SUNDAY JULY 31: Small probability turns into modest reality: key policy rate cut by 50 basis points to 13.5 percent

KARACHI: The State Bank of Pakistan has lowered its policy rate by 50 basis points to 13.5 percent from 14 percent with effect from August 1st, 2011, as it views that the direction of inflation for the full year could drop to 11.5 percent instead of 12 percent as envisaged by the fiscal authorities.
Further, SBP's inflation models of aggregate demand and supply showed directionally inflation is expected to come down due to softening of commodity prices. Since there was some headroom available for real interest rates turning positive, SBP decided to cut the policy rate by 50 basis points.
According to SBP's monetary statement, the composition of reserve money shows that 82 percent of 17.1 percent increase is due to rise in Net Foreign Assets (NFA) on account of $542 million surplus in current account as exports surged by 29.4 percent and home remittances for the year touched the $11.2 billion mark. However, SBP cautioned about the increase in Pakistan's country risk adversely affecting the capital and financial flows in the external sector, which dropped to $1.8 billion in FY 2010-11.
Further, SBP sounded a note of warning that suspension of the International Monetary Fund (IMF) stabilisation programme and increase in debt obligations could impact the SBP, forex reserves which stood at 14.8 billion dollars on 30th June 2010. Incorporating the recent decline in international cotton prices and oil prices expected to remain above $100 per barrel, the expected growth rate of exports is 6 to 7 percent and of imports 10.5 to 11.5 percent for FY12.
SBP while appreciating a drop in government borrowing from SBP, however, noted with concern that governments borrowing from scheduled bank grew by 74.5 percent last year and contributed 65 percent to the 15.9 percent growth in broad money (M2). The drop in private sector credit was only four percent. As a result of the drop in tax-to-GDP ratio to 8.6 percent and rigid government expenditure, the fiscal deficit from the financing side is estimated at 6.2 percent of the GDP. In case the one-off payment of Rs 120 billion to partially settled circular debt is taken into account the fiscal deficit comes down to 5.6 percent of the GDP, says SBP.
SBP's analysis after discounting for seasonal increase in prices (due to Ramazan) for 12 months showing inflation coming down from 14 percent last year to 11.5 percent in FY12. The market players' pattern of participation in Treasury bill auction also points towards growing interest in long tenor paper. The underlying reasons for government's borrowing are structural and not specific to last year, says SBP. It has complicated SBP's liquidity management in terms of liquidity, payment systems and build-up of foreign exchange reserves, SBP concludes.
SBP press release says: "The State Bank of Pakistan (SBP) has decided to reduce its policy rate by 50 basis points to 13.5 percent with effect from August 01, 2011. This was announced by Yaseen Anwar, Acting Governor, State Bank of Pakistan, while unveiling the Monetary Policy Statement at a press conference held at SBP, Karachi today [on Saturday].
The key parameter in this assessment is the outlook of inflation that indicates that average inflation in FY12 is expected to remain in line with the announced target, he said, adding that no adjustment in the interest rate would have entailed further tightening of monetary policy in real terms, which is not warranted given the decline in private investment.
Anwar said that despite fiscal slippages, the government has adhered to restricting the stock of its borrowings from SBP to Rs 1155 billion (on cash basis). 'In fact, the government retired these borrowings compared to both the end-June 2010 level as well as the mutually agreed limit of end-September 2010 level,' he added.
He said the government has also expressed its commitment to continue with a stance of zero borrowings from SBP in yearly flow terms in FY12, which bodes well for anchoring inflation expectations. He, however, observed that the developments related to expected financial inflows and pattern of government borrowings from scheduled banks will need to be monitored closely to assess potential risks for macroeconomic stability.
SBP Acting Governor said that a relative decline in average CPI inflation compared to earlier projections and a gradual buildup of foreign exchange reserves provide a modicum of macroeconomic stability as the economy begins a new fiscal year. Anwar noted that expectations of inflation are fairly entrenched in the economy. "Thus, a meaningful reduction in inflation would require consistent and credible implementation of monetary and fiscal policies," he added.
He observed that acknowledging the persistence of inflation, the government has announced an inflation target of 12 percent for FY12. "The government has also provided in the Medium Term Budgetary Framework (MTBF) - a desired path of inflation of 9.5 percent and 8 percent for the subsequent two years," he said, adding that conditional upon factors such as adjustments in the administered prices of electricity and oil and a projected broad money (M2) growth of 15 to 16 percent, SBP's forecast of average inflation ranges between 11 and 12 percent during FY12.
