The annual report of the State Bank, released on 30th October, 2004, gives a fairly comprehensive assessment of the economy for the year 2003-04 and outlines likely trends for the current year. The robust growth of 6.4 percent during Fy04 was not only substantially higher than the 5.1 percent increase recorded during 2002-03 but was also well above the 5.3 percent target for the year.
The growth was led mainly by industry and in particular Large Scale Manufacturing (LSM) which recorded a rise of 18.1 percent, the highest in the last three decades. High growth in manufacturing was the result of domestic aggregate demand expansion facilitated by an accommodative monetary policy, and increased external demand aided by a stable exchange rate and a very low export financing rate. While talking about manufacturing and growth, the State Bank has also made certain pertinent remarks.
The aim to sustain the growth momentum in the LSM amid perceived vulnerability of this sector to interest rate increases, was the key determinant of the SBP decision to only gradually increase interest rates in the face of rising inflationary pressures.
The central bank was keenly aware of the rise in headline inflation and the attendant increase in inflationary expectations but tried to strike a balance between the growth and inflation management imperatives. The quality of growth for Fy04 was poorer compared to Fy03, being quite concentrated in only a few sector, ie LSM, electricity and gas distribution, wholesale and retail trade and construction.
Investment activity in the country witnessed a strong revival. In nominal terms, total investment rose by an impressive 22.3 percent during Fy04, the highest ever in the recent history of Pakistan, pushing the investment - GDP ratio to 18.1 percent compared with 16.7 percent in the preceding year. However, the ratio of national savings to GDP fell to 19.8 percent from a record high of 20.6 percent in Fy03 due to substantial decline in private savings and negative growth in net factor income from abroad.
On the fiscal front, the government not only managed to post higher revenue collection but was also able to contain expenditures to bring down the fiscal deficit to 3.9 percent of GDP from 4.5 percent in Fy03. However, development allocations again showed underutilization of Rs 5.6 billion during Fy04. Private sector credit grew by a record level of Rs 325.2 billion or more than twice the cumulative net credit expansion in the preceding three years.
The year 2003-04 also witnessed a sharp resurgence of inflationary pressures with CPI inflation ending a seven-year downward trend. According to the State Bank, "the concentration of inflation in food and other essentials also raises concerns over the impact on low-income groups." The current account surplus at US $1.8 billion during 2003-04 was substantially lower than US$4.2 billion registered in the preceding year.
The country's debt profile improved further for the third successive year. "Not only did the debt bearing capacity of the economy increase but the growth in outstanding debt was insignificant."
As for Fy05, the State Bank expects the growth momentum of the economy to continue. The continued strong performance of industry and reasonable showing by agriculture are likely to support real GDP growth of over 6 percent but the inflation target of 5.0 percent may not be met. The risks to the economy emanate mainly from high oil prices that can adversely affect the current account and fiscal balance, putting pressure on exchange and interest rates.
"This exogenous shock can be amplified if the water shortages (1) reduce wheat output and other Rabi crops, and (2) raise demand for imported fuel oil to generate electricity." However, "these risks can be mitigated if exports and remittances continue to show better than assumed results, government revenues exceed their target, wheat supplies are augmented through timely imports, development expenditure is not curtailed, and gas and coals are increasingly used for power."
The distinguishing feature of this year's report, in our view, is a clear tilt towards analysing the economic events rather than usual description of developments based on a variety of statistical sources. At a number of places, various policy alternatives have been discussed and the reasons recorded for preferring one option over the others.
This is bound to enhance the value of the report among the people familiar with economic developments of the country. Another quality of the report is its objectivity. Unlike other official documents, it offers criticism at appropriate places with some justification. For instance, the government has all along boasted about high GDP growth rate during 2003-04 and claimed that it is sustainable.
The State Bank has indirectly challenged both these claims by saying that the quality of growth was poorer during 2003-04 and economic performance highlighted the vulnerability of the economy to shocks. On the other hand, the report is quite generous about certain positive developments. According to the State Bank, acceleration in investment would lead to continuation in the industrial growth momentum in the years ahead. Reduction in fiscal deficit has been attributed to the successful efforts of the government to boost revenues and contain expenditures.
Another valuable contribution of the report is the clear warning about the risks to the Fy05 prospects. The exceptionally high escalation in oil prices could adversely affect the current account and fiscal balance of the country which would put pressure on exchange and interest rates. Water shortages would hit many major crops and inflation target of 5.0 percent was not likely to be met. Already, there are clear signs that the economy will face a number of problems in the coming months and favourable trends of the last few years could undergo a reversal. For instance, the trade imbalance has widened to $839 million in the very first quarter and may rise to well over $5.0 billion by end-June, 2005 as against the target of $3.0 billion.
The international oil prices are hovering around at a peak level of $55 a barrel and still remain unpredictable. There is the unforeseen demand for import of wheat because of bad wheat crop and the government is left with no choice but to provide generous subsidy in wheat trade. Urea is being imported while reduced water levels in rivers have affected hydle power generation, which would warrant import of more fuel oil.
Price spiral has pushed inflation to near double digit and the Utility Stores Corporation has been asked to provide 450 items of daily consumption at 5 to 10 percent less than the market prices. The rupee has lost by about 4.0 percent against the dollar during the current year despite the fact that US dollar is losing value against other major currencies in the international market. All these unfavourable developments have left the common people and the businessmen guessing and worried.
They are wondering about the tall claims of the government of economic gains on all fronts and watching with fear the situation unravelling before their eyes. The State Bank, in our view, has done a service by highlighting the uncertainties and suggesting measures to mitigate the risks but the dream of the common man of a better future, at least in the short-run, stands shattered.
Ironically, however, the policies falling within the domain of the State Bank also need to be reviewed because, to a large extent, they are not based on very valid assumptions. After going through the report, one clearly gets the impression that the State Bank feels that supply side shocks, particularly the shortage of wheat, was largely responsible for acceleration in inflation and only a gradual increase in interest rates was required to contain demand to subdue inflationary expectations. It is also concerned about striking a proper balance between growth and inflation management.
At his press conference, the Governor, however, declared that "if inflation starts going up, we will not hesitate to fight it with raise in interest rates." In our view, time has come to refrain from giving confusing signals, think clearly and act boldly to ensure that inflation is contained within a tolerable limit of around 6 percent or so. The main reason for acceleration in inflation is that for the third successive year, growth in monetary assets in Fy04 has outstripped the rise in nominal GDP.
"In fact, the 19.6 percent growth in M2 during Fy04 was the highest in the last 12 years". Injection of such high doses of liquidity in the economy unaccompanied by similar increases in availabilities is bound to exacerbate price pressures which can now only be controlled through strict monetary management by increasing the interest rates adequately.
This is essential because rising inflation always favours the rich and punishes the poor and it is the fundamental responsibility of a central bank to ensure price stability. The State Bank has also been shifting its stand on exchange rate policy.
Only a few days back, the Governor had announced that the State Bank would let the rupee depreciate according to the market conditions and intervene only to smooth excess volatility but at the press conference on 30th October, he declared that the rupee would be kept stable and strong despite the rising oil prices and all payments for oil imports will be met from the existing foreign exchange reserves of the State Bank.
The latest declaration would entail a high cost to the country in terms of fall in foreign exchange reserves but still may not be enough to protect the rupee for a long time. It would be much more prudent to let the rupee find its own value which would also ensure a reasonable balance in inflows and outflows of foreign exchange in the long run and obviate the need to intervene heavily in the market.
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