Discount rate lowered by 100 basis points to 14 percent

The State Bank of Pakistan, easing its monetary policy for the first time in 22 months, on Monday slashed key policy rate by 100 basis points to 14 percent citing positive inflation outlook. The SBP adopted tight monetary stance in July 2007 aiming to curb inflation and shrink liquidity in the market and since then has raised its policy rate by 550 basis points to take it 15 percent.
-- Expected inflation of 14 percent for fourth quarter-fiscal year 2009 and 8 percent for fiscal year 2010 illustrates a positive outlook:
-- Easing of the monetary policy stance may not be sufficient to fully revive the private sector credit and thus the growth prospects.
-- The real challenge here is to improve the business climate.
-- Sustainable medium-term recovery remains a challenge.
However, when the economy witnessed a steady progress on its way towards macroeconomic stability, the SBP announced relaxation in its tight monetary policy with an aim to provide relief to the country''''s crises-hit economy. Addressing a press conference at the State Bank of Pakistan on the occasion of release of Monetary Policy Statement for the April-June quarter of the current 2008-09 fiscal year (FY09), SBP Governor Syed Salim Raza said almost all economic indicators have positively responded and the decision to reduce the key policy rate has been taken on the basis of the assessment that inflation will continue to decline.
He pointed out that CPI inflation (Year-on-Year), though still higher than desired, has declined to 19.1 percent in March 2009 from a high of 25.3 percent in August 2008. Persistent demand pressures, as depicted in core inflation measures, have also eased, he said adding that the 20 percent trimmed core inflation has come down by about 2.4 percentage points from its peak in October 2008, Raza said.
Although the projected average CPI inflation for FY09 is around 21 percent, expected inflation of around 14 percent for Q4-FY09 and 8 percent for FY10 illustrates a positive outlook, he added.
Referring to recent fiscal developments, Raza said that fiscal deficit of Rs 251 billion (1.9 percent of projected GDP) for H1-FY09 and the government commitment to cap it at Rs 562 billion (4.3 percent of projected GDP) for the entire FY09 is very significant improvement over last year''''s 7.4 percent.
Raza said that improved fiscal discipline and contraction in the external current account deficit indicate that aggregate demand is showing a downward trend. "This will help narrow the output gap and strengthen the positive outlook for inflation," he added.
He said containment of twin deficits (current and fiscal) has reduced demand pressures and helped to align, to some extent, the investment capacity of the economy with the limited availability of foreign and domestic savings. The impact of these adjustments is visible in monetary aggregates.
The necessary measure of restricting the government borrowing from the SBP has restricted reserve money creation in the system as has the low, albeit gradually improving, foreign exchange reserve position. "Rise in SBP''''s foreign exchange reserves of $4.3 billion between November-April, FY09 and projections that this level will increase to $9.1 billion by end-June, 2009 is also a key indicator of emerging macroeconomic stability," he added.
Consequently, overall liquidity (M2) in the economy remains tight. The equilibrium growth rate of M2, consistent with projections for fiscal and external current account deficits, is expected to be around 8 percent or half of that in the comparable period last year, the SBP governor said.
He said that a significant source of M2 slackness has been the fall off in private sector credit demand, for both demand and supply reasons, as we will see later. Total private credit growth for the last 9 months has been only Rs 48 billion, versus Rs 345 billion for this period last year.
As a result banks have built up considerable excess liquidity, some Rs 410 billion or about 10 percent above their reserve requirements. "This has allowed comfortable accommodation of the government rollover of maturing bills, Rs 1475 billion being bid against Rs 700 billion accepted bills," he added.
The deceleration in monetary aggregates poses two interrelated challenges, looking into the remaining months of the fiscal year. First, the burden on the banking system to cater to the needs of various sectors, including government, has increased, he said.
"This would test the ability of scheduled banks to match the incremental credit demand coming from the government to meet budgetary requirements and finance the commodity operations," he added. The Q4-FY09 calendar for the fortnightly T-bill auctions shows that the fiscal authority plans to raise an additional Rs 97 billion (over and above the maturing T-bills) in six T-bill auctions.
Also, the wheat procurement cycle has begun and preliminary estimates indicate that there would be new credit demand of approximately Rs 60 to Rs 80 billion, on flow basis, for this purpose by the end-June, 2009, SBP governor said. Second, as the growth of the banking system deposits remain weak and the injection of fresh reserve money is constrained, the already dwindling credit to the private sector might be squeezed further.
He pointed out that cumulative flow of private sector credit, which peaked in January, 2009 at Rs 179 billion has consistently declined since then and stands at only Rs 48 billion for the 1 July -11 April, FY09 period. Similarly, the total deposits with the banking system are still Rs 69 billion lower than their end-June, 2008 level, though they have recovered to a large extent after experiencing a sharp fall during the early period of FY09, he added.
