The impact of monetary tightening pursued in FY06 as well as the policy signals through the FY07 changes, is already evident in the slowdown in private sector credit growth, which has dropped to 5.9 percent during July-November FY07 against the 10.9 percent growth witnessed in the corresponding period of FY06.
Moreover, core inflation, as measured by non-food non energy (NF-NE) inflation has slowed to 5.6 percent (YoY) in November 2006 from 7.6 percent (YoY) in November 2005. This was stated in the State Bank of Pakistan's (SBP) First Quarterly Report for the year 2006-2007 issued here on Thursday.
However, the growth in monetary aggregates during July-November FY07 remained strong. This was because of the deceleration in private sector credit has not been matched by an equally strong decline in government borrowings, which have remained significant; and the contraction in NFA during July-November FY07 has been much lower than that in FY06.
The impact of continuing pressures on the external account was evident on the NFA of the banking system that showed a contraction of Rs 41.1 billion during July-November FY07, almost equally distributed between SBP and all commercial banks. However, it is important to note that the contraction in the NFA of the banking system during July-November FY07 was considerably lower than the sizeable reduction of Rs 90.5 billion witnessed during July-November FY06. This is largely because the NFA of commercial banks did not decline as sharply as in FY06.
The government borrowings from the banking system are higher and volatile. Although the government may be able to remain within the budgetary borrowing target of Rs 120 billion from the banking system for FY07, excessive borrowing during the course of the year is a source of concern for monetary policy, particularly because the government borrowing is entirely from the central bank, which is the most inflationary in nature as it contributes to reserve money growth.
The high government borrowings and the resulting rise in reserve money, has the potential of re-igniting inflationary pressures in the economy. If this happens, the time path for achieving a stable low inflation could be extended, as in the absence of low stable inflation, the central bank would have to keep interest rates high for a longer duration.
The government has however, sought to increase its non-bank borrowings. Unfortunately, instead of raising these incremental funds entirely through PIB issues, the government has also re-allowed institutional investment in NSS. While the latter decision would, in theory, allow institutional investors to rollover large NSS maturities, this major policy reversal is likely to have significant negative implications for the development of the domestic debt market, and raise interest rate risk for the government.
In contrast to government borrowings, the private sector credit seems to be responding to interest rate signals from the central bank. Specifically, the growth in private sector credit during July-November FY07 has slowed down to 5.9 percent compared to 10.9 percent rise witnessed during the corresponding period of the previous year.
However, so far, this slowdown in private sector credit growth is not a source of disquiet for SBP for the following reasons:
The YoY growth in private sector credit remains very strong at 18.0 percent by November 25, 2006, although down from 31.9 percent last year. A review of monthly trends in private sector credit shows that the slowdown is largely concentrated in the month of September 2006. In fact, trends during October and November 2006 indicate presence of strong demand for private sector credit in the economy.
The available evidence suggests that the slowdown in private sector credit is not broad-based as the increased net retirement, particularly by the sugar manufacturers during July-November FY07 contained the growth in private sector credit; and deceleration in bank credit against equities.
More importantly, while the nominal lending rates are rising, the real lending rates are still very low. The real lending rates under export finance facility are even negative. In sum, though the overall demand for credit by the private sector has decelerated, the slowdown is not broad-based. This suggests that monetary policy needs to remain tight.
However, while the transmission of the monetary policy on lending rates has improved over the last year, the impact on deposit rates has been less than desired, contributing to an unhealthy high banking spread. The available evidence shows that banks are mobilising deposits at higher returns and the share of such deposits has been rising. Since the long-term deposits lower the maturity mismatch for banks and reduce liquidity risks, it was expected that the banking spread would decline. But in the meanwhile, lending rates have also risen thereby leading to a sharp rise in the banking spread (calculated on the basis of incremental loans and deposits) in recent months. Such a large spread can have a dampening effect on economic growth by discouraging savings.
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