Falling inflation, other factors: policy rate cut by 50 basis points to six percent

Due to a fall in inflation, a discernible improvement in perishable food supplies and the likelihood of governmental policy to pass through a portion of falling international oil prices to consumers to persist, the State Bank of Pakistan decided to reduce the SBP policy rate to six (6) percent from 6.50 percent for the next two months.
-- Savings-investment gap narrows down
-- Gross fixed investment falls as a percentage of GDP
-- Debt servicing as a percentage of GDP falls
-- NDA drop contributes to monetary contraction
-- Monetary growth entirely due to OMO injections
-- Government shifts borrowing from SBP to scheduled banks
The Central Bank''s Board of Directors which met at the SBP Head-office, on Saturday, with Governor Ashraf Wathra in chair, saw the space available for cutting the rate by 50 basis points to 6.0 percent. SBP''s conservative estimates of inflation (CPI) for the current financial year (2015-16) remained unchanged; ie, within a range of 4.5 to 5.5 percent - as against governmental target of 6.0 percent. With higher probability of falling inflation (CPI) than otherwise and lower expectations in coming months - the data clearly showed that there was room for a cut.
As SBP press release issued says: "Year-on-year headline CPI inflation decelerated to 1.7 percent in August 2015 from 7.0 percent in August 2014. Following its declining trend of the past several months, the 12-month moving average CPI inflation came down to 3.6 percent in August 2015 from 8.4 percent in August 2014. Other indicators, such as core inflation measures, have also decreased in August 2015. Major sources of declining inflation are favourable supply shocks and demand management policies. The current deceleration owes much to the smooth supply of the perishable food items and falling international oil price pass-through to consumer prices.
Continuation of current trends along with moderate pick up in aggregate demand would largely determine the path of inflation in FY16. Recent increases in natural and compressed natural gas prices and their likely second round impacts would be offset by lower global oil price that has yet to find the bottom. Thus, there is no change in SBP''s forecast of average CPI inflation for FY16 with its range of 4.5-5.5 percent remaining below the annual plan target of 6 percent.
There are, however, two possible upside risks to this forecast. Government plans of paring down of subsidy on electricity along with increase in its tariffs and the possible adverse impact of low food prices on crop production. Downside risks to the forecast include the lesser likelihood of recovery in global commodity prices including that of oil. With current trends and projections, the probability of downside risks appear to be greater than the upside risks. Moreover, the latest IBA-SBP survey of September 2015 has reported lower inflation expectations for the coming months.
The situation in external current account at the beginning of FY16 is not much different from the end of the last fiscal year. While the exports again declined in the month of July 2015, external current account deficit recorded slight improvement due to declining oil import payments and increasing workers'' remittances. With favourable trends in these variables, a current account deficit of the size of end-FY15 seems manageable in this fiscal year. This is supported by the expected surplus in the capital and financial account in FY16 on the back of planned Euro/Sukuk bonds inflows, official disbursements, and the remaining IMF funding under the EFF program. Apart from yielding an overall balance of payments surplus, this would help maintain the foreign exchange reserves'' upward trajectory of the last two fiscal years.
However, increases in exports and foreign direct investments are imperative for sustainability of external sector. In this regard, recent improvements in law and order situation and continued macroeconomic stability are likely to increase the prospects for long-term foreign capital inflows. Moreover, going forward, much needed boost to Pakistani exports may come through US economic recovery and through further gains in EU''s GSP-Plus scheme. However, structural bottlenecks especially in the textile sector and subdued international commodity prices remain the major risk to exports outlook.
The contraction in broad money (M2) during 1st July to 28th August, 2015 was mainly a result of reduction in net domestic assets of the banking system. Increase in government borrowing from scheduled banks was offset by repayment to SBP and Pakistan Investment Bonds (PIBs) maturing during this period. The retirement of working capital in July FY16 by majority of the private sector businesses is as per their normal credit cycle. The off-take of fixed investment loans by energy generation and distribution, chemicals and services sectors signal possible pick-up in their productive activity in the coming months. Therefore, in the coming days, credit off take is expected to strengthen further.
Moreover, monetary conditions, despite easing, still appear to be tight as real lending rates are hovering around 4 percent since December FY15 due to rapidly falling inflation. Overall liquidity situation in financial markets remained stressed in the post July 2015 monetary policy period. Government borrowing from commercial banks, Eid related cash withdrawals, and some deposit withdrawal from banks due to seasonal factors increased liquidity shortfall in the money market. Considering liquidity shortages, SBP continued to support the market, keeping the overnight money market rate range bound.
With better law and order situation, investor and consumer confidence is improving. After recording a growth of 3.3 percent, Large-scale Manufacturing is expected to gain further traction at the back of improvement in energy supplies. Implementation of infrastructure development and energy projects under China Pakistan Economic Corridor would further enhance the improving investment environment. Therefore, there is anticipation of higher economic activity in FY16 which is expected to boost credit uptake. Given the above macroeconomic conditions, the central board of Directors of SBP has decided to reduce the SBP policy rate by 50bps from 6.5 percent to 6.0 percent." Net OMO injections remained the key driver of reserve money growth during FY16 so far.

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Monetary Assets of SBP                                   (billion Rs)

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                                        Cumulative flows         FY15

                         End June       since end-June          flows

                      2015 stocks     Latest week    A year ago

                                       28-Aug-15      29-Aug-14

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NFA                       729.0          27.0          -55.4    239.3

NDA: of which             2,414.5       223.1           58.8     42.9

Budgetary borrowing       1,935.7      -135.5          110.6   -474.1

Other items (net)            58.5       389.8          -19.0    613.7

Net impact of OMOs/

discounting                 662.0       447.8           36.3    679.2

Reserve money             3,143.4       250.1            3.4    282.2

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Monetary Liabilities of SBP                              (billion Rs)

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                                   Cumulative flows      FY 15

                End June        since end-June      flows

                  2015 stocks  Latest week      A year ago

                             28-Aug-15       29-Aug-14

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Currency in circulation   2,554.7       147.5           27.8    376.9

Cash in tills               160.3       -14.3          -10.3     20.8

Bank deposits with

SBP (reserves)              413.2       117.0          -14.3   -117.5

Other deposits with SBP      15.2        -0.1            0.2      2.0

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                          YoY

                    (28-Aug-15)                   (percent growth)

NFA of the SBP               74.1         3.7          -11.3     48.9

NDA of the SBP: of which      8.5         9.2            2.5      1.8

Budgetary borrowing         -28.6        -7.0            4.6    -19.7

Reserve money                18.5         8.0            0.1      9.9

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