Despite some improvement on several economic fronts, the State Bank of Pakistan has decided to keep the policy rate unchanged at 12.5 per cent due to some risk on inflation, which is rapidly increasing for last two months after some easing.
“The inflation outlook for full FY10, nevertheless, remains somewhat vulnerable to the effects of fiscal consolidation efforts and to incipient international commodity price pressures,” according to Monetary Policy Statement (MPS) issued by SBP for next two months.
State Bank expects the average CPI inflation for FY10 to remain between 11 and 12 per cent, still much lower than the 20.8 per cent inflation of last year, but higher than the 10.3 per cent recorded in the first half of FY10.
Macroeconomic stability has proceeded apace, as evident in the considerable decline in average Consumer Price Index inflation, which is the primary objective of monetary policy. In the first half of the current 2009-10 fiscal year (FY10), inflation was recorded at 10.3 per cent, compared to 24.4 per cent during the corresponding period of FY09, and this decline is visible across almost all the subgroups of CPI.  
SBP has also revealed that uncertainty on the availability of external financial inflows, rising international commodity prices and extent of impetus received from the global economic recovery are prominent risks to the economy.
According to MPS, the most prominent risk to macroeconomic stability is the uncertainty regarding availability of external financial inflows, which has the deep effects on both fiscal accounts and the external current account sustainability. It also has implications for future trends in both the accounts and other sectors of the economy.
"Less than required inflows or a mix of financial inflows skewed towards debt creating flows, particularly of short term nature, would reduce fiscal space and jeopardize financing of the current account deficit," it said.
The SBP said the challenge, in the first place, is to address the underlying causes for such uncertainties and build capacity to forestall its ramifications and the ideal solution is to increase the economy's resource envelope to meet the requirements of a growing economy.
The second best solution, however, is to live within the resources available. In the absence of adequate resources, the onus of macroeconomic stability also falls on timely adjustment of relative prices i.e. interest rate and the exchange rate. These prices should be allowed to adjust in time since a delayed adjustment only tends to waste resources, it added.
According to the MPS, extent of impetus received from the global economic recovery is the second most prominent risk to the economy. The fruits of growth in the global economy cannot be reaped fully if the increase in domestic productive capacity and the depth of financial markets is not commensurate with the demand created for exports or to absorb financial inflows, respectively, it added.
“This requires removal of bottlenecks related to the improvement of law and order situation, infrastructure development, continuation of reforms process and increase in financial sector depth," the central bank said.
Linked with the global economic recovery, recurrence of rising international commodity price trend poses another risk to the economy, the SBP said in the MPS.
Given its widespread impact on the economy, the real challenge is to ensure a transparent pass-through of its effect to the economy so that it adjusts to them in full and in time, the SBP said and added that absence of transparency and any artificial delay in the adjustment would impair pass-through and bring complacency among economic agents.
According to the MPS, the circular debt issue has also posed a threat to the stability of institutions, in both the power and financial sectors. Moreover, it is distorting the pricing of assets in the banking sector, and weakening the pricing mechanism and transmission of monetary policy changes. "There is a need to address the root cause of this issue, which is timely generation of resources by institutions and payments by the government, in its entirety and without delays," the SBP suggested.
The capital and financial account balances have improved significantly during H1-FY10 due to a modest increase in foreign portfolio investment, SDR allocation and SBA flows from IMF, despite a fall in foreign direct investment.
According to MPS despite the shortfall in foreign flows, a significant reduction in the external current account deficit to $2 billion during H1-FY10 led to an overall surplus of $1.4 billion in the balance of payments.
A broad-based decline in imports, supported by strong workers' remittances, explained the considerable contraction in the external current account deficit. Notably, this improvement was despite the delay in foreign reimbursements and shortfall in grants from Friends of Democratic Pakistan (FoDP).
The decline in imports mainly reflects the moderation in aggregate demand and the benefits of relatively lower international commodity prices. The decline in exports, on the other hand, had been restrained by a gradual global economic recovery, availability of exportable surplus due to better cotton crop, and higher international prices of some exportable commodities. This helped in limiting the trade balance to $5.7 billion during H1-FY10, the SBP said.
