SBP to maintain its key policy rate of 14% against all odds
February 04, 2011
Following government's assurance to limit borrowing from the central bank and to create balance between risks to inflation and economic growth, surprisingly the State Bank of Pakistan, on Saturday, maintained the key policy rate unchanged at 14 percent for next two months.
However at the same time the Central Bank has warned that achievement of revised fiscal deficit target would be a challenge in the absence of fiscal reforms.
Before announcement of policy most of economists and analysts believed that the central bank was well ahead of rising inflationary pressure and considering the heavy government borrowing, will raise the key policy rate by 50 basis points to 14.5 percent for next two months. Only one economist Muzammil Aslam from JS Global hinted that SBP will maintain its interest rate at 14 percent on the basis of some positive indication in the economy, which include surplus current account deficit, decline in government borrowing, historical foreign reserves and rising exports.
"We can not ignore economic challenges ahead, however, an improved external current account, stable financial markets and multi-partisan efforts for improving fiscal revenue allow for some optimism," said SBP’s Monetary Policy Statement while announcing its maintenance policy rate as unchanged. SBP, however made it clear that future course of policy action would be contingent upon expected progress of key areas of concern to State Bank.
"While the structural reasons for policy stance have not changed significantly, there are three major developments to provide comfort to the State Bank and that include assurance of limited government borrowing from SBP, surplus current account balance and hope of improvement in fiscal revenues and cut in current spending through recent multi-partisan efforts".
Discussing the government borrowing statement, the report indicated that government budgetary borrowing was already on decline and an understanding has been reached with the government that it will restrict its borrowings from the SBP to below the end September stock of Rs 1290 billion.
Regarding current state of the economy, it said that despite high interest rates, the fiscal deficit and borrowings from the banking system continues to stoke inflationary pressures, and delays in crucial economic reforms have increased challenges for the management of the economy. This is hampering economic recovery and increasing the debt burden of the country.
"Under these challenging circumstances, a proactive monetary policy is necessary but not sufficient to tackle high and persistent inflation," MPS said. Presently, the government is negotiating with several political parties to make consensus on the RGST and to develop a long-term policy for revenue enhancement and SBP believes that some positive results would be witnessed through these dialogues.
Despite some adjustments in the prices of electricity and gas, the larger issue of energy shortages remains unresolved, and this is contributing to the under-utilization of existing productive capacity and discouraging new investment in the economy.
The statement has criticized the government’s fiscal stances and stressed the Federal Government to spell out a clear and coherent strategy to limit fiscal slippages. “This is all the more important, given that the proposed reforms in the GST, along with other tax measures, have been postponed”. In January 2011, the government also reversed the decision of increasing retail prices of petroleum products. While at the same time apart from adversely affecting revenue collections and increasing expenditures on subsidies, these actions have made it difficult to raise external resources for budget financing.
According to MPS , after a continuous rise in government borrowing from SBP since the beginning of FY11, there seems to be some respite on this front. The outstanding stock (on cash basis) of these borrowings, which had increased to Rs 1500 billion by mid-December 2010 from Rs 1171 billion at end-June 2010, had reached close to Rs 1277 billion by January 25, 2011. "This is an encouraging development and, if sustained, could help in restricting excess money growth and moderating expectations of high inflation".
The external current account showed a surplus of $26 million during H1-FY11, which was a marked improvement over earlier projections. Robust export earnings of $11.1 billion are the main reason underlying this encouraging development.
Further support to the external current account in H1-FY11 was provided by strong inflows of remittances of $5.3 billion, and the disbursement of Coalition Support Funds (CSF), $743 million.
The credit availed by the private sector during Q2-FY11 was Rs 211 billion, compared to Rs 199 billion in the corresponding period of last year, and it was despite a declining growth in large-scale manufacturing (LSM) and is largely attributable to the rising cost of inputs and pickup in private sector credit may slow down in the coming months as it was mostly due to seasonal working capital requirements.
"To understand SBP's policy stance for H2-FY11, it would be useful to assess these developments in the backdrop of three successive 50 bps hikes in the policy rates that have already been announced in this fiscal year," MPS said. Further, candid disclosure by the government of the impending crisis in case of failure to reinvigorate fiscal reforms cannot be brushed off lightly, the report said; adding that under these exceptional circumstances "it is expected that tangible steps will be taken to steer the economy back on track".
