"The central bank is keeping real interest rates at zero," Governor State Bank of Pakistan told BR Research one month ago, explaining the rationale behind its latest monetary policy decision. Based on this argument and considering the fact that CPI averaged at 11.3 percent in July-October; chances of 50 bps cut in the policy rate to 11.5 percent cannot be ruled out. And the market is expecting the same as 20 out of 27 banks and research houses contacted by BR Research predicted that the central bank would slash the discount rate by 50 bps, while the remaining expect the status quo to prevail. Market expectations are anchored by SBPs rationale; not what should be done. The countrys economists are divided in their opinions regarding the root cause of persisting inflation in the country. The hawkish camp contends that inflation is a supply side phenomenon, which cannot be curbed through monetary tightening which only serves to stifle growth. On the other hand, policymakers including some young advocates of Milton Friedman at the SBP consider inflation, a monetary phenomenon; hence, arguing that price stability in goods and services and exchange rate can be attained by adjusting interest rates. The rebased consumer price index prompted a slowdown in rising prices, motivating SBP to cut the discount rate but a closer look at the index provides clues that inflation may head northward in coming months. Monthly average increase in CPI stood at 1.2 percent in first four months of this fiscal year. However, high base effect has kept the yearly numbers low, for now. Assuming a modest one percent hike in the index, per month; CPI for the second half of this fiscal year would average 13.45 percent. The recent revision of Rs.100 per maund in wheat support prices will only exacerbate this tally. So, does the argument of keeping real interest rates at zero imply some hike in rates come January? Is it a wise decision to have high volatility in interest rates? What signal this is giving to domestic and international investors? SBP monetary policy committee should ponder upon these questions before it passes recommendations to the SBP board on Wednesday. The elephant in the room is the fragile balance of payments. From the beginning of this fiscal year SBP foreign reserves are down by about $1.3 billion. Mind you, the crises faced by the country in 1998 and 2008 were both spurred by imbalances on the BoP front. The financial account has seen no significant inflows of late. FDI is at multi years low as it attracted a mere $340 million in Jul-Oct, while portfolio investment is pouring out thanks to the eurozone crisis and the lack of structural reforms at home. In October alone, financial accounts slipped by $655 million. The only silver lining in the previous year came in the form of the current account which is in deficit of $1.5 billion in first four months of this fiscal year. The export bonanza witnessed last year has also screeched to a halt as commodity prices have eased from historic highs. Prices of textile exports will also reflect this fall in coming months. On the imports front, any further hikes in oil prices may pose serious threats to economic conditions at home. The sustained growth of remittances is also not a certainty and even extrapolating these transfers at similar growth rates projects a current account balance stymied by $3-3.5 billion FY12 compared to last year. With major IMF repayments commencing from February any extraneous shock could rattle the local currency. The reactive tightening introduced by SBP in 2008 had compounded economic woes back then. Should the central bank not be more proactive this time around? Last but not the least, the fiscal fiasco continues unabated and the fiscal deficit will likely stay above six percent of GDP. OMOs worth Rs.300 billion are not just highlighting the liquidity crunch; rather they are symptomatic of the commercial banks overwhelming investments in government securities, which is as inflationary as promissory note printing. Proponents of a rate cut should look at private sector credit growth after the cut of 150 bps-it fell by Rs.48 billion, year to date while commercial banks lent Rs.621 billion to government in the same period. It is crystal clear that lower rates have failed to entice private investors who seem preoccupied by the lack of energy, political stability and law and order in the country.
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