licenses in telecommunication sector is positive development and could help in containing potential fiscal slippage.

Anwar said: “However, based on seasonal pattern of tax collections, full year target of Rs1952 billion still seems ambitious. At same time, there are indications that issue of circular debt in energy sector remains and losses of major Public Sector Enterprises PSEs continue to increase. Thus, likelihood of slippages on expenditure side on account of subsidies, over and above budgeted amount, cannot be ruled out. Delay in these subsidy payments may have implications for resolving circular debt issue.”

“The risks to external position have also increased due to worsening terms of trade, fragile global economic conditions, and continued paucity of financial inflows. In addition, $1.1 billion are scheduled to be repaid to IMF in H2FY12. SBP’s foreign exchange reserves have already declined to $12.2 billion as on 9th February 2012 from $14.8 billion at end June 2011. Similarly, rupee dollar exchange rate has depreciated by 5.2 percent in FY12 so far.”

Led by 33.7 percent growth in imports of petroleum products on back of elevated international oil prices, total imports have increased to $19.7 billion in H1FY12. Volume of imports remained muted, which indicates moderation in domestic demand pressures. Given rising tensions in US-Iran relations and political uncertainty in Middle East region, oil prices are unlikely to fall significantly in near future and may even increase. Therefore, despite low volumes, imports are projected to grow in range of 12.5 to 14.5 percent for FY12.

Similarly, while falling cotton prices played their part in sharper than expected slowdown in export receipts, $12 billion in H1FY12, volume of exports have also declined considerably. Assuming that these trends would continue in H2FY12 export receipts are projected to show decline of 3 to 5 percent in FY12. Incorporating steady flow of workers’ remittances, external current account deficit is expected to remain in range of $3.5 billion to $5.5 billion or 1.5 to 2.4 percent of GDP. The possibility of limiting deficit to lower bound of range is mainly contingent upon realization of Coalition Support Fund, $800 million, and proceeds from auction of 3G licenses, estimated to be around $850 million.

SBP Governor said: “The real challenge is to finance this projected external current account deficit. Actual net capital and financial inflows during H1FY12 was only $167 million due to decline in both direct and portfolio investments and shortfalls in official flows. Assuming that all official flows contemplated by the government are realized – $500 million from issuance of euro bonds, $800 million from privatization proceeds of PTCL, and budgeted loans from international financial institutions – the net capital and financial inflows could increase to $3.8 billion by June 2012.

“These fiscal and external developments have resulted in a skewed composition of monetary aggregates. In particular, increase in Net Domestic Asset NDA component of M2 is disproportionally large while Net Foreign Assets NFA has contracted. Given its strong correlation with inflation, resulting increase in NDA to NFA ratio is not a welcome development. The year-on-year growth in M2 for FY12 is projected to be in range of 12 to 13 percent.”

The changing composition of M2 requires a careful interpretation. For instance, deterioration in external sector is mostly due to adverse terms of trade developments and uncertain official inflows and may not be a sign of rising aggregate demand. Similarly, pressure on aggregate demand due to government borrowings from banking system is being partly offset by weak private investment demand.

These conjectures are supported by decline in year-on-year CPI inflation to 10.1 percent in January 2012. In addition to moderation in aggregate demand, this also reflects improvement in domestic supplies of food items. However, there are indications of underlying inflationary pressures. For instance, number of CPI items showing year-on-year inflation of more than 10 percent is significant and mostly belong to non-food category.

SBP expects average inflation in FY12 to remain in range of 11 to 12 percent, which implies an uptick in inflation in H2FY12. The main reasons for this assessment include: increases in electricity and gas prices, high international oil prices, impact of exchange rate pass-through, increase in support price for upcoming wheat procurement season, and substantial government borrowings from banking system.

For inflation to come down further, implementation of Medium Term Budgetary Framework MTBF is imperative. MTBF envisages a systematic reduction in fiscal deficit to 3.0 percent of GDP in FY14 by increasing tax to GDP ratio and stipulates inflation targets of 9.5 percent for FY13 and 8 percent for FY14. Decisive reforms in energy sector can also go a long way in achieving MTBF targets. These reforms not only will reduce government’s reliance on banking system borrowings but also minimize need to adjust energy prices in a sporadic and unpredictable manner. Both these factors would help in improving effectiveness of monetary policy and its contribution in keeping inflation low and stable.

He said: “In conclusion, despite moderate aggregate demand, pressure on rupee liquidity is likely to continue due to uncertain foreign inflows and substantial government borrowings to finance fiscal deficit. Moreover, inflationary pressures have not eased significantly. It must be emphasized that sustainable economic recovery over the medium term would call for a sizeable increase in both domestic and foreign private investment in economy. For this to happen, business confidence needs to be revived by reducing uncertainties due to energy shortages. Against this backdrop, SBP Central Board of Directors considers 200 bps reduction in policy rate, already introduced in FY12, to be appropriate and has decided to keep policy rate unchanged at 12 percent.”

Leave a Reply