Analysing certain key variables, Business Recorder had forecast exactly two weeks before the announcement of the Monetary Policy Statement (MPS) on 30th January, 2010, that the State Bank of Pakistan (SBP) was likely to retain the discount rate at 12.5 percent for the next two months.
The fact that our guesstimate turned out to be true, shows in a small way that monetary policy formulation at the SBP is now, more transparent and rule-based. To be more specific, the assessment of the present situation seems to have persuaded the SBP to keep the discount rate and all other elements of the monetary policy unchanged. It had lowered the policy rate by a cumulative 150 bps during the first half of FY10; by 100 bps in August and 50 bps in November, in response to the expectations of easing of inflationary pressures.
The average CPI inflation had declined to 10.3 percent during July-December, 2009 as compared to 24.4 percent in the corresponding period last year, but there was now considerable uncertainty about the continuation of this trend. According to the State Bank, the inflation outlook for the full FY10 is susceptible to fiscal consolidation efforts, incipient international commodity price pressures and the announced and planned increases in electricity and gas prices.
Added to these developments was the difficult-to-assess negative impact of the law and order situation and power shortages on the productive capacity of the economy. All these factors influence people's expectations and impart stubbornness to inflation. Based on these considerations, the SBP now expects the average CPI inflation to remain between 11 and 12 percent during 2009-10.
So far as the real economy was concerned, agriculture was showing some improvement and there was also a modest recovery in the LSM. The SBP was now expecting real GDP growth at around 3 percent, compared to a 2 percent growth in FY09. Key factors holding back GDP growth were persistent power outages, water scarcity and a very challenging security environment. Progress in the external sector was encouraging.
As a result of the favourable trade outlook, combined with projections of other components like home remittances, the SBP has projected a current account deficit of 3.4 percent of the GDP for the current year. However, its foreign exchange reserves are projected to be close to dollar 15 billion by the end of June, 2010, as compared to dollar 10.6 billion as on 27th January, due to a surplus in the overall balance of payments on account of expected inflows from various sources.
However, the State Bank sees considerable difficulties in achieving the fiscal deficit target of 4.9 percent of GDP or Rs 740 billion due to significant pressure on expenditures and shortfall or delay in projected foreign inflows and non-tax revenues on account of foreign reimbursements. A substantial amount of outstanding credit for commodity operations, the continued flow of credit to PSEs and lingering inter-agency circular debt would also add pressure to resources.
SBP, in its own opinion, has effectively managed liquidity to support the smooth functioning of the market, reduced volatility in the interbank overnight money market repo rate and ensured consistency in the monetary policy stance. After taking into account the behaviour of various sources of monetary growth, M2 was expected to expand by around 14.5 percent during FY10.
Overall, the State Bank is of the view that much has been gained on the macroeconomic stability front despite a very challenging environment, but a lot of work still needs to be done to consolidate this stability. We strongly feel that there can hardly be any counter-argument to the SBP's own prognosis of the economy and the direction of its monetary policy.
Modest improvement in agricultural and manufacturing sectors, pick-up in private sector credit and some increase in demand for exports by our trading partners are some of the positive developments but their impact on growth may not be very significant due to persistent energy scarcity, poor security environment, etc. SBP's estimate of the GDP growth rate of 3.0 percent for FY10, therefore, appears to be realistic.
Similar is the situation with the external sector that is likely to show improvement. Nonetheless, it is most perturbing to see fiscal slippages and undue dependence of the government on foreign sources of finance. The increasing need for credit for commodity operations and for PSEs, together with lingering circular debt, are further compounding the problem of fiscal management.
While this underscores the need to improve the fiscal outcome through domestic measures of resource mobilisation and pruning current expenditures, the PSDP often becomes a casualty and monetary policy, hostage to fiscal mismanagement. For instance, budgetary developments this year have forced the government to cut PSDP by 30 percent and coerced the State Bank into adopting a tight monetary stance.
As if this was not enough, the inflation outlook at present is highly susceptible to both domestic and external developments that are highly uncertain at the moment. An inflation rate, between 11 and 12 percent during 2009-10, is projected but it could be even higher than the estimates.
Most probably, the SBP did not anticipate the announcement of a steep increase in the price of petrol and other oil products by the government with effect from 1st February, 2010 that would push up the domestic price level beyond its expectations in the coming months.
A projected increase of only 3 percent in the real economy and a higher increase in M2 than the rise in nominal GDP may further exacerbate price pressures on the economy. In this situation, it is highly unlikely that the SBP can soften its monetary policy stance.
In fact, if the expected inflationary pressures emerge in the economy due to negative developments, an upward revision in the policy rate in the next few months cannot be discounted. Those who are known for their advocacy of lowered interest rates in Pakistan, on the basis of a comparison with other countries, often overlook the fact that the inflation rate in the rest of the world is very low and idle, productive capacity quite high.
While there is nothing wrong with the current monetary policy stance, it would be appropriate for the SBP to look deeply into certain areas within its domain. Non-performing loans have tended to rise in the recent past. Although, there are certain valid reasons for this, including a difficult situation for business and industry, this negative development cannot be ignored for long. Bank spreads continue to be phenomenal with obvious implications for the economy.
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