The message from the State Bank of Pakistan (SBP) is unambiguous. It will not be unduly moved by demands from certain quarters for a substantial downward revision in its policy rate, but would base its judgement on its own analysis of the situation.
Such an approach was clearly visible in the Monetary Policy Statement (MPS) released by the State Bank on 24th November, 2009 when it opted to reduce the bank rate only by 50 bps to 12.5 percent, as against the market expectation of a higher rate cut of around one percent.
Explaining the reasons for its cautious attitude, the State Bank stressed the point that although key macroeconomic indicators had shown considerable improvements, yet there were formidable risks to the economy, warranting a conservative thinking on the subject.
On the positive side, inflation had fallen to 8.9 percent in October, 2009 and was expected to remain in the vicinity of 11 percent by the end of the current fiscal year. The external sector account had improved vastly, altering its projected trajectory. Government borrowings and money supply were contained along the projected path. The real sector was also showing signs of improvement as large-scale manufacturing (LSM) had staged a recovery after a protracted declining phase.
However, the SBP was not so sure about the sustainability of these improvements. It was of the view that factors like poor administration in the supply chain of some food items, a higher than projected fiscal deficit for the FY09, the impact of electricity and gas price adjustments and the recent resurgence of international commodity prices remain a source of uncertainty for the inflation outlook. In the external sector, improvement in the balance of payments position crucially depends on the resumption of foreign financial flows.
The public sector's steady borrowing requirements had the potential to raise the Net Domestic Assets (NDA) of the banking system. After reviewing the situation from various angles, the State Bank concluded in the MPS that overall level of risk and uncertainty had increased considerably due to the present law and order situation, pressure on the fiscal position had escalated, growth in the real economy was limited and striking a balance between monetary stability and growth had become increasingly difficult.
It was against this background that the SBP had decided to support the recovery of the economy, while keeping a close watch on developments concerning macroeconomic stability in the next two months. On the face of it, the State Bank's analysis of the economy and its decision to reduce the policy rate by 0.5 bps would appear to be largely appropriate. Of course, deceleration in the inflation rate was not yet entrenched, foreign financial flows were uncertain, the fiscal position was still weak and recovery of the economy was slow.
The likely developments in these areas, as perceived by the State Bank, seem to have acted as a big constraint to act boldly and in an objective fashion. In our view, there was hardly any need to be so pessimistic when some of the fundamental variables affecting the formulation of monetary policy were showing such a visible improvement.
The inflation rate, which is the major determining factor in this context, had declined from a peak of 25 percent to only a single digit in October, 2009, the latest month for which the data was available. The second most important area of concern in this respect is usually the current account deficit of the country, which had improved tremendously (by 84 percent) during July-October, 2009.
The governor had himself stated a few days ago that to fill the gap in the foreign sector was not a big issue any more. The rupee rate had, more or less, stabilised and the level of foreign exchange reserves of the country was steady at a comfortable level. The army was winning the war against the terrorists and this could be a precursor of a better law and order situation in the country.
There was also some recovery in the LSM sector. The apprehensions of a large fiscal deficit that could again trigger inflationary pressures were not well-founded due to the strict covenant agreed with the Fund. The argument that the economy is still prone to risks and uncertainties would never allow the SBP to take an optimistic view, as such, this would always remain an integral part of the economic outlook.
There was no doubt that a continued tight monetary stance of the State Bank had paid dividends in regaining financial stability but such a stance, in view of the latest developments, needed to be revisited in the latest MPS to make an appreciable difference on the behaviour of the entrepreneurs.
The SBP has claimed that it "has decided to support the recovering real economic activity" together with certain other objectives but, as everybody including the business community could see, a reduction in policy rate by a very small margin, of only 50 bps to 12.5 percent, is insufficient to make a meaningful impact on the investment plans of a business enterprise.
Apparently, a larger cut of about one percent in the discount rate would have been more beneficial in increasing credit demand in the private sector and helping the recovery process. Nobody knows it better than the SBP that though inflation is essentially a monetary phenomenon, yet higher growth rate and larger availabilities in the economy also impact price levels significantly.
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