States Bank leaves policy rate unchanged at 12 percent

Karachi: Central Board of Directors of State Bank of Pakistan in meeting Tuesday chaired by SBP Governor Yaseen Anwar decided to keep policy rate unchanged at 12% after thoroughly considering need to revive growth and emerging risks to macroeconomic stability.

“To promote competition in banking system and to offer alternative sources of savings to the population, SBP has been encouraging depositors to invest in government securities through Investor’s Portfolio Securities IPS accounts,” SBP said in its Monetary Policy Decision.

It said option of maintaining saving deposits or investments in IPS accounts could provide stiff competition to banks forcing them to offer better returns on deposits. “This in turn would incentivize savings and help lower the currency in circulation. Moreover, it will improve transmission of monetary policy changes to market interest rates,” it said, adding that over time this strategy would also diversify government’s funding source, deepen secondary market of government securities, and facilitate issuance of corporate debt.

Monetary Policy Decision Text: “SBP reduced its policy rate by 200 bps to 12%, in FY12 so far. The objective of adopting this stance is to support revival of private investment in the economy despite a constraining domestic and global economic environment. The primary factors in support of this stance were expectation of average CPI inflation remaining within the announced target in FY12 and a small projected external current account deficit. In pursuing this stance SBP did acknowledge risks to macroeconomic stability emanating from fiscal weaknesses and falling foreign financial inflows. These include resurgence of medium term inflationary pressures and challenges SBP is facing in managing market liquidity and preserving foreign exchange reserves.

“A reassessment of latest developments and projections indicate that macroeconomic risks have somewhat increased during last two months. For instance, although year-on-year CPI inflation stands at 11% in October 2011, month-on-month inflation trends, averaging at around 1.3% per month during first four months of FY12, show existence of inflationary pressures. The sifting of commodity level CPI data reveal that number of CPI items exhibiting year-on-year inflation of more than 10% is consistently increasing and almost all of these items belong to non-food category. The government also increased its wheat support price by Rs100 to Rs1050 per 40kg for next wheat procurement season.

“Thus, while average inflation may settle around targeted 12% for FY12, it is uncertain that inflation will come down to a single digit level in FY13. The main determinants of this inflation behaviour are government borrowing from banking system and inertial effects of high inflation on its expected path. The severe energy shortages are also holding back effective utilization of productive capacity and adding to high inflation weak growth problem.

“On external front, earlier comfortable external current account position for FY12, which helped SBP in lowering its policy rate, has become less benign. Actual external current account deficit of $1.6 billion for first four months of FY12 is now higher than projected deficit for the year. The main reason for this larger than expected deterioration is the rising trade deficit. In particular, windfall gains to export receipts due to abnormally high cotton prices in FY11 have dissipated faster than anticipated. This is indicated by slightly less than $2 billion per month export receipts in September & October 2011. At the same time, international oil prices of around $110 per barrel and strong growth in nonoil imports have kept total import growth at an elevated level of close to $3.4 billion per month. Adding to challenges faced by external sector is the precarious global economic outlook.

“A relatively larger external current account deficit in FY12 would require higher financial inflows to maintain foreign exchange reserves. However, during July-October, FY12, total net direct and portfolio inflows were only $207 million while there was net outflow of $113 million in official loans. As a consequence, SBP’s liquid foreign exchange reserves have declined to $13.3 billion at end October 2011 compared to $14.8 billion at end June 2011. Given scheduled increase in repayments of outstanding loans in H2FY12, realization of substantial foreign flows, especially proceeds of assumed privatization receipts, euro bond, Coalition Support Funds, and 3G licence fees, becomes important for strengthening external position.

“A reflection of widening external current account deficit and declining financial inflows can be seen in reduction of Rs115 billion in Net Foreign Assets (NFA) of SBP’s balance sheet during 1 July- 18 November, 2011. This implies that to meet economy’s prevailing demand for money, SBP has to provide substantial liquidity in the system, at least to extent of compensating for declining NFA of SBP. As of 28 November 2011, outstanding amount of liquidity injected by SBP through its Open Market Operations (OMOs) is Rs340 billion. This is significantly higher than normal SBP operations and appears to have developed characteristics of a permanent nature at this point in time.

“A dominant source of demand for money and thus liquidity injections by SBP is government borrowings for budgetary support from banking system. Excluding issuance of government securities of Rs391 billion to settle circular debt and commodity loans, the government has borrowed Rs255 billion from scheduled banks and Rs62 billion from SBP during 1 July- 18 November, 2011 to finance its current year’s budget deficit. The growth in private sector credit has remained muted so far but may pick up in coming months as desired effects of cumulative decrease of 200bps in policy rate and reduction in financial constraints of energy sector gather momentum.

“In this context where government is main user of system’s liquidity and banks remain hesitant to extend credit to private sector, SBP faces a dilemma. Efforts to scale down liquidity injections could have implications for settlement of payments in interbank market, which is an important consideration given SBP’s mandate of maintaining financial stability. Even if these considerations are addressed, the government may end up settling its obligations by borrowing from SBP. This does not bode well for government’s own commitment of keeping such borrowings at zero on quarterly basis. The marginally increasing trend of these injections, on other hand, also carries inflationary risk, which is not consistent with objective of achieving and maintaining price stability.

“There are three solutions to this predicament of reconciling price and financial stability considerations and supporting private investment in economy. First, the government needs to ensure that all or major parts of budgeted foreign inflows materialize as soon as possible. This will alleviate pressure on balance of payments and help inject fresh rupee liquidity in the system. Second, sooner than later government will have to initiate comprehensive tax reforms that broadens tax base of the economy. This is of paramount importance to reduce government’s borrowing requirements from scheduled banks that are currently not consistent with objective of promoting private sector and economic growth. Third, efforts need to be stepped up to improve financial deepening and increase competition in banking system.

“The last of these solutions is something that SBP has been actively working on. For instance, to promote competition in banking system and to offer alternative sources of savings to the population, SBP has been encouraging depositors to invest in government securities through Investor’s Portfolio Securities (IPS) accounts. The option of maintaining saving deposits or investments in IPS accounts could provide a stiff competition to banks forcing them to offer better returns on deposits. This in turn would incentivize savings and help lower currency in circulation. Moreover, it will improve transmission of monetary policy changes to market interest rates. Over time this strategy would also diversify government’s funding source, deepen the secondary market of government securities, and facilitate issuance of corporate debt.

“Finally, it must be understood that there are uncertainties involved in realizing full benefits of these measures. These uncertainties can potentially have adverse effects on SBP’s recent efforts to support private sector credit and investment in economy. Therefore, after giving due consideration to need to revive growth and emerging risks to macroeconomic stability, Central Board of Directors of SBP has decided to keep policy rate unchanged at 12%.”

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