"The likely positive outcome of these developments has been incorporated in monetary policy considerations, while not ignoring the existence of a monetary overhang", the state bank stressed and said that fiscal problems are not only undermining the monetary policy stance but also carrying the risk of adversely affecting external accounts.
The current level of high inflation remains the primary concern for sustainable economic growth. "Its persistence carries risks for macroeconomic stability and increase in uncertainty, discouraging savings and investment in the economy and, in particular restricts the development of productive capacity of the economy and thus contributes in increasing the aggregate demand supply gap".
Persistence of high inflation is also eroding competitiveness of exports through a real appreciation of the domestic currency, and if the difference between domestic inflation and that of the trading partners is not brought down, the pressure on exchange rate to depreciate could increase. In turn, this could make imports more expensive, causing domestic inflation to rise further, the statement said.
Moreover, persistence of inflation at elevated levels strengthens expectations of it remaining high, making it all the more difficult to have desirable effects of anti-inflation policies. Under these circumstances, to bring inflation down, even larger adjustments in the interest rate and exchange rate would be required. As a result, the contraction in economic activities could be relatively higher, and may prolong, it added. Therefore, SBP primarily focused on high and persistent inflation, which was being exacerbated by a structural fiscal deficit, frequently financed by government borrowings from SBP. The direct link between the pace of government borrowings from SBP and the expectations that individuals and businesses formulate about future inflation was also emphasized and in SBP's view, these expectations were a major contributing factor in pushing core inflation up, which often gets less attention than supply side factors like fuel and food prices.
"Consequently, the aggregate demand and supply gap is still large enough to push inflation further and surging international food and commodity prices are also playing a role in intensifying expectations of rising domestic inflation," the SBP statement said. SBP also pointed out that inflationary pressure was already high at the beginning of FY11, and remained at elevated levels during first half of FY11. In December 2010, year-on-year CPI inflation was 15.5 percent while its average for H1-FY11 stood at 14.6 percent, he said, and added that not only did the contributing factors of inflation continued to prevail in H1-FY11, the economy also experienced an additional shock in the form of unprecedented devastating floods.
The SBP MPS said that the revised projection of average CPI inflation for FY11 falls in the range of 15 to 16 percent, along with high probability of double-digit inflation in FY12. "To bring inflation under better control, the critical measures would be fiscal consolidation and reduction in fiscal deficit and government borrowings from SBP and these measures would support SBP's efforts to contain monetary expansion and thus ease aggregate demand pressures”.
At the same time, due to an improvement in the external current account, the increase in Net Foreign Asset (NFA) contributed to maintaining year-on-year reserve money growth at 16.6 percent. Thus, while there is a favorable compositional change in reserve money, the growth of its Net Domestic Asset (NDA) component still needs to be curtailed to reduce inflation, it pointed out.
The State Bank said that achievement of revised fiscal deficit target would be a challenge in the absence of fiscal reforms. According to SBP at the beginning of the fiscal year, the announced fiscal deficit target was Rs 685 billion (4 percent of GDP) that was revised to Rs 812 billion (4.7 percent of GDP) in the aftermath of devastating floods.
The provisional data from the financing side of the budget, however, suggests that the deficit has probably beginning to touch Rs 500 billion by the close of first half of current fiscal year. Thus, even meeting the revised target would be a challenge in the absence of fiscal reforms. Tax collection of Rs 661 billion by the Federal Board of Revenue (FBR) during July-December 2010 shows a growth of 13 percent only. While, growth rate of 26 percent was estimated, at the beginning of the fiscal year, to achieve the full year target of Rs 1667 billion.
Therefore, SBP sees a shortfall in revenue receipts and at the same time more difficulties because of rising expenditures, primarily owing to subsidies for energy, food items, cash transfers, and security related activities. These fiscal developments have two implications. First, the overall demand for money is unlikely to fall down, which indicates high aggregate demand relative to current productive activity. Second, the private sector is likely to be squeezed out, which is contrary to what the economy needs for the revival of investment and growth, it added.