"The underlying reasons of growing government borrowings are structural and not specific to FY11 though it must be acknowledged that FY11 was a difficult year given floods and other pressing spending needs. The consolidated fiscal data has not been released, however, provisional estimates from the financing side indicate that the fiscal deficit in FY11 may have reached close to Rs 1127 billion or 6.2 percent of GDP. Excluding the one-off payment of Rs 120 billion to partially settle the circular debt in the energy sector, the fiscal deficit in FY11 comes down to 5.6 percent of GDP," he added.
Anwar underscored the need to accelerate the implementation of fiscal reforms currently being considered by the government. He observed that a path of fiscal deficit in the next three fiscal years has been provided in the Medium Term Budgetary Framework (MTBF), which shows a budget deficit target of 4 percent for FY12. "Moreover, the government is planning to reduce the revenue deficit to zero in FY12 with a projected surplus in the following two years. This assumes an ambitious increase in tax collection by the Federal Board of Revenue (FBR)," he said, adding that an effective implementation of fiscal reforms, especially those related to broadening of the tax, base and better co-ordination with the provinces are urgently required to implement this plan.
He said that unlike fiscal accounts, the position of the external current account improved considerably in FY11 and contrary to earlier projections, a surplus of $542 million has been realised. "A significant and unexpected growth of 29.4 percent in exports and a robust growth in workers' remittances, which now stand at $11.2 billion, are the primary factors responsible for this improvement," he said and added that fragile global economic conditions and dominance of price effect in both exports and imports, which was more pronounced in H2-FY11, has increased the exposure of the economy to movements in international commodity prices.
SBP Acting Governor observed that the external current account is expected to show a modest deficit of 0.8 percent of GDP in FY12. "Given an increase in debt obligations and continued suspension of IMF's Stand-By Arrangement (SBA) financing even a small external current account deficit could pose challenges in terms of maintaining an upward trajectory of SBP's foreign exchange reserves," he added.
He noted that the main risk in external accounts emanates from the declining capital and financial flows, which have dropped to $1.8 billion in FY11 from $5.3 billion in FY10. "The perceived high country risk, relative to other emerging market economies, is the main factor underlying the reluctance of private foreign investors to invest in the country," he said, adding that the delays in implementation of economic reforms, on the other hand, resulted in shortfalls in estimated foreign loans. Nonetheless, by end-June 2011, SBP's liquid foreign exchange reserves have increased to $14.8 billion from $13.0 billion at end-June 2010.
Anwar said that the gross fixed capital formation by the private sector contracted by 3.1 percent, leading to a decline in total gross investment to 13.4 percent of GDP; the lowest level since FY74. He, however, observed that due to strong growth in real consumption expenditures, aggregate domestic demand grew by 5.9 percent.
He said that at the same time, national savings have increased to 13.8 percent of GDP, mainly due to net factor income from abroad. "Consequently, the gap between national savings and investment as a percent of GDP has turned marginally positive," he added. 'Against this backdrop, SBP has decided to reduce the policy rate by 50 basis points to 13.5 percent effective 1st August 2011,' he concluded."

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Table 3: Private Sector Credit

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flows in billion rupees

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                                     H2-FY11   H1-FY11     FY11

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Total credit to private sector         -41.7     163.0    121.3

1. Loans to private sector business      -17     190.2    173.2

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By type:

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Working capital: of which              -20.0     183.5    163.5

Fixed investment                         3.0       6.7      9.7

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By sectors: of which

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Agriculture                              1.9       9.1     11.0

Manufacturing: of which                -21.7     143.6    121.9

Textiles                               -61.9     106.3     44.5

Electricity, gas and water              30.6      23.3     53.9

Construction                            -2.4         3      0.6

Commerce and trade                     -20.1       4.1    -16.0

2. Personal : of which                 -12.0     -15.5    -27.5

Consumer financing                     -10.9     -16.3    -27.2

3. Investment in securities & shares     1.7       8.9     10.5

4. Others                              -14.3     -20.6    -35.0

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Source: SBP

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