While global output growth and rising trade volumes would help Pakistan's economy, rise in commodity prices could have a negative impact, it said. The rises in energy as well as metal prices were significant and any acceleration in them could potentially result in a more than anticipated increase in the import bill and domestic inflation.
"Current trade outlook, combined with projections of other components such as current transfers, leads to a projected external current account deficit of 3.4 per cent of GDP for FY10, and this represents significant improvement over last year's deficit of 5.6 per cent and earlier projections of close to 5 per cent," the MPS said.
Though the higher financial inflows appeared impressive, one would need to be cautious in interpreting this improvement. Out of total financial inflows of $3.8 billion, $1.1 billion consist of IMF credit for budgetary support, part of which is required to be retired in Q4-FY10.
According to MPS, sustained improvement in the balance of payments position would depend significantly on the timing and scale of projected foreign inflows, especially the official flows pledged by the FoDP. The actual disbursements are slightly behind schedule and thus the original $2.5 billion projected disbursements for FY10, have been revised to $1.5 billion. Thus, despite improvements in the external current account, the external sector outlook seems uncertain, the central bank said.
State Bank of Pakistan Governor Syed Salim Raza, while unveiling the Monetary Policy Statement, said the agriculture sector has shown improvement. The wheat crop was good with higher prices stimulating demand for consumer goods, and the cotton crop higher than last year improving textile production and corresponding exports.
Modest but consistent recovery in Large-scale Manufacturing (LSM) is also encouraging, he said, and added that the LSM grew by 0.7 per cent in November 2009 compared to a negative 20 per cent in March 2009.  “Revival in private sector credit and better-than-expected global recovery should further support economic growth,” he added.
Assuming that the current trend in LSM growth continues, the governor said the overall real Gross Domestic Product growth is expected to be 3.0 – 3.5 per cent in FY10, as compared to 2.0 per cent in FY09.
Referring to external current account, Raza said progress in the external sector is also encouraging. The external current account deficit has declined to $2 billion during H1-FY10 from $7.8 billion in H1-FY09.  A small decline in exports was substantially offset by a higher decline in imports resulting in significant reduction in the trade deficit, he said and added that the sustained flow of workers’ remittances ($4.5 billion during H1-FY10) has further contributed to the reduction of the external current account deficit.  
“External current account deficit is projected at 3.4 per cent of GDP for FY10 - a significant improvement over last year’s deficit of 5.6 per cent and earlier projections of close to 5 per cent,” he emphasized.
The SBP governor said as a result of significant contraction in the external current account deficit, the overall balance of payments has posted a surplus of $1.4 billion during H1-FY10 compared to a deficit of $4.8 billion in H1-FY09. A modest increase in foreign portfolio investment, additional SDR allocation, and SBA flows from IMF, more than compensated for the decline in foreign direct investment, he added.
However, sustained improvement in the balance of payments would depend significantly on the timing and scale of projected foreign inflows, especially the official flows pledged in Tokyo by the Friends of Democratic Pakistan.  “Assuming the revised financial inflows are realized, the SBP’s foreign exchange reserves are projected to reach close to $15 billion by the end of FY10,” he added.
On the fiscal front, Raza said the federal government has continued efforts for rationalizing expenditures, by phasing out subsidies and by adjusting the administered energy prices. “It has also taken in hand the organizational and administrative measures to bolster tax administration and revenue collection,” he added.
Raza said the State Bank has managed system’s liquidity to both support smooth functioning of the market and to do this consistently with the monetary policy stance. As a consequence, volatility in the interbank overnight money market Repo Rate – the operational target of SBP – has come down substantially and market interest rates have gradually eased in line with reduction in the Policy Rate.  
“Integrating projections for balance of payments, fiscal accounts, and credit growth and given their interrelationships with inflation and real GDP projections, the equilibrium M2 growth is forecasted to be around 14.5 per cent for FY10,” he added.
While summing up the overall macroeconomic scenario, Raza said that much has been gained with respect to macroeconomic stability front in a challenging economic and security environment.  Difficult decisions have been taken and adjustments made to address a host of structural constraints.
“However, work remains to be done to consolidate this stability and set the stage for sustainable recovery.  At the short term, we would want to see a reversion of the current inflationary uptick, and a more certain outlook for system’s liquidity,” Raza asserted.