State Bank of Pakistan keeps policy rate unchanged at 14 percent

Karachi: The State Bank of Pakistan (SBP) has decided to keep its policy rate unchanged at 14 percent.

This decision was taken at a meeting of the Central Board of Directors of State Bank of Pakistan Saturday.

For the economy to grow on sustainable basis, the debt burden to become manageable and inflation to come down to single digits, the private productive activity and investment will have to increase considerably and quickly, the SBP said in its Monetary Policy decision. It said this would require government borrowings from the banking system to subside to create space for private sector credit, which in turn would need satisfactory implementation of the aforementioned fiscal reforms.

The government is mindful of fiscal pressures and has expressed its resolve to address these issues, especially the containment of the fiscal deficit, SBP said.

“A careful analysis of Pakistan’s current economic conditions reveals a mixed situation. Led by strong export earnings and robust growth in remittances, the external current account position has surpassed all earlier projections, said SBP Governor Shahid H Kardar. During July 1 May 7, FY11 incremental government borrowing from the banking system, including SBP, for budgetary support was Rs 614 billion; a year-on-year growth of 28.3 percent.

The borrowings from SBP explain almost 80 percent of the expansion in reserve money while total banking system budgetary borrowings explain 95 percent of the expansion in M2.

Demonstrating its commitment the government retired its borrowings from the SBP in Q3-FY11 and by end-March 2011 the stock of these borrowings (on cash basis) had come down to Rs 1155 billion. The recent increase in these borrowings is temporary and a reflection of the government’s efforts to internalise the growing quasi-fiscal expense related to the circular debt of the energy sector. The SBP has already shifted a portion of this borrowing, Rs 61 billion to the market through an outright Open Market Operation and expects that government borrowing would soon converge to the end-September 2010 level Rs 1290 billion, as committed by the government.

The rising total debt, Rs 11.2 trillion by end-March 2011 and its servicing is demanding an increasing portion of fiscal revenues. At the same time, the GDP growth rate of below 4 percent over the past four years appears to be highly correlated with declining real private investment expenditure and driven by consumption demand. More importantly, despite falling financial account inflows, $0.5 billion during July-April, FY11 compared to $3.7 billion in the corresponding period of last year, SBP’s foreign exchange reserves have increased to $13.7 billion by May 18, 2011 and are expected to increase further by end-June 2011.

This has helped the SBP in building foreign exchange reserves and accumulating Net Foreign Assets (NFA), which contributed in keeping the foreign exchange market stable and provided rupee liquidity in the system. However, key challenges remain in the shape of persistent inflation, weak economic growth and private investment and a large budget deficit.

In such circumstances, SBP is endeavouring to strike a delicate balance to address the multiplicity of considerations in formulating the monetary policy stance such as containing inflation, promoting private productive economic activity and keeping financial markets stable.

The remarkable improvement in the external current account, a surplus of $748 million during July-April, 2010-11 has been a major positive development. Given the turmoil in global economic conditions, especially in the export-destination and remittance-generating economies, there were expectations of an external current account deficit.

However, a spectacular rise in international cotton prices has boosted exports, which are expected to exceed $25 billion in 2010-11. This together with consistently rising flow of remittances helped neutralise import and other payments. Caution needs to be exercised while assessing the outlook of the overall balance of payment position. The main reasons for this prudence include the sharp decline in international cotton prices in the last two months, likely continuation of oil prices at around $100 per barrel, and debt obligations that are due in 2011-12.

Barring any unforeseen developments, these factors together with the continued suspension of IMF’s Stand-By Arrangement (SBA), which has implications for other financial inflows, imply that the stellar performance of the external account may be difficult to sustain.

Therefore, maintaining the current upward trajectory of SBP’s foreign exchange reserves would be a challenging task. For instance, government borrowings from the banking system have increased significantly, partly due to the shortfall in external financing and partly due to the increase in the fiscal deficit on account of security spending, the impact of unprecedented floods and the recent one-off adjustment of Rs 120 billion to address the issue of ‘old stock’ of the circular debt of the power sector.

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