The likely impact of these developments would be an upward pressure on interbank and other market interest rates such as KIBOR and T-bill yields, he said. The weekly weighted average overnight repo rate, which averaged 11.25 percent during Q3-FY09, has moved upwards reaching 12.86 percent during Q4-FY09 up to the week ending April 17, 2009.
The 6-month KIBOR and 6-month T-bill yields, for example, have inched upwards, 13.51 percent and 12.98 percent respectively in April 2009 after hitting lows of 12.43 and 11.79 percent seen earlier in the previous quarter. However, improved inflation expectations, as revealed by a downward shift in yield curve, are indicating that the market is anticipating lower interest rates in the near future. Therefore, it seems likely that the market will continue to operate smoothly.
It is pertinent to mention that T-bill cut off rates in auctions along with the volume targets are no longer under the purview of the SBP and are determined by the Ministry of Finance and thus reflect the fiscal authority''''s considerations, the SBP governor said, adding "therefore, any interpretation of monetary policy stance through movements in T-bill cut off rates would be misleading."
Much of this tightness emanated from the auction coinciding with the substantial tax payments to the government at quarter end-March and is expected to be temporary. The positive view of the lower long term rate expectations was reinforced by the PIB bidding on April 15, where about Rs 50bn was bid for a target volume of Rs 20bn, where the heaviest volume bid was for the 10-year bond, at 1.7 percent below the rate for the last auction, he said. Rising net foreign assets and high agricultural procurement prices will tend to build up the supply of bank deposits and M2 in the short term. Progressively, improving private sector demand will also spur the bank multiplier.
Talking about challenges that the economy is facing, the SBP governor said that despite positive outlook for inflation, the real challenge here is to improve the business climate. "The difficulty is that not only has the demand for credit by the private sector reduced sharply but that the supply of credit by banks has also remained subdued, and the two issues are difficult to disentangle," he said.
The SBP governor said that slowdown in domestic economic activity exacerbated by power shortages, decline in domestic demand, as well as in external demand due to the global recession. However, he said that easing of the monetary policy stance to some extent will send a positive signal in this context but may not be sufficient to fully revive the private sector credit and thus the growth prospects, by itself.
Negative wealth effect transmitted through a fall in assets (stock markets and property) prices has also played their part in this decline of demand, Raza said. He said that rising Non Performing Loans (NPLs) and the availability of alternate avenues to extend credit, such as to the government and Public Sector Enterprises (PSEs), has allowed the banks to follow a strategy of risk aversion and avoid building private sector exposure in an uncertain environment.

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                   INFLATION INDICATORS

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                      YOY INFLATION

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                                 8-Jun           8-Mar    9-Mar

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CPI                               21.5            14.1     19.1

Food group                          32            20.6     19.7

Non-food group                    13.8             9.4     18.5

Non-food non-energy                 13             9.3     18.5

20-percent trimmed                17.2            11.3     19.3

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                                          Average inflation

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                                     Jul-Jun            Jul-Mar

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                                  FY08            FY08     FY09

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Headline CPI                        12             9.5       23

Food group                        17.6            13.8     27.8

Non-food group                     7.9             6.3     19.2

Non-food non-energy                8.4             7.1     17.9

20-percent trimmed                10.2             8.7     20.4

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                                            12m MA inflation

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                                   July-June        April-March

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                                   FY08           FY08     FY09

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Headline CPI                        12             8.9     22.1

Food group                        17.6              13       28

Non-food group                     7.9               6     17.6

Non-food non-energy                8.4             6.7     16.5

20-percent trimmed                10.2             8.4     22